working with funders1 extra notes: working with funders questions answered –how is the value of a...

Working with Funders 1

Extra Notes: Working with Funders

Questions Answered

– 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?


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Table 13-2: Summary of Sources of New Venture Financing

Sources of New Venture Financing

Financier Development Startup Early Growth Rapid Growth Exit

Entrepreneur

Friends and Family

Angel Investors

Strategic Partner

Venture Capital

Asset-based Lender1

Equipment Lessor

SBIC

Trade Credit

Mezzanine Lendor

IPO

Acquisition, LBO, MBO

Dark Grey=Primary Focus, Light Grey=Secondary Focus or focus of a subset of investors of that type

Source: Smith, Entrepreneurial Finance, p. 34.Note: 1Asset-based lenders are the debt financing sources that include commercial bank loansFurther definition of sources not covered in the chapter are available in Table 13-3


Equity Financing (Cont’d) 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


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Table 13-3: Definition of Other Sources of Funding

Source: Jack S. Levin. Structuring Venture Capital, Private Equity, and Entrepreneurial Transactions. Panel Publishers, 2000John Downes & Jordan Elliot Goodman. Dictionary of Finance and Investment Terms. New York, Barrons, 1995.

An MBO is the purchase of all a company’s publicly held share by the existing management, which takes the company private

MBO – Management Buyout

An LBO is a takeover of a company using borrowed funds. Most often, the target company’s assets serve as security for the loans taken out by the acquiring firm, which repays the loan out of cash flow of the acquired company.

LBO – Leveraged Buyout

A mezzanine lender (like the VC professional) generally employs active investment professionals who negotiate the purchase of privately-placed securities in venture capital/private equity transactions, such as buyouts, but the securities purchased are normally from the portfolio company and are predominantly debt securities - generally, a slice of common stock, warrants, or conversion rights.

Mezzanine Lender

Equipment lessors finance various equipment types general costing $1 million or more (ex. production equipment, R&D equipment, etc.) for midsize companies and large corporations, typically for lease terms of three to seven years.

Equipment Lessor

DefinitionFunding Source


Valuation

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


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

– Performance 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


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Table 13-4: Example of Discounted Cash Flow Analysis

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

FCF (in Millions) 10 50 50 75 85 100

Terminal Value 588

Present Value 8 35 29 36 270


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


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Table 13-5: Discount Rates

25%-35%IPO

30% to 40%Fourth Stage

30% to 50%Third Stage

35% to 50%Second Stage

40% to 60%First Stage

50% to 70%Startup

Source: J ames L. Plummer, QED Report on Venture Capital Financial Analysis (QED Research, Palo Alto, CA), 1987


Negotiations

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

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)


Negotiations (Cont’d)

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


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Zero Coupon Bond

With Warrants attached--must wait one year after debt is redeemed and warrants are exercised to sell underlying stock. Zero Coupon Bond is the ultimate in locking in a return: upon maturity get interest at a fixed rate and interest on interest.

Convertible Debentures

Redeemable preferred

Convertible Preferred

Participating Convertible Preferred

Common

Essentially loans convertible to equity shares. Can sell immediately upon conversion as long as not deemed an affiliate. Investor profile: likes upside potential leavened with downside protection.

No convertibility into equity, only face value (FV) plus any dividend. Always carries a term specifying when redemption occurs, usually at the option of the shareholder. Not considered outstanding for EPS purposes.

Converted at shareholder’s option into common. Usually a mandatory conversion at IPO. Usually includes a provision to redeem--par plus some form of ROIC as if dividends had been declared but not paid.

Receive FV and conversion to common. Term usually in event of sale or liquidation. Typically used in later rounds when investors have to pay a higher price to play. (Essentially preferred stock bundled with common.)

Each share has one vote. Class A common is a form of preferred.

