Keys to Financing the New Venture Alec Johnson

Keys to Financing the New Venture Alec Johnson, Ph. D. University of St. Thomas

The Problem “Small business management is cash flow management. ” Dr. Robert Pricer, Weinert Applied Ventures Program, Unviersity of Wisconsin “Cash is King. ” Dave Stassen, Partner, St. Paul Venture Capital “You’re not an entrepreneur until you’ve written payroll checks on Friday and spent the weekend collecting the cash to cover them. ” Keith Streckenbach, founder and CEO of Pharmacy. One. Souce. com

Entrepreneurial Finance vs. Corporate Finance Differences from Corporate Finance – Diversification and Value – Involvement of Investors – Harvesting

The Problem - Objectives Entrepreneur Investor Minimize Cost Maximize Return Maintain Control Maximize Ownership Minimize Involvement Minimize Risk

The Problem - Management What is the Ultimate Task of an Entrepreneur? • Job #1 is Risk Management • Largest risk is Financial and question becomes “How? ”

The Problem - Structure Type, i. e. Do I use debt, equity or some combination. Timing, i. e. When do I need it? Amount, i. e. How much do I need?

Type – Two General Classes Debt – Represents a fixed cost – Represents more risk – Cheapest type of outside financing Equity – No interest payment – No obligation to repay – Most Expensive type of financing

Sources of Debt Financing Friends and Family Banks Leasing Factoring

Bank Financing Commercial banks are the largest source of external capital for growing firms. Problems: – Lack of collateral – Lack of earnings history

Leasing Often used technique to acquiring assets without having to purchase them. Two types of Leases: – Operating Lease – Capital Lease

Factoring Factors buy company’s accounts receivables at a discount. Recall R&R case. Gets cash to company quickly, but must have cost of factor available in profit margin.

Equity When to use equity? – Every company has some form of equity. – Founders raise equity when: • there is no collateral to secure debt • insufficient cash flow to secure debt • required growth capital more than banks can provide.

Types of Equity Instruments Typically used in small business placements: – Common Stock – Preferred Stock

Types of Equity Instruments Common Stock Characteristics: – Most common form of issuance – Last in liquidation = ? – Represents Entire ownership of firm.

Types of Equity Instruments Preferred Stock Characteristics: – Pays dividends – Preference in liquidation

Types of Equity Instruments Preferred Stock Characteristics: – Looks a lot like Debt! – Used by Venture Capitalists to gain position in liquidity event while minimizing risk.

Types of Equity Investors Angel Investors Venture Capitalists

Types of Equity Investors: Angels Typical Angel Investor – Private individual (not an institutional fund) – Age: 47 – 54 years – Gender: Male – Net Worth: $1, 000 +

Types of Equity Investors: Angels Typical Angel Investor – Education: Bachelors or greater – Average Investment: $59, 000 – Preferred Stage: Start-up (56%) and infant or young (24%)

Types of Equity Investors: Angels Typical Angel Investor – Required Rate of Return: 15% - 45% – Length of Investment 3 – 10 years – “Patient Money”

Types of Equity Investors: Venture Capital Typical Venture Capital Firms – Institutional Firm – Raises money from various sources, including Angels – Creates “pool” of capital, a fund. – Develops portfolio of firms under management

Types of Equity Investors: Venture Capital Typical Venture Capital Firms – Average Investment: $1 M to $50 M per investment. – Industries: High Growth, early or later stages – Services Provided: None to direct management decision making and board control. – Required Rate of Return: 10 X in 3 -5 years. – Typically invest using Preferred Stock

Venture Capital Investments, Q 2 2001 2. 2% of Venture Capital invested in Midwest!

Timing – Sources of New Venture Financing* Developme nt Start. Up Early Rapid Growth Exit Entrepreneur/ Friends/Famil y Angels/Partne r Banks/Lessor s Venture Capital IPO *Adapted from: Smith and Smith, Entrepreneurial Finance, 2000

Timing - Cash Needs Goal is to manage risk to business and to investor. Minimize risk by staging investments Establish stages by developing solid business plan and financial projections!

Case Study – Ascend Medical Facts: • Development stage Medical Device company. • Prototype of catheter for stroke victims nearly complete. • Market need unclear. • FDA process is three years and $30 M in expense • No guarantee of approval.

Case Study – Ascend Medical Analysis – Type? • Debt is not an option. • Angels to get the product through prototype development, further market study, conduct focus groups with doctors. $500, 000. • Venture Capital to take it through FDA process and initial market launch. $45 M

Case Study – Sporto Facts: • • • Start up phase winter apparel company One season’s sales under it belt Moderate growth plans Required funds: $1. 5 M Needs immediate funds of $100, 000 to expand sales organization and $1. 4 M to expand product line and related marketing expenses over the next 18 -24 months

Case Study – Sporto Analysis – Type? • Venture Capital not an option – growth too slow • All debt not an option – unless financials can demonstrate adequate cash flow and plenty of collateral available. • Private equity with debt mix is viable option • Factoring after sales grow, leasing office equipment • Alternative?

