Entrepreneurial_Finance_Lecture_1

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					    Entrepreneurial
Finance, Private Equity
         and
    Venture Capital


                          1
Admin & General
1. Office: Leslie Commerce 5.37.
2. Core Available times:
  •   Mo and Thu from 9:00 to 12:00, otherwise
      by appointment.
3. One exam, one assignment.

4. Reading pack.

5. Numbered slides and notes.

                                                 2
          Times and Dates
1. Four Lectures.
  •   19, 26 April, 3, 10 May.

2. Exam:
  •   17 May, 15:00.
  •   Venue: Jameson Hall (unless otherwise
      informed).
  •   Lectures, reading packs and general
      insights.

3. Course Assessment
  •   70% Exam, 30% Assignment.
                                              3
               Course Goals
•   Understanding the pros and cons of various options
    for entrepreneurial financing.

•   Apply general investment concepts in entrepreneurial
    settings.

•   Understanding the workings of V/C and P/E.

•   The basics of assessing a proposed equity
    investment in an idea or business.

•   Not everybody ends up in the corporate world or
    investment industry.
                                                           4
          Course Structure
Lecture 1:
Entrepreneurship and funding options.

Lecture 2:
The V/C and P/E industries.

Lecture 3:
Looking at the investment.

Lecture 4:
?? Plus assignment plus exam discussion

                                          5
                    Assignment (1):
•       Topic: A basic business plan of a novel business idea / concept / product.

•       Target Audience: A venture capitalist or VC firm.

•       Objective: To obtain funding from the venture capitalist to start the business.

•       Format: MS Word format. Maximum length of text: 15 A4 pages of (minimum)
        font 11.

•       Should include (at a minimum):
    •       A description of the concept
    •       The need and how this idea will satisfy it
    •       The target market
    •       Why it would be a good investment for the venture capitalist (build an investment
            case).
    •       The financial case (attached financial projections as an Annexure)
    •       Competition issues.
    •       A clear indication of the amount of funding that will be required and why.

•       Annexures may be added to the above (e.g. supporting material, competing
        products etc., website info, additional research etc.).

                                                                                                6
    Assignment: Practical Arrangements
•    To be done in groups of between 3 and 5.
     You are expected to form your own groups timeously and will not be required
     to register your groups in advance.
     Assignments handed in by groups of more than 5 or less than 3 members will
     automatically be marked down 25%.
•    The key will be to be original, comprehensive and concise within the space
     constraints
•    Deadline for hand-in: 12:00 on 10 August 2007 to Tina Petersen (LC 5.28)
•    Grading will be on a relative basis – therefore there is no absolute right or
     wrong.
•    Remember you will be graded on how well you achieve your objective, namely
     to convince the venture capitalist of the size of the opportunity, the novelty of
     the idea, the profits that can be made from it etc.
•    Therefore, you have to achieve a fine balance between being creative and
     being realistic. The more realistic your assumptions, idea, financials etc,. the
     better your mark will be. This is an exercise in realism, not a license to dream
     or go on a flight of fancy.
•    In short: You have to come up with an idea that can work and that can make
     money, and you have to be able to sell this idea as being realistic and
     profitable in order to get funding from a VC, which is your objective.

                                                                                         7
Would you invest in these guys?
This guy did…




       Dave Marquardt,
 Technology Venture Investors
                                9
    Microsoft as an investment
•    1981
     Revenues:                 $16,000,000
     Employees:                128

        TVI buys 5% of Microsoft for $ 1,000,000

•    2005
     Revenues:                 $39,000,000,000
     Operating Income:         $4,200,000,000
     Employees:                31,000
     Market Value (4/05):      $266,000,000,000

                  5% = $13,000,000,000
                                                   10
 Which is a return of…



       48,4%

per annum over 24 years!
                           11
Could this happen at UCT?




                            12
  Lecture 1:
Entrepreneurial
  Financing




                  13
    Lecture Structure

1. Entrepreneurship.

2. Funding needs and basics.

3. Sources of finance.

                               14
   What is Entrepreneurship?

“The act of initiating, creating, building
and expanding an enterprise or
organisation, building an entrepreneurial
team and gathering other resources to
exploit an opportunity in the marketplace
for long-term gain.”