DEBT SECURITIESHighest Liquidation Preference/Can Force LiquidationSafest

COMMONLowest Liquidation Preference

Riskiest

Sources: Fundamentals of Venture Capital, Bartlett; HBS Note on Deal Making; HBS Note on Private Equity Securities; Venture Capital and Private Equity, a Casebook, Lerner; The Entrepreneurial Venture, HBS Publishing.

Exhibit 13-8: The Spectrum of Securities


Negotiations (Cont’d) 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


Negotiations (Cont’d)

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


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Table 13- 6: Pre- and Post-Money Valuations Made Easy

Cumulative

Round of Financing

Amount invested this round

% Received this round

VC’s Share

Founder’s Share

Implied Valuation (Post Money)

Seed-stage Round

$1,000,000 40% 40% 60% $2,500,000

First Round

$4,000,000 20% 52% 48% $20,000,000

Second Round

$15,000,000 20% 62% 38% $75,000,000


Exit (The Path to Liquidity) 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


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Exhibit 13-9: Exit Strategies of VC Firms —IPOs and M&A

Note: Venture Economics estimates that through Q2 2000, there were 131VC backed IPOs for a total of $12.8B. Through Q2 2000, there were 132 M&A transactions of venture-backed firms for $37.5B (the 2000 numbers above simply double the current available numbers through Q2 2000).

Source: Venture Economics and 2000 National Venture Capital Association Yearbook

OfferingSize($BB)

VC-Backed IPOs: 1985-2000*

# of Offerings

Venture-Backed M&A Deals 1985-2000*

AcquisitionAmount($BB)

# of Acq

0

5

10

15

20

25

30

0

50

100

150

200

250

300Total Offering Size

# of Offerings

0

10

20

30

40

50

60

70

0

50

100

150

200

250

300Total Acquisition Amount# of Acquisitions


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Table 13-7: IPO Pros and Cons

Pro Con

Provides founders and shareholders with liquidity (although not immediate liquidity because of lock out periods, signals to the market, etc.)

IPOs are expensive and time-consuming. An unfavorable market (something that the company can not control or predict) might necessitate pulling the IPO at the last second

Provides capital to fuel expansion and growth within the company

Strict SEC reporting requirements

Possibility of attracting and retaining employees at lower than market rates because of granting of stock options and promise of eventual liquidity

Pressure to product quarterly numbers for analysts

The price of the company’s shares should increase dramatically with an IPO, providing (at least paper) wealth to the founders and other shareholders

Increased Officer and Director liability

As long as the company is performing well, it can return to the market to raise additional cash

Hostile takeover is possible

The ability to use stock as currencyDoesn’t necessarily provide a liquid market for all shareholders because of restrictions on trading the stock


Exit (Cont’d)

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


Future of Capital Markets

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


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63%

72%

74%

78%

81%

80%

75%

74%

60%

65%

70%

75%

80%

85%

Q1 99 Q2 99 Q3 99 Q4 99 Q1 00 Q2 00 Q3 00 Q4 00

Quarter

% o

f T

ota

l VC

Dea

ls

Exhibit 13-10: Allocation of VC Investment to Internet Related Ventures

Source: PWC Moneytree Survey 2000


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


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0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Q1 Q2 Q3 Q4

150

160

170

180

190

200

210Number of Deals Average Size of Deal

Exhibit 13-11: Decline of Mergers in 2000

Number of Deals / Year

Source: Thomson Financial, from “Garage Startup to Garage Sale. ” The Industry Standard . February 19, 2001.

Thousands of Dollars

Year 2000


Future of Capital Markets (Cont’d)

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


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0

100

200

300

400

500

600

700

800

Mar-00 Apr-00 May-00 Jun-00 Jul-00 Aug-00 Sep-00 Oct-01 Nov-00 Dec-01 Jan-01

Telecom Services

Network Hardware

Business Software

Exhibit 13-12: Recent Seed Financing by Industry

Seed Financing (M illions)

Source: Venturewire, from “W here the Seed Money Is.” The Industry Standard . February 19, 2001

working with funders1 extra notes: working with funders questions answered –how is the value of a...

Documents

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