Chapter 13 Working with Funders q Questions Answered

Chapter 13: Working with Funders q Questions Answered in this Chapter – What are the major sources of equity financing, and how do these sources differ from one another? – How is the value of a startup determined? – What are the steps involved in negotiating with investors? – What is an IPO? What process must an entrepreneur undertake to complete an IPO successfully? September 2001 Ch 13: Working with Funders 1

Introduction q q Entrepreneurs must raise financial capital, protect the company from bad deals and follow through to a liquidity event Funding Considerations – – – Equity Financing Valuation Negotiations Exit (The Path to Liquidity) Future of Capital Markets September 2001 Ch 13: Working with Funders 2

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Equity Financing q Bootstrapping – Bootstrapping is the act of using personal resources to get the business off the ground – Guiding Principles when bootstrapping • Get operational as soon as possible • Take on cash-generating projects, even if they are not in line with the written strategy • Go the extra mile to satisfy customers • Get comfortable with being cheap, but do not skimp on essentials to the business • Establish a relationship with a bank as soon as possible September 2001 Ch 13: Working with Funders 6

Equity Financing (Cont’d) q Angels – Angels are wealthy individuals who invest their own capital in startup companies they find potentially lucrative – Angels close the gap between bootstrapping and Venture Capital (VC) firms – Pros & Cons of Angel financing • Pros – Flexible exit strategy – Favorable terms sheet – Improved valuation before approaching VC • Cons – Possible last-minute backing-out of deals – Poorly structured agreements – Relatively small investment (sufficient for proof of concept, but not for mass-deployment) September 2001 Ch 13: Working with Funders 7

Equity Financing (Cont’d) q Venture Capital (VC) Community – VCs are in the business of finding companies with the potential for great growth and great economic return – Key Considerations • VC funds are organized as limited partnerships looking for long-term (5 -10 years) investments • VC firms make money through a combination of profits on investment and fund management fees • VC funds are created by a group of investors with a specific strategy for investment. The pool of money in the fund is fixed • The majority of VC investments are in companies that have entered an expansion phase • In the past few years, VC funds went largely to startup companies. The recent trend, however, has been to return to more traditional investments in stronger companies September 2001 Ch 13: Working with Funders 8

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Valuation q q Valuation is the art/science of trying to determine the worth of a company Methods used in valuing a company – The Comparables Method • Determine the worth of a company by comparing it to other similar companies • The companies should be similar with respect to industry focus, income statement ratios, location, relations with suppliers, customer base, potential growth, growth rate and capital structure • This method assumes that similar companies exist and that the information for comparison is available September 2001 Ch 13: Working with Funders 16

Valuation (Cont’d) – The Financial Performance Method • Uses a company’s earnings (or potential earnings) to project future cash flows and applies a discount rate to determine the Present Value (PV) of those cash flows • The Discounted Cash Flow (DCF) is determined from – Proforma Income Statements – Projections about the company’s future income statements are made based on growth assumptions for cost and revenues – Free Cash Flow – The amount of cash the company will have at its disposal is estimated based on the proforma income statement – Terminal Value – The expected value of the company at the end of the projected period is estimated. A discount rate is then applied to this value to estimate the present value of the company September 2001 Ch 13: Working with Funders 17

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Valuation (Cont’d) – The Venture Capital Method • VC’s use a hybrid valuation method, looking at both comparables and free cash flows • To compensate for their high risk investments, VC’s apply a very large discount rate to estimate the company’s present value • To compensate for future dilution, VC’s require a higher percentage ownership (for a given investment) based on an estimated retention ratio • This valuation method is necessarily subjective – The Asset Valuation Method • The company’s worth is determined from its current assets • Because the majority of their assets are intangible, this method is generally not used for startups in the e-commerce industry September 2001 Ch 13: Working with Funders 19

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Negotiations q Principles for Entrepreneurs – Investors want to know two things: What is the opportunity and why is this management team the best to pull it off – Guidelines for pitching an investment opportunity • Know the audience • Keep the presentation concise • Talk about the management team q Term Sheet – A Term Sheet is a non-binding description of the proposed deal between the financier and the entrepreneur – The Term Sheet is analogous to a Letter of Intent (LOI) or Memorandum of Understanding (MOU) September 2001 Ch 13: Working with Funders 21

