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Informal Risk Capital, Venture Capital, and

Going Public

McGraw-Hill/IrwinEntrepreneurship, 7/e Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 12

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Financing the Business

Criteria in evaluation of appropriateness of financing alternatives: Amount and the timing of the funds required. Projected company sales and growth.

Three types of funding: Early stage financing. Development financing. Acquisition financing.

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Stages of Business Development Funding

<<Insert Table 12.1>>

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Risk Capital Markets

Markets providing debt and equity to nonsecure financing situations.

Types of risk capital markets: Informal Venture-capital Public-equity

All three can be a source of funds for stage-one financing. However, public-equity market is available only

for high-potential ventures.

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Informal Risk Capital

Consists of a virtually invisible group of wealthy investors (business angels).

Investments range between $10,000 to $500,000.

Provide funding, especially in start-up (first-stage) financing.

Contains the largest pool of risk capital in the United States.

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Characteristics of Informal Investors

<<Insert Table 12.2>>

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Venture Capital

A professionally managed pool of equity capital. A long-term investment discipline, usually

occurring over a five-year period. Found in the:

Creation of early-stage companies. Expansion and revitalization of existing

businesses. Financing of leveraged buyouts of existing

divisions of major corporations or privately owned businesses.

Venture capitalist takes an equity participation in each of the investments.

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Types of Venture Capital Firms

<<Insert Figure 12.1>>

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Percentage of Venture Dollars Invested in 2005 by Industry Sector

<<Insert Figure 12.2>>

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Venture Capital Criteria

Objective of a venture-capital firm: generation of long-term capital appreciation through debt and equity investments.

Criteria for committing to venture: Strong management team. Product and/or market opportunity must be

unique. Business opportunity must show significant

capital appreciation.

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Venture-Capital Financing: Risk and Return Criteria

<<Insert Figure 12.4>>

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Venture Capital Process

Stage I: Preliminary screening Initial evaluation of a deal. Begins with the receipt of the business plan.

Stage II: Agreement on principal terms between entrepreneur and venture capitalist.

Stage II: Due diligence Stage of deal evaluation.

Stage IV: Final approval Document showing the final terms of the deal.

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Percentage of Venture Dollars Raised by Stage in 2005

<<Insert Figure 12.3>>

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Guidelines for Dealing with Venture Capitalists

<<Insert Table 12.6>>

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Company Valuation Factors

Economic outlook- general and industry. Comparative data. Book (net) value. Future earning capacity. Dividend-paying capacity. Assess goodwill/intangibles. Previous sale of stock. Market value of similar companies’ stock.

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Ratio Analysis

Serves as a measure of financial strengths and weaknesses of the venture.

Should be used with caution. Typically used on actual financial results. Provide a sense of where problems exist in the

pro forma statements.

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Liquidity Ratios

Current Ratio

_Current assets_ _108, 050_Current liabilities 40, 500

Acid-Test Ratio

Current assets - Inventory_ _108, 050 – 10, 450_

Current liabilities 40, 500

= = 2.67 times

=

= 2.40 times

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Activity Ratios

Average Collection Period

_Accounts receivable_ __46, 400___ Average daily sales 995, 000/ 360

Inventory Turnover

Cost of goods sold_ _645, 000_ Inventory 10, 450

= = 17 days

= = 61. 7 times

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Leverage Ratios

Debt Ratio

Total liabilities_ __249, 700_Total assets 308, 450

Debt to Equity

Total liabilities_ _249, 700_Stockholder’s equity 58, 750

= = 81 %

= = 4.25 times

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Profitability Ratios

Net Profit Ratio

Net profit_ __8, 750_Net sales 995,000

Return on Investment

Net profit_ _8, 750_ Total assets 200, 400

= = 0.88 %

= = 4.4 %

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General Valuation Approaches

Methods for determining the worth of a company. Present value of future cash flow: based on its

future sales and profits. Replacement value: cost of replacing all assets. Book value: indicated worth of the assets. Earnings approach: based on present and future

earnings. Factor approach: using the major aspects of a

company to determine its worth. Liquidation value: worth of a company if

everything was sold today.

