New Venture Financing: Considerations and Choices PDF

Chapter 2 NEW VENTURE FINANCING CONSIDERATIONS AND CHOICES  Learning Objectives Identify the financing sources available to new ventures and understand the factors that favor one source over another Recognize basic attributes of the various financing sources and...

Chapter 2 NEW VENTURE FINANCING CONSIDERATIONS AND CHOICES  Learning Objectives Identify the financing sources available to new ventures and understand the factors that favor one source over another Recognize basic attributes of the various financing sources and when each is likely to be available Understand considerations that influence the financing choice, including organizational form and regulatory considerations Recognize and use the common terminology of the market for new venture financing Identify the key elements of deal structure (term sheets and investment agreements) and the basic functions they serve Understand international differences in financing options 2 Figure 2.1 3  Sources of New Venture Financing: Bootstrap Financing Financing that does not depend on an investor’s assessment of the merits of the opportunity or on the value of the assets of the venture May be from entrepreneur’s own resources or from friends and family – personal savings (90%) – credit card/personal loans (28%) – loans from family and friends (7%) – equity investment from family and friends (5%) 4  Sources of New Venture Financing: Angel Investors Individual freelance investors usually interested in investing fairly small amounts ($25,000 - $500,000) in early-stage ventures Willing to invest over long horizons Evolved to a quasi-institutional form with angels acting as groups and may co-invest Often bring significant industry experience and are interested in active involvement 5  Sources of New Venture Financing: Venture Capital Venture Capital (VC) funds are organized as limited partnerships – Limited partners (LPs) provide most of the capital – General partner (GP) is responsible for managing the fund, including investment selection, working with entrepreneurs, and harvesting the investments Focused on equity investment in high-risk ventures with large potential return 6 Figure 2.2 7 Figure 2.3 8  Sources of New Venture Financing: Asset-Based Lenders Asset-based lenders, or “secured lenders,” provide debt capital to businesses that have assets that can serve as collateral – rely on the ability to liquidate business assets for debt servicing if necessary (rather than cash flow) – estimated at $590 billion in 2008 in the United States 9  Sources of New Venture Financing: Venture Leasing An entrepreneur who requires tangible assets can lease, rather than purchase them Usually involves assets that are key to the operation of the venture The lessor’s return may be tied to the financial performance of the venture Tax advantages to leasing as compared to owning 10  Sources of New Venture Financing: Corporate Venturing Can be internally or externally managed – Internally managed venture investing more likely to occur in firms that depend on innovation to sustain competitive advantage attempts to keep good ideas from “escaping” – Externally managed venture investing may seek only financial returns or strategic investments 11 Figure 2.4 12  Sources of New Venture Financing: Government Programs Many countries have established agencies to support small business formation and growth The US Small Business Administration (SBA) funds entrepreneurship via – loan guarantee programs – Small Business Investment Companies (SBIC) – Small Business Innovation Research Program (SBIR) Research grants – National Science Foundation, National Institutes of Health 13  Sources of New Venture Financing: Trade Credit Trade credit, or vendor financing arises whenever a business makes a purchase from a supplier that offers payment terms Terms are usually industry-specific Largest source of external short-term financing for firms in the US More important in emerging economies, where risk capital is often scarce 14  Sources of New Venture Financing: Factoring A factor buys accounts receivable of the venture and manages the collection activities Factoring comes in two basic types – with recourse – without recourse Basic elements of a factoring transaction – advance: 70 to 90% of face value of receivables – reserve: a portion held back if with recourse – fees: 2 to 6% for handling, lending, and risk 15 Figure 2.5 16  Sources of New Venture Financing: Franchising Franchising can enable a business concept to grow rapidly by using capital from franchisees Franchisor establishes a business format and offers franchising opportunities to prospective franchisees Examples: 17  Sources of New Venture Financing: Mezzanine Capital Capital raised after the firm has established a record of positive net income with revenues approaching $10 million or more – subordinated debt or preferred equity – a hybrid of senior debt and common equity “sweeteners” – often provided by some VC firms or other private equity funds 18  Sources of New Venture Financing: Debt Pros – interest is tax deductible – debt is usually less expensive than equity – no loss of control Cons – cash flow required for interest and principal payments – senior to equity and has contractual rights in the case of financial distress 19  Sources of New Venture Financing: Private Placements Both equity and debt can be issued via “private placement” Examples: VC and angel investments Benefits – can be faster and less expensive than a public offering – limits disclosure of strategic information – facilitates monitoring 20  Sources of New Venture Financing: Initial Public Offering (IPO) First sale of equity to public investors IPOs provide a very small fraction of overall new venture funding Provides exit for VCs and other investors in high-risk, high-growth ventures Company raises capital by selling registered equity shares to the public via a formal offering process 21  Sources of New Venture Financing: Initial Public Offering (IPO) Pros – establishes outside market for the venture’s shares investor feedback on managerial decisions can be used to effect acquisitions employee stock incentives – large amounts of capital can be raised Cons – relatively expensive – disclosure requirements – focus on short-term earnings 22  Sources of New Venture Financing: Direct Public Offering SEC regulations provide “safe harbors” Fall between private and public offering Firm issues equity to small numbers of “sophisticated” investors No formal public offering process Shares may eventually become freely tradable 23  What’s Different about Financing Social Ventures? Unable to issue equity Financing through – structured debt – royalty-based financing or revenue rights – philanthropic funding – may allow investors to make tax-deductible contributions to “giving funds” – philanthropic angel investors – social VC funds 24 Considerations When Choosing Financing Are not-for-profit status and the attendant tax exemption worthwhile? Should liability be limited, or should losses be passed on to the company’s owners? Is it important to be able to switch corporate forms easily as the company evolves? How important is it to avoid corporate-style taxation (i.e., double taxation)? Who are the best monitors of the firm-owners, investors, or managers? How will the monitors be monitored? 