Negotiations (Cont’d) q Securities – Types of Securities: The type of securities chosen by the company and the investor reflect the risk/reward appetite • Zero Coupon Bonds - Upon maturity of this security, the investor redeems the initial investment and interest at a predetermined rate. This type of security provides ultimate protection to the investor • Convertible Debentures – These securities are loans that are ‘converted’ into common stock (equity). The investor is considered to be a creditor until the company is past its high-risk stage • Preferred Stock – This is the most commonly used security with VCs – Convertible Preferred – Redeemable Preferred – Participating Convertible Preferred • Common Stock – Since they do not provide investors with any of the protections of the other securities, common stocks are rarely used by VCs September 2001 Ch 13: Working with Funders 22

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Negotiations (Cont’d) q Rights and Privileges of Investors – Common rights that investors demand are • Right of First Refusal – Investor has the right to meet any offer of outside financing in future investment rounds • Preemptive Right – Investor has the right to maintain his percentage of ownership by investing additional funds in future investment rounds • Redemption Rights – Investor has the right to achieve liquidity if the company has not been sold or undergone IPO within a predetermined time period • Registration Rights – Investor has the right to demand that shares be registered, forcing the company into liquidity (public offering) • Covenants – Terms designed to ensure that the money provided by the investor is used in a manner that is consistent with the agreement between the entrepreneur and investor • Antidilution Provisions – Provisions that protect the investor from dilution in ownership that might occur in future round of financing September 2001 Ch 13: Working with Funders 24

Negotiations (Cont’d) 1. Dilution – Dilution refers to the percent reduction in ownership that occurs whenever the company issues new shares of stock – While investors can protect themselves from dilution, founders are diluted with every round of financing – Two types of antidilution provisions to protect the investor • Full Ratchet – Provides most protection to investor, but can be extremely punitive to entrepreneur • Weighted Average – More fair to entrepreneur while still protecting the investor September 2001 Ch 13: Working with Funders 25

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Exit (The Path to Liquidity) q Initial Public Offering (IPO) – Determining the Right Time for an IPO • Asses if the company is ready for an IPO • Asses if the market is ready to accept their offering – The IPO Process • Selection of Underwriters – The underwriters are the bankers that will arrange for the purchase of stock for a commission • Preparation of Registration Statement for SEC – Create prospectus outlining the company’s business and financial fundamentals • Distribution of Preliminary Prospectus - or ‘Red Herring’ • Preparation for and Completion of the Road Show – The company’s offering is presented directly to potential investors • The Incorporation of SEC comments into the Registration Segment • Agreement on a final share price and number of shares to be offered • Close of the offering and distribution of the final prospectus September 2001 Ch 13: Working with Funders 27

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Exit (Cont’d) q Mergers and Acquisitions (M&A) – M&A can often achieve the same goals as IPO (e. g. liquidity and increased valuation) with lower potential risk – In a Merger, two companies combine to achieve a financial and/or strategic objective, usually through the exchange of shares – In an Acquisition, one company buys another, usually with cash and/or stock – Analysts predict that M&A will become increasingly popular September 2001 Ch 13: Working with Funders 30

Future of Capital Markets q Likely Trends of the post-new-economy boom era – A Return to Classic Venture Capitalism • • Investors will be more selective in their investments Investors will monitor their investments more actively Investors will diversify their portfolio across multiple industries The time to liquidity will be longer – A Shakeout of Both Funding Sources and Startups • VC firms will select which companies to continue supporting and which to abandon • Many of the smaller VC firms will be unable to recoup their losses and will disappear • Angel investing will be curtailed September 2001 Ch 13: Working with Funders 31

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Future of Capital Markets (Cont’d) – A Rougher, Tougher Breed of Entrepreneurs • The balance of power in the VC community will shift back to the investor • Startup valuations will be lower (more realistic) • Individuals will take on the entrepreneurial challenge under more difficult conditions – Entrepreneurs Will Seek Other Sources of Liquidity • Raising money from public will no longer be sure thing • Acquisitions will become an increasingly desirable alternative for startups • The value of these acquisitions will also decline as willing buyers become more scarce September 2001 Ch 13: Working with Funders 33

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Future of Capital Markets (Cont’d) q Where Will the Investment Dollars Go in 2001? – VCs will be far more conservative than during the Internet boom – VCs will look for companies that are creative problem solvers – VCs will still have dollars to invest September 2001 Ch 13: Working with Funders 35

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