Financing Your Business Presented by: David Hessler October 17, 2006 GBA 491.

Financing Your Business

Presented by: David HesslerOctober 17, 2006

GBA 491


Outline:– Background– Hessler background/biases– Sources

• “F, F & F”• Grants and Debt• Seed Equity• Venture Capital

– Questions?


Why Financing?– Seems obvious, but not

necessarily– Integral part of the plan for

the business (and “Business Plan”)

– Varies by type of business


How much spending is necessary/desirable before cash flow breakeven?– Financing should be a MEANS

to an end, not an END in itself.


David Hessler:– Technology entrepreneur– $ from/to friends and family– Past guarantor of “serious” debt– Financed by Angels– Ran venture fund; “successful” Angel

investor• Closed many debt & equity deals

– BEEN ON BOTH SIDES OF THE DEAL


Sources of Growth Capital– Personal assets– Company balance sheet– Grants– Loans– Equity– Strategic Alliances/Licensing


SOURCES OF GROWTH CAPITAL

Personal Assets:– There IS a level below which you cannot

start a company– “Need money to raise money”

• Staying power• Responsibilities/need for current income

– Part of this is short term salary expectations.


SOURCES OF GROWTH CAPITAL Trade debt – accounts payable

− Positive “float” can often be negotiated with vendors/customersA. Pre-paymentsB. Progress payments (Gov’t contracting)C. Extended payment terms from

suppliers In hopes of future business For equity (?)

D. Factoring



For technology start-ups, grants can be key

1. Small Business Innovation Research (SBIR)

2. Cooperative Research & Development Agreement (CRADA)

3. Local government (few)


SOURCES OF GROWTH CAPITAL Senior, secured debt− Usually commercial banks

− Common misperception:− – BANKS DON’T FINANCE LOSSES !

− Need multiple collateral sources− Assets: A/R – 80%,− Inventory – 20-60%,− Fixed assets – 50%

− Cash flow – debt service as small % of earnings/cash


SOURCES OF GROWTH CAPITAL Senior, secured debt (Cont’d)

– Additional collateral / common issue:− Personal guarantee

1. (Almost) always required2. Considered a show-of-faith by

borrower3. All 20% owners (?)4. “Joint and several”5. Important to equity investors as well6. Can be reduced over time


SOURCES OF GROWTH CAPITAL Senior, secured debt (continued)

• Many costs beside interest rate• Usually includes difficult covenants

Profitability Coverage ratio Prohibited borrowing Liquidity

UCC Filings SBA Loans



Junior secured debt− Sometimes used when collateral

can be segregated− Used for unique asset− Vendor financing− Inter-creditor agreements



Unsecured (subordinated) debt− Varies widely in terms, prices covenants, etc.

A. Used when bank rules cannot be metB. Almost always more expensiveC. May include an “equity kicker”D. Different “personality”

1.Gunslinger2.Dealmaker3.Tough

E. Inter-creditor (?)F. May trigger bank covenants


SOURCES OF GROWTH CAPITAL Convertible, subordinated debt

− Varies widely in terms, prices & covenantsA. Often really an equity investment, but

with extra protection (liquidation preference) for the investor

B. Key features1. Term2. Interest – rate, timing3. Conversion price (to what Security?)4. With, without detachable equity

featureC. Terms are (usually) part of the Security



Convertible Preferred stock− Senior rights in liquidation, AND…

A. Security of choice for VC’sB. Always convertible to Common (VC version)C. Allows for numerous special termsD. Can be issued in multiple classes (A round, B

round, etc.)

Common stock− Typically held by founders, friends-and-family,

etc.


BREAK


Equity Financing


Venture Capital: Part of the larger asset class of “private equity” Definition: Money provided by

professionals who invest alongside management in rapidly growing companies


– History 1920’s - DuPont Financing of GM 1930’s - Rockefellers Back Entrepreneurs 1946 - American Research & Development (ARD) 1950’s - Shockley transistor/Fairchild; Haloid/Xerox 1960’s - SBIC & Private Partnership Proliferation 1970-75- Industry shakeout 1978+ - “Boom” in Venture Capital

--20% capital gains tax rate --SEC Rule 144; S-18 -- ERISA Exemption

1980s – Growth of the “Mega fund” - Bigger Deals, Geographic concentration

1990s – Bigger Funds, Bigger Deals - Record Returns (1999 Vintage, 100%+ IRR)

2000+ - Serious Slowdown/Troubled Portfolios 2004-06 - Coming Back to “Normal” (?)


