Part IV – Initiating Part IV – Initiating Entrepreneurial Ventures Entrepreneurial Ventures

Chapter 11 – Assessment and Evaluation ofChapter 11 – Assessment and Evaluation of Entrepreneurial Opportunities Entrepreneurial OpportunitiesChapter 12 – Legal Structures for NewChapter 12 – Legal Structures for New Business Ventures Business VenturesChapter 13 – Legal Issues Related to Chapter 13 – Legal Issues Related to Emerging Ventures Emerging VenturesChapter 14 – Sources of Capital for Chapter 14 – Sources of Capital for Entrepreneurs Entrepreneurs

Copyright (c) 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter 14 – Sources of Capital Chapter 14 – Sources of Capital For Entrepreneurs For Entrepreneurs

Debt Versus EquityDebt Versus Equity

The use of The use of debtdebt to finance a new to finance a new venture involves a payback of the venture involves a payback of the

funds plus a fee (interest for the use funds plus a fee (interest for the use of the money. of the money. EquityEquity financing financing involves the sale of some of the involves the sale of some of the

ownership in the venture.ownership in the venture.

Debt FinancingDebt Financing

• Commercial BanksCommercial Banks

• Other Debt-Financing Sources:Other Debt-Financing Sources:– Trade CreditTrade Credit

– Accounts Receivable FinancingAccounts Receivable Financing

– FactoringFactoring

– Finance CompaniesFinance Companies

Source of Finance Throughout the Source of Finance Throughout the Evolution of the Entrepreneurial FirmEvolution of the Entrepreneurial Firm

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HighHigh

LowLowSeedSeed Start-UpStart-Up EarlyEarly

GrowthGrowthEstablishedEstablished

Founder, friends,Founder, friends,and familyand family

Business AngelsBusiness Angels

Venture CapitalistsVenture Capitalists

NonfinancialNonfinancialcorporationscorporations

EquityEquitymarketsmarkets

Commercial banksCommercial banks

Stage of Development of the Entrepreneurial FirmStage of Development of the Entrepreneurial Firm

Equity FinancingEquity Financing

Public OfferingsPublic Offerings““Going public” is a term used to refer to a Going public” is a term used to refer to a

corporation’s raising capital through the sale of corporation’s raising capital through the sale of securities on the public markets. Here are some of securities on the public markets. Here are some of the advantages to this approach:the advantages to this approach:

• Size of capital amountSize of capital amount• LiquidityLiquidity• ValueValue• ImageImage

(new issues, referred to as initial public (new issues, referred to as initial public offerings IPOs)offerings IPOs)

Public OfferingsPublic Offerings

Disadvantages of going public:Disadvantages of going public:

• CostsCosts

• DisclosureDisclosure

• RequirementsRequirements

• Shareholder pressureShareholder pressure

Private PlacementsPrivate PlacementsThe SEC provides Regulation D, which eases the The SEC provides Regulation D, which eases the

regulations for the reports and statements required regulations for the reports and statements required for selling stock to private parties – friends, for selling stock to private parties – friends, employees, customers, relatives, and local employees, customers, relatives, and local professionals. Regulation D defines four separate professionals. Regulation D defines four separate exemptions, which are based on the amount of exemptions, which are based on the amount of money being raised:money being raised:

1.1. Rule 504a – placements of less than $500,000Rule 504a – placements of less than $500,0002.2. Rule 504 – placements up to $1,000,000Rule 504 – placements up to $1,000,0003.3. Rule 505 – placements of up to $5 millionRule 505 – placements of up to $5 million4.4. Rule 506 – placements in excess of $5 millionRule 506 – placements in excess of $5 million

Accredited PurchaserAccredited PurchaserAs noted in Rules 505 and 506, Regulation D uses the As noted in Rules 505 and 506, Regulation D uses the

term “accredited purchaser”. Included in this term “accredited purchaser”. Included in this category are the following:category are the following:

• Institutional investors such as banks, insurance Institutional investors such as banks, insurance companies, venture capital firms.companies, venture capital firms.

• Any person who buys at least $150,000 of the Any person who buys at least $150,000 of the offered security and whose net worth, including offered security and whose net worth, including that of his or her spouse, is at least 5 times the that of his or her spouse, is at least 5 times the purchase price.purchase price.

• Any person who, together with his or her spouse, Any person who, together with his or her spouse, has a net worth in excess of $1 million at the time has a net worth in excess of $1 million at the time of purchase.of purchase.

““Sophisticated” InvestorsSophisticated” Investors

““Sophisticated” investors are wealthy Sophisticated” investors are wealthy individuals who invest more or less individuals who invest more or less regularly in new and early- and late-regularly in new and early- and late-

stage ventures. They are knowledgeable stage ventures. They are knowledgeable about the technical and commercial about the technical and commercial

opportunities and risks of the business in opportunities and risks of the business in which they invest.which they invest.