Van Aardt, Van Aardt and Bezuidenhout in “Entrepreneurship and New Venture Management”




                                                                                         15
      Personal Attributes
1. Are you considering starting your
   own business at some stage?

2. Do you have start-up skills?

3. Do you see opportunity?

4. Do you know an entrepreneur?
                                   16
Personal Attributes




                      17
2006 Entrepreneurship Survey




     South Africa




                               18
At least SA ladies rank slightly better…




              South Africa




                                           19
Obstacles to SA Entrepreneurs




                                20
Entrepreneurial Businesses
• Family owned businesses.
     • 80-90% of US businesses.
     • >50% globally.

• Franchises.
     • 188 registered with FASA. Many
       more 100’s of outlets.

• Home-based Businesses
 •   Over 50% of small businesses.

                                        21
        Cash Flow of a Business Venture
                                          Capital
                                      (equity and debt)

                                  Infusions
                                       Beginning cash
                                                                         Reinvestment
                   Expenditures                                          (to retained earnings)

                     Employees              Materials     Fixed Assets

                     Production

                                            Inventory         Credit Sales

                                 Cash sales                         Accounts
                                                                    Receivable

                                         Ending Cash           Collections




           Equity Returns                 Debt Service            Taxes

2000, Entrepreneurial Finance, Smith and Kiholm Smith                                             22
Cash Flow Profile of a Business

                     Cash Break
                        Even                  Net Cash
                                                Flow
         Cash Burn

                                              Cash In


                                              Cash Out


                           Efficiency Gains

 Capex




                                                   23
 Factors Increasing Cash Needs
1. Capital investment needs.
2. High rates of sales growth – investment.
   in working capital.
3. Protection of intellectual property (IP).
4. Marketing and brand building costs.
5. Research.
6. Large established competitors (“deep
   pockets”).
7. Low profit margins.
                                          24
And then there is Tax…




                         25
    Option1: Raise as much as possible.

•   Available for emergencies (a “rainy day”).

•   Ability to benefit from unforeseen
    opportunities.

•   Good for morale / feeling of security.

•   Improves credit rating from banks and
    suppliers (reduces cost of further capital).

                                             26
Option 2: Raise as little as possible.

•   Cost of capital (interest or equity).

•   Excess liquidity promotes wastage /
    bad financial discipline.

•   Reduces risk in case of failure.

•   Promotes a focus on cash flow.


                                            27
Financing Option Determinants

1. Firm’s economic potential

2. Life cycle stage of company

3. Assets

4. Owner preferences
                                 28
    Returns: Debt vs. Equity
                                  Funding option
                                 Debt      Equity
Owners’ Equity                   100         100    For 40% share
External Equity                              100
Debt                             100

Assets                           200         200


Pre-Interest Profit               50         50
Interest at 10%                   10
Net Profit                                   50
Profit Attributable to Founder    40         30
                                                     60% of profit
Return on Equity                 40%        30%
                                                               29
          Financial Cost of Debt
Assume a successful business:                  Net cash flow
                                                before debt
                                                                 Net cash flow
                           Cost of                             after cost of debt
                            Debt
          Cash flow
           deficit

+
0                                                                             Time
-
                                                               Term of Debt

      Debt capital                        Cash Break-even
                       Cash Break-even       after debt
        amount           before debt


Fin. cost of debt    = PV (interest and capital repayments – loan proceeds)
                                                                                30
       Financial Cost of Equity
 Assume a successful business:                Net attributable
                                                cash flow




          Cash flow                                              FV of Equity
           deficit                                                sacrifice

+
0                                                                   Time
-

                      Cash Break-even

         Investment


Financial cost of equity = PV (future cash flow sacrifice – investment)

                                                                           31
    Financial Choice: Debt vs. Equity
Assume a successful business:                     Net attributable
                                                    cash flow

                                      Net cash flow
                                    after cost of debt
                                                                         FV of Equity
         Cash flow                                                        sacrifice
          deficit
                                                               Cost of
+                                                               Debt
0                                                                             Time
-                                                        Term of Debt

                         Equity    Debt
       PV of Capital     Cash Break-even
      amount of loan /
        investment

      Cost Difference: PVs of
                  (interest and capital repayments – loan proceeds)
                - (future cash flow sacrifice – investment)                      32
Other Considerations: Equity
•   Irreversible (-).
•   Skills and experience (+).
•   Networks and contacts (+).
•   Personality issues (-/+).
•   Recapitalisation (-/+).