Stages of Venture Capital:– Seed: Business plan; market validation;

technical feasibility– Start-up: Prototype development; non-

revenue customers; company infrastructure

– First Stage: Initial Mfg.; revenue generation

– Second Stage: Shipping , but not profitable– Third Stage: Profitable, need expansion– Bridge Financing: Additional growth prior to

liquidity event


Venture Economics (Example):– $300M Fund Raised from:

• Pension Funds• Endowments• Foundations• Corporations• Individuals


Venture Economics (Example):– Managed by ten principals– Annual Fee: 2.5%, ($7.5 Million/yr.)

Pays office staff, travel, principal salaries, etc.

– Returns: 5X growth over 5 yrs: - $300M becomes $1.5 B (35-40%)

- Gain: $1.2 B- VC Team gets 20% $240M (split 10 ways)


Common Myths:– VCs want majority control– Founders/owners get ‘fired’


“Venture Capital is not for most companies.”– Millions of privately-held businesses– 700,000 new businesses formed

annually– But only 3000-5000 venture financings

annuallyInvestors seek 10x return in 5 years

- Very Rare


Equity Investment, therefore:– Liquidity event is required– Requires size and growth– Means the investor behaves like

an owner


Valuation Example:Year Five Revenue: $100MYear Five Net Income: $ 10MFuture Value (15 P/E) $150MBPlan Investment Req’d $ 10M

VC Ownership: 67% (10X)If B. Plan investment required today is $5M, VC Ownership: 33%


Why not (institutional) Venture Capital?

Small deals cannot attract venture capital:

- Financial capital has grown faster than human capital

- VC requires intense management (Board seat)

- Each VC can only do five boards- With $300M fund, 10 principals,

each deal is $6M (Minimum)


• The good news:• The rise of angel investment:

• Institutional: $22.13B to 2239 companies

$9.9M/deal

• Angel: $20 B to 40,000 +/- companies

$500K/deal

Financing Your Business -Term Sheet Discussion

• The Term Sheet

1. “Shorthand” description of the terms of a proposed investment

2. Delays incurring legal costs until terms are agreed

• Can be more or less company or investor “friendly”


Terms included: Representations & Warranties Positive and negative

covenants Securities description

– - rights & responsibilities


The “mechanics”:• Three page cover letter• Four page security

description


Why required? Investors will (usually) be minority

investors They do not control day-to-day actions Key management actions can “ruin” the

investment

The goal is not control of the company,

it is protection of the investment!


Key Terms:• Series A Redeemable,

Convertible, Participating Preferred Stock

• How many shares; how many $$• Investors: individually or via a

single purpose legal entity


Key Terms:

• Conditions of closing: Business Plan Showing… Receipt of info requested… Declaration of capitalization Employment agreements (salary) Shareholder notes converted “Definitive docs…,” “…no material

change…”


Key Terms: Company pays closing costs (no cap) Exclusivity/no shop

• 30 days (??)• Must terminate other deal discussions• Must disclose other offers to us

Company representations• No breach of any other contract• No broker’s fees


Key Terms: Valuation – spells this out several

different ways • “Fully diluted…” (including provision for

options)• Pre-money total• Per share price

Dividends – provision for:• None• Cumulative/Non-Cumulative• Accrued or cash


Key Terms: Liquidation preference

• A specified amount first, PLUS• Continue to participate with the

Common• Series A Investors get to determine if a

sale/merger is a liquidationMandatory conversion (to Common)

• 2/3 majority want it • IPO of at least $XXX


Key Terms: Redemption at Investor option

• Specified return• After five years• With payment terms

Voting Rights• On an as-converted basis, except• As a class on matters of corporate

control


Key Terms:Board of Directors

• Series A investors specify size of the Board and number of Series A members

• Audit and Compensation committees with independent directors

Dilution protection – full ratchet


Key Terms : Information rights

• Financial statements Annual audited; monthly and quarterly unaudited

• Annual operating plan 30 days before fiscal year• Standard inspection and visitation rights

Two Demand Registration rights after IPO and unlimited Piggyback Registration rights

Pre-emptive rights (to hold % ownership constant)


Covenants: Need 2/3 majority of Investors to:

• Issue stock;• Declare dividends;• Repurchase stock (except employee);• Incur debt greater than $X;• Acquire or dispose of assets greater than

$Y;• Incur capital expenditure greater than $Z• Sell or merge


Key Terms (2/3 Majority):• Transact with related parties;• Amend By-Laws;• Create a subsidiary;• Change the business or enter a new

business

Key Man Life insurance on….


Conclusions:

Sounds difficult, but… There are reasons for the demands Need alignment of goals

and…. Everything is negotiable!


QUESTIONS/DISCUSSION

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Financing Your Business Presented by: David Hessler October 17, 2006 GBA 491.

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