25  Considerations When Choosing Financing Table 2.1 26 Figure 2.6 27  Regulatory Considerations All countries regulate public capital markets Regulations limit access and affect financial disclosure US federal securities laws – The Securities Act of 1933 regulates offerings and sale of securities – The Securities and Exchange Act of 1934 regulates aftermarket trading State regulations: “blue sky” laws 28  What Is a Security? A variety of instruments are normally considered to be securities and are subject to regulation – stocks – bonds – investment contracts – profit-sharing agreements – puts – call – warrants – notes – limited partnership interests 29  Exemptions from Registration in the US Two important types of exemptions – exempt securities government securities, commercial paper, insurance policies – exempt transactions – intrastate offerings, private placements, small offerings Exemptions from registration (Reg. D) – small offerings – offerings to small numbers of accredited investors – private placements 30  The “Deal” The deal defines the allocation of risk and return and the rights and obligations of the entrepreneur and the investor Attempts to resolve information problems Starts with a term sheet which becomes the basis for the investment agreement Describes milestones and staging A well-structure deal can create value for both the entrepreneur and the investor 31 Information Problems Facing the Entrepreneur and Investors Three basic information problems – information about the value of the opportunity may be incomplete and uncertain – information about the value of the idea and the ability of the entrepreneur is held asymmetrically – risk of appropriation of intellectual property 32 Term Sheets and Investment Agreements Pre-money and post-money valuation The investment agreement Representations and warranties Covenants and undertakings Liquidation and registration rights Rights of first refusal and preemptive rights Ratchets and anti-dilution rights Overarching considerations 33  Pre-Money and Post-Money Valuation Pre-money valuation is the implied value of the venture prior to new investment Post-money is the total value of the venture after the new investment 34  Pre-Money and Post-Money Valuation Example: Prior to raising capital, a venture has 100,000 exiting shares. A new investor will invest $150,000 and get 20,000 shares. What are the pre- and post-money valuations? Implied share price = $150,000 ÷ 20,000 shares = $7.50 Pre-money valuation = 100,000 shares x $7.50 = $750,000 Post-money valuation = $750,000 + $150,000 = $900,000 35  Ratchets and Antidilution Rights Protects the investor from the possibility of a lower valuation in a subsequent financing round If valuation declines, earlier investors gets enough free shares to make their overall average cost per share equal to that of the new investor May make an investor willing to accept a smaller stake for a given level of investment Can make subsequent financing difficult or even impossible to raise 36  Ratchets and Antidilution Rights Example: An investor purchases 100,000 shares with antidilution rights for $2.00 per share. In a subsequent financing round, a new investor invests $75,000 for 50,000 shares. How many new shares must the first investor be given under the antidilution provision? Total investmentOld = $2.00/share x 100,000 shares = $200,000 Share priceNew = $75,000 ÷ 50,000 shares = $1.50 Number of sharesOld = $200,000 ÷ $1.50 = 133,333 New shares to old investor = 133,333 – 100,000 = 33,000 shares 37  Ratchets and Antidilution Rights Example: An investor purchases 1 share with a full ratchet for $1.00 share. The entrepreneur has 2 share. The venture needs money again. There is no ratchet provision. A new investor is willing to invest $1 for 2 shares. Find pre-and post-money value and the value of each party’s ownership. 1. Pre-money value = 3 shares x $0.50 = $1.50 2. Post-money value = 5 shares x $0.50 = $2.50 3. New values to entrepreneur, old investor, new investor Entrepreneur: 2 x $0.50 = $1.00 Old investor: 1 x $0.50 = $0.50 New investor: 2 x $0.50 = $1.00 38  Ratchets and Antidilution Rights Example: An investor purchases 1 share with a full ratchet for $1.00 share. The entrepreneur has 2 share. The venture needs money again. Now, suppose there is a full ratchet for the old investor. Find the resulting share price in the new round and the values of each party’s ownership. (Note: Old investor gets new shares). 1. Post-money value = $2.50 2. Old investor value = $1.00 3. New investor value = $1.00 4. Entrepreneur value = $0.50 (with 2 shares) 5. Value per share for entrepreneur = $0.25 6. Resulting total shares = $2.50/$0.25 = 10 Old investor shares and value: 4 x $0.25 = $1.00 New investor shares and value: 4 x $0.25 = $1.00 39  International Differences in New Venture Funding Type and availability of funding varies globally – enforceability of contracts – institutionalization of investment management – overall societal wealth – level of entrepreneurial activity Ventures in emerging markets rely more on – trade financing – family and friends for equity 40 Figure 2.7 41  New Venture Financing: Summary Funding options are a function of venture stage Staging can reduce the overall funding costs Choice of organizational form can affect the type, amount, and cost of available funding Securities regulations may impact financing options The deal defines the entrepreneur/investor relationship Global differences in new venture financing 42