                                 33
Sources of Funding
•   Own Funds.
•   Family and Friends.
•   Bank Finance (Loans).
•   Government Funding.
•   Community Based.
•   Angel Financing.
•   Venture Capital.
                            34
The Main Considerations.
• Involvement of the financier
  (good / bad).

• Risk if things go wrong.

• Sacrifice of upside.

                                 35
                Own Funds

Pros                 Cons

Retain all equity.   Own capital / at risk.
                   Least amount of business
Remain in control.
                   support.
Easiest method.      Can be lonely.
Least outside        Increased investment can
involvement.         be tricky.

                                                36
 Family and Friends

Pros                      Cons
Can be cost effective.    Most emotional option.
If venture fails – easy   Outside involvement
exit plan.                when not needed.
Usually little business   Not always familiar with
structure needed.         risks.
                          Limited amounts
                          available.

                                                   37
Downside to Family Funding…




                              38
Bank Financing




                 39
Four “C”s of Credit Granting

• Character.
• Cash Flow.
• Collateral.
• Contribution.


                               40
Bank Financing




                 41
  Barriers of Debt Financing (1)
• Applicant’s lack of collateral.

• Financial institutions lack capacity,
  skills and knowledge to assess risk
  (especially in specialised markets).

• Determining risk vs. potential
  returns is expensive and difficult.

                                        42
  Barriers of Debt Financing (2)
• Often no track records and history
  to go on (company, management
  and/or financial histories).
• High transaction costs on smaller
  deals.
• Banks look at current CASH FLOW ,
  not potential future cash flow and
  growth.
                                      43
             Bank Financing
Pros                    Cons
No sharing of upside.   Surety or collateral required.

Zero involvement in     Inflexible if venture takes
management as long      longer than expected (always
as interest paid.       the case).
Establishment of a      If venture unsuccessful - bad
credit history.         credit record immediately.
                        Not typically
                        entrepreneurially focused.


                                                         44
           Government Financing
•       Based on government objectives, e.g.
    •     economic growth.
    •     job creation.
    •     technological innovation.
    •     Ownership transfer - “black empowerment”.

•       Tax money.
•       Generally not grants – can be “soft loans”,
        equity participation or partial subsidisation.
•       Examples: Umsobomvu, IDC, Khula.
                                                         45
       Government Funding
Pros                      Cons
Low risk to               Bureaucracy & red tape –
entrepreneur.             slow decisions.
Funder may accept
                          Lack of guidance and
lower returns as often
                          involvement can be
not commercial criteria
                          detrimental.
only.

                          Funder does not have
Cheap option.
                          direct / personal interest.

                          Terms and conditions
                          can be inflexible.
                                                    46
        Angel Financing
• Local networks of investors
  (friends, business associates etc).
• Invest close to home.
• In familiar markets & technologies.
• Required investment returns lower
  than venture capital funds.
• Fairly informal terms & conditions.
• Example: Ellerine brothers.
                                    47
           Angel Financing
Pros                         Cons
Very effective and           Can be restrictive due
flexible: quick decisions.   to investor involvement.
Sophisticated investors -
                             Difficult to find in South
excellent business plan
                             Africa.
needed.
Can bring on much            Decision making can be
needed expertise.            emotional.
Well networked.
Access to future capital
is easier.
                                                     48
        Venture Capital
• Similar investment principles to
  angel investors.
• Structured investment businesses.
• Equity for money.
• Examples: Brait (listed), Ethos
  (part of RMB), HBD etc.


                                  49
           Venture Capital
Pros                     Cons
Comprehensive            Expensive – may have to
selection process.       give up too much equity.
Strong likelihood of a
                         Depressed valuations.
good venture.
Secondary funding        Reduced control and
usually easier to        restrictions on ability to
access (at a price).     take actions.
No regular cash          VC’s usually require very
outflows (e.g.,          high project returns.
interest).
                                                      50
    Benefits of V/C Involvement
•         Sounding board for management
          team.
•         Access to further equity funding.
•         Interfacing with investor group.
•         Monitoring financial performance.
•         Monitoring operational performance.
•         Obtaining alternative debt financing.

Source: Iwisi D.S., Kitindi E.G., & Tesfayohannes, M. 2003. “Venture Capital: Overlooked Financing Source for SA Small Businesses”

                                                                                                                                     51
   Other Forms of Finance
• Barter.
• Supplier financing.
• Factoring.
• Leasing.
• Credit cards.
• Community, e.g. “Stokvels”.
                                52