Case Study – Sporto Analysis – Timing? • Could split rounds up, reduce overall cost of capital. • Rounds are close enough that it might make sense to raise all at one time. • Unless founder gets lucky? Example

The Big Picture – Business Plan Competitor Analysis Environmental Trends Customer Analysis Functional Plans Business Plan Pro formas Financing Evaluation-CMOPs

Business Plans What is a business plan? – Something you produce because the bank expects it? – Something you produce because every says you should? –?

Business Plans – Make Your Argument contains some consistent themes – What is the product or service? – Who is MOST likely to buy it? – How much are they willing to pay for it? – How many of “THEM” are there?

Business Plans – Make Your Argument contains some consistent themes – Who is MOST likely to buy it? – Where and How will they purchase the product? – How will I let them know about it? – Does my team have the ability to execute the plan?

“Everything should be made as simple as possible, but not more so. ” Albert Einstein

Business Plan-The Purpose A Sales Document to Raise Capital A Road Map to Developing a Successful Organization-Do we have a product the market wants and do we have an organization that can see it to market? The Plan makes an argument for why the business will be successful!!!!!

Business Plan Outline Executive Summary Company History Major Products/Services Marketplace Competition Marketing Plan Operations. Manufacturing Management Team Risks Financial Analysis

Company Description What business are you in? What are your: – products or services? – customers? – applications? (Different uses and needs satisfied What is your distinctive competence? What is your competitive advantage? What is your Mission Statement

Sustainable Competitive Advantage Versus Distinctive Competence Ask the question “What do we have that can’t be replicated by our competitors? ” vs. “What are we good at? ”

Mission Statement What do we do? How do we do it? Who do we do it for? Example: Brew – On - Premise

Market Analysis & Marketing Industry description and outlook Target markets (segments) Competition Reaction from prospective customers Marketing activities (strategy/pricing) Selling activities The Key is your Feasibility Study

Example 1: Brew on Premise Total Population (% age 2455) Median Income Median Rent (upper quartile) Boulder County, Colorado 225, 339 (52%) $35, 322 $449 ($585) Dane County, Wisconsin 367, 085 (54%) $32, 703 $423 ($527)

Example 1 - Brew on Premise • Counties are comparable • 15 batches per day in Boulder • Ratio of target population 1. 6: 1 • Expected revenues for Badgerland to reach 24 batches per day after 2 years of operation.

Example 2 – Ascend Medical Different approach to argument Focus isn’t one likely demographic Focus is on treatable number of cases

Example 2 – Ascend Medical Process: 1. Population growth through 2010 (Source: US Census) 2. “Target” population not important. All medical research data based on incidence in US population. 3. Medical data implies number of treatable cases by type of stroke.

Example 2 – Ascend Medical Process: 1. Once number of treatable cases established by type of stroke, can then establish type of treatments received. 2. Those requiring clot removal (vs. stenting, etc. ) are established as likely candidates for this procedure. 3. 356, 000 treatable cases today, growing to 560, 000 in 2010.

Management and Ownership Key management positions Background of personnel Board of Directors Ownership Starting a business is about building a successful organization and working in a “team. ” Does your team cover all the necessary roles or have you developed a plan to cover areas that are weak?

Management Franchise Granite Gear Low Moderate Level of Sophistication Software, Medical Device, etc. High

Product Development Franchise Granite Gear none moderate Level of Complexity Software, Medical Device, etc. high

Time To Market Franchise Granite Gear short moderate Software, Medical Device, etc. high

Time to Profitability Franchise Short < 6 months Granite Gear Moderate 9 to 18 months Software, Medical Device, etc. High >24 months

Market Risk Franchise Granite Gear High Moderate Product Acceptance Software, Medical Device, etc. Low

Capitalization Franchise Low < $50, 000 Granite Gear Moderate $500 K to $2 M Software, Medical Device, etc. High > $2 M

Risks Competitive Risks Technological Risks Organizational Risks Main Point: Identify them and develop a plan to deal with them if and when they arise.

Funds Required and Their Uses How much money do you require now? How much will you require over the next five years? How will the funds be used?

Funds Required and Their Uses Debt/Equity mix What terms do you ask? (Let the commercial money market help you select winners) Do you plan to “harvest? ” Be explicit about the deal you offer…

Financial Data Historical financial statements and projections for the next five years Key assumptions

Appendices Resumes Pictures of products Sales literature Supporting published market studies or trade journal articles Patents

The Big Picture Competitor Analysis Environmental Trends Customer Analysis Functional Plans Business Plan Proformas Financing Evaluation-CMOPs