The Venture Capital The Venture Capital MarketMarket

Venture Capital InvestmentsVenture Capital Investments

YearYearNumber ofNumber ofCompaniesCompanies

Amount InvestedAmount Invested(in billions)(in billions)

20012001 4,9324,932 42.942.920002000 8,4048,404 108.8108.819991999 5,8245,824 56.556.519981998 4,3454,345 22.222.219971997 3,3363,336 16.716.7

Venture Capital InvestmentsVenture Capital Investmentsby Stages of Developmentby Stages of Development

Stage ofStage ofDevelopmentDevelopment

Start-up/SeedStart-up/Seed

Early StageEarly Stage

ExpansionExpansion

Later StageLater Stage

AmountAmount(in billions)(in billions) CompaniesCompanies

AmountAmount(in billions)(in billions) CompaniesCompanies

20012001 20022002

540.6540.6

4,682.94,682.9

1,911.11,911.1

229.4229.4

193193

642642

291291

4141

2,311.62,311.6

16,499.516,499.5

9,654.79,654.7

718.5718.5

537537

1,8721,872

853853

7777

Dispelling Venture Capital MythsDispelling Venture Capital MythsMyth 1:Myth 1: Venture capital firms want to own control of Venture capital firms want to own control of

your company and tell you how to run the business.your company and tell you how to run the business.

Myth 2:Myth 2: Venture capitalists are satisfied with a Venture capitalists are satisfied with a reasonable return on investment.reasonable return on investment.

Myth 3:Myth 3: Venture capitalists are quick to invest Venture capitalists are quick to invest

Myth 4:Myth 4: Venture capitalists are interested in backing Venture capitalists are interested in backing new ideas or high-technology inventions – new ideas or high-technology inventions – management is a secondary consideration.management is a secondary consideration.

Myth 5:Myth 5: Venture capitalists need only basic summary Venture capitalists need only basic summary information before they make an investment.information before they make an investment.

Criteria for Evaluating Criteria for Evaluating New-Venture ProposalsNew-Venture Proposals

Returns on Investment Typically South by Returns on Investment Typically South by Venture CapitalistsVenture Capitalists

Stage ofStage ofBusinessBusiness

ExpectedExpectedAnnual ReturnAnnual Returnon Investmenton Investment

ExpectedExpectedIncrease onIncrease on

Initial InvestmentInitial Investment

Start-up businessStart-up business (idea stage) (idea stage)

60%60% 10-15 x investment10-15 x investment

First-stage financingFirst-stage financing (new business) (new business)

40%-60%40%-60%

Second-stage financingSecond-stage financing (development stage) (development stage)

30%-50%30%-50%

Third-stage financingThird-stage financing (expansion stage) (expansion stage)

25%-40%25%-40%

Turnaround situationTurnaround situation 50%50%

6-12 x investment6-12 x investment

4-8 x investment4-8 x investment

3-6 x investment3-6 x investment

8-15 x investment8-15 x investment

Venture Capitalist Screening CriteriaVenture Capitalist Screening Criteria

• Venture Capital Firm RequirementsVenture Capital Firm Requirements• Nature of the Proposed BusinessNature of the Proposed Business• Economic Environment of Proposed IndustryEconomic Environment of Proposed Industry• Proposed Business StrategyProposed Business Strategy• Financial Information on the Proposed Financial Information on the Proposed

BusinessBusiness• Proposal CharacteristicsProposal Characteristics• Entrepreneur/Team CharacteristicsEntrepreneur/Team Characteristics

Informal Risk Capital – Informal Risk Capital – “Angel” Financing“Angel” Financing

Many wealthy people in the United Many wealthy people in the United States are looking for investment States are looking for investment

opportunities. They are referred to opportunities. They are referred to as “business angels” or informal as “business angels” or informal

risk capitalists.risk capitalists.

Informal Risk Capital – Informal Risk Capital – “Angel” Financing“Angel” Financing

One newly created source is the Angel Capital One newly created source is the Angel Capital Electronic Network (ACE-Net). This Electronic Network (ACE-Net). This

Internet-based service provides information Internet-based service provides information to institutional and individual accredited to institutional and individual accredited investors about small, dynamic, growing investors about small, dynamic, growing

businesses seeking $250,000 to $5 million in businesses seeking $250,000 to $5 million in equity financing.equity financing.

Types of Angel InvestorsTypes of Angel Investors

• Corporate AngelsCorporate Angels

• Entrepreneurial AngelsEntrepreneurial Angels

• Enthusiast AnglesEnthusiast Angles

• Micromanagement AngelsMicromanagement Angels

• Professional AngelsProfessional Angels

Angel StatsAngel Stats

• Typical deal size: Typical deal size: $250,000$250,000

• Typical recipient: Typical recipient: Start-up firmsStart-up firms

• Cash-out time frame: Cash-out time frame: 5 to 7 years5 to 7 years

• Expected return: Expected return: 35 to 50%35 to 50%

The Pros and Cons of Business The Pros and Cons of Business Angel InvestmentsAngel Investments

Angels’ CharacteristicsAngels’ CharacteristicsValue-addingValue-adding

Geographically dispersedGeographically dispersedMore permissive investorsMore permissive investors

Investment CharacteristicsInvestment CharacteristicsSeek Smaller DealsSeek Smaller Deals

Prefer start-up & early stagePrefer start-up & early stageInvest in all industry sectorsInvest in all industry sectors

Like high-tech firmsLike high-tech firms

Added BonusesAdded BonusesLeveraging effectLeveraging effect

Give loan guaranteesGive loan guaranteesNo high feesNo high fees

AdvantagesAdvantages

Business AngelsBusiness Angels

DisadvantagesDisadvantages

LittleLittlefollow-onfollow-on

moneymoney

Want a sayWant a sayin firmin firm

Could turnCould turnout to beout to be“devils”“devils”

No nationalNo nationalreputationreputationto leverageto leverage