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General Valuation Method

Venture capitalist ownership (%) =

VC $ investment x VC investment _______multiple desired

Company’s projected profits in year 5 xPrice earnings multiple of comparable company

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Steps in Valuing Your Business and Determining Investors’ Share

<<Insert Table 12.7>

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Evaluation of an Internet Company

Qualitative portion of due diligence carries more weight.

Focus is more on the market itself. Company's financial is compared with the future

market in terms of: Fit. Realism. Opportunity.

Management team is examined. Opportunities available in the investor market

are examined.

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Deal Structure

Terms of the transaction between the entrepreneur and the funding source.

Needs of the funding sources: Rate of return required. Timing and form of return. Amount of control desired. Perception of the risks involved.

Entrepreneur’s needs: Degree and mechanisms of control. Amount of financing needed. Goals for the particular firm.

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Going Public

Selling some part of the company by registering with the SEC.

Resulting capital infusion provides the company with: Financial resources. A relatively liquid investment vehicle.

Company consequently gains: Greater access to capital markets in the future. A more objective picture of the public’s perception

of the value of the business.

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Advantages and Disadvantages of Going Public

<<Insert Table 12.8>>

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Evaluating the Timing for Going Public

Is the company large enough? What is the amount of the company’s earnings,

and how strong is its financial performance? Are the market conditions favorable for an initial

public offering? How urgently is the money needed? What are the needs and desires of the present

owners?

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Underwriter Selection

Managing underwriter: lead financial firm in selling stock to the public.

Underwriting syndicate: group of firms involved in selling stock to the public.

Factors to consider in selection: Reputation. Distribution capability. Advisory services. Experience. Cost.

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Registration Statement and Timetable (1 of 2)

“All hands” meeting: preparing timetable. First public offering: six to eight weeks. After filing: six to 12 weeks to declare the

registration effective. Reasons for delays:

Heavy periods of market activity. Peak seasons. Attorney’s unfamiliarity with federal or state

regulations. Issues arising over requirements of the SEC

resulting from its review of the filing When the managing underwriter is inexperienced.

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Registration Statement and Timetable (2 of 2)

SEC attempts to ensure that the document makes a full and fair disclosure of the material reported.

Registration statement consists of: Prospectus. Registration statement.

Most initial public offerings will use a Form S-1 registration statement.

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Prospectus

Cover page Prospectus summary Description of the

company Risk factors Use of proceeds Dividend policy Capitalization

Dilution Selected financial data Business,

management, and owners

Type of stock Underwriter

information Actual financial

statements.

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Part II

Information regarding: Offering. Past unregistered securities offering of the

company. Other undertakings by the company.

Includes exhibits: Articles of incorporation. The underwriting agreement. Company bylaws. Stock option and pension plans. Initial contracts.

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Procedure

Preliminary prospectus can be distributed to the underwriting group. Red herring: Preliminary prospectus of a potential

public offering. Deficiencies are communicated through

telephone or a comment letter. Waiting period: time between the initial filing

and its effective date. Underwriting syndicate is formed and briefed. Company publicity regarding the proposed

offering is very restrictive.

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Legal Issues and Blue-Sky Qualifications

Legal issues Quiet period: 90-day period in going public when

no new company information can be released.

Blue-sky qualifications Blue-sky laws: laws of each state regulating

public sale of stock. May cause additional delays and costs to the

company going public. Many states allow their state securities

administrators to prevent an offering from being sold in their state.

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After Going Public

Aftermarket support: actions of underwriters to help support the price of stock following the public offering.

Relationship with the financial community Entrepreneur will need an increasing portion of time to

develop a good relationship with this community.

Reporting requirements Filing of annual, quarterly, and specific transaction or

event reports. Company must follow proxy solicitation requirements.