Transcript Document
11-1
Chapter 11: Human and Financial
Capital
Questions answered in this chapter:
What is a startup?
What are the different sources of human capital that can
play a role in a startup business?
What are the typical sources of funding for an early-stage
startup business?
What elements are needed for a successful pitch to
investors?
How is the value of a startup determined?
What are the factors involved in negotiating with investors?
What is an initial public offering? What process must an
entrepreneur undertake to successfully complete and IPO?
11-2
Exhibit 11-1: Venture Capital —
Market Size, 1995-2001
120
9000
Amount invested
8000
Number of deals
100
7000
80
6000
5000
60
4000
40
3000
2000
20
1000
0
0
1995
1996
1997
1998
1999
Source: Data from PricewaterhouseCoopers, MoneyTree Survey: Full Year & Q4 2001 Results: US Report.
2000
2001
11-3
Defining a Startup
A startup is a business that is in the process of
developing the underlying infrastructure needed to
support future growth
A startup is a business engaging in the the
following three basic processes:
–
–
–
Developing and refining the offering and strategy to go
to market
Obtaining initial funding to begin operations
Building a capable management team to handle
operations
11-4
Exhibit 11-2: Startup Business
Investment Stages
Early Stage
Financing
Stages
Seed Stage
Validate the
business concept
(e.g. build
prototype,
develop business
plan, conduct
market research)
–
Investment
Purpose
Type of
Investors
Source:
Angel investors
Traditional VC
Consulting firms
Online VC firms
Incubators
Expansion Stage
Startup
Build
management
team and
complete
product
development
Angel investors
Traditional VC
Consulting firms
Incubators
Gold Book of Venture Capital Firms, Bob Zider,
“How Venture Capital Works,” Harvard Business Review
SecondStage
First-Stage
Expand
production,
marketing, or
sales
capabilities
Traditional VC
Corporations
Later Stage
Provide working
capital once
shipping products
or providing
services
Traditional VC
Corporations
Mezzanine
Fuel substantial
growth (typically
provided to
business that
are at least
break even)
Traditional VC
Corporations
Buyout firms
Investment banks
Bridge
Prepare for
initial public
offering,
usually
planned in the
next 6 months
to a year
Traditional VC
Corporations
Buyout firms
Investment
banks
11-5
Relationship between Human
and Financial Capital
Human and financial capital resources can
influence the business planning process and,
in turn, be influenced by the business plan
–
–
Human capital resources may include
entrepreneurs, management team, strategic
advisors and partners, and logistical advisors and
partners
Sources for financial capital include debt
financing and equity financing
11-6
Exhibit 11-3: The Relationship
Between
Financial Capital
Human
Human Capital and Financial Capital
Equity
Entrepreneur
Bootstrapping
Management Team
Business
Planning
Process
Angels
Venture Capital
Corporate Ventures
Holding Company
Strategic Advisors
& Partners
Debt
Logistical Advisors
& Partners
Trade Credit
Commercial Bank
Loans
11-7
Elements of a Solid Business
Planning Process
The major elements of a business planning process
include the following:
–
–
–
–
–
–
–
–
–
–
Defining the value proposition
Framing the market opportunity
Detailing how to reach customers
Developing an implementation plan
Evaluating potential external influences
Articulating the revenue model
Identifying needed people
Calculating preliminary financial projections
Establishing critical milestones
Summarizing the advantage
11-8
Human Capital
The role of human capital in a startup business is
especially critical because, for a time, it is the only
resource available
When investors consider funding an early-stage
company, they assess its human capital
–
–
–
–
Who is the entrepreneur?
Does she have the drive to see this business through?
Who is on the management team?
Will they be able to execute?
The human capital attracts the financial capital
11-9
Characteristics of Successful
Entrepreneurs
Key characteristics common to successful entrepreneurs
include the following:
–
–
–
–
–
Keenly Observant. Entrepreneurs are those who are able to
make observations about the needs of industries, markets, and
everyday life and find the best way to meet these needs
Willingness to take risks. Entrepreneurs are willing to leave
stable jobs and guaranteed salaries for their enterprises
Drive. The entrepreneur’s personal drive is especially important
in the early stages, when his enthusiasm spurs the drive of
other employees
Flexibility. The ability to adapt and react quickly are especially
important in the fast-changing Internet environment
Vision. The most successful entrepreneurs are not driven by
money, but by a vision or a passion consistently pursued
11-10
The Trials and Tribulations of the
Entrepreneur
From the outset, the entrepreneur is faced with
reconciling several difficult paradoxes:
–
–
–
Being visionary vs. being realistic. The entrepreneur is
faced with the challenge of coming up with unique ideas
that are grounded in reality
Generating quick returns vs. investing in the future. The
entrepreneur is challenged with staying the course to
build the organization while meeting the demands of the
investors who are needed to build the organization in the
first place
Optimism vs. pragmatism. While optimism is an essential
motivating force, it must be balanced with the
pragmatism to evaluate potential weaknesses of the
business
11-11
The Entrepreneur and the Idea
Some of the most common types of
business ideas include the following:
–
–
–
Introduce a new product (new software—MP3)
Introduce a new service (overnight delivery—
FedEx)
Improve an existing model of business (selling
books on the Internet—Amazon.com)
11-12
The Management Team
The core team consists of individuals essential to
the early formative days of the startup who will fill
the following three roles:
–
–
–
Technology specialist: is the person who understands the
specific mechanics of how the product works, how it is
manufactured, and how it can be utilized
Sales and marketing specialist: is the person with an indepth understanding of the startup’s customer
Execution specialist: is the person who keeps everything
in perspective in the startup’s development making the
vision for the business a reality
11-13
The Management Team (cont’d)
Extended management team can be created on an
as-needed basis, depending on how quickly the
startup is growing
–
–
–
–
–
–
Chief operating officer
Chief financial officer
VP of marketing
VP of sales
VP of business development
Chief people officer
11-14
Strategic Advisors and Partners
Strategic advisors and partners provide the startup
with strategic direction, advice, and in many
instances credibility for the organization as a whole
–
–
–
–
Advisory board members serve as an outsourced resource to
fill a particular need and may receive stock options in exchange
for their expertise
The board of directors consists of individuals who will be
responsible for the well-being of the company, as well as
holding the management team accountable for its actions when
the business formalizes operations
A strategic association is the agreement of two entities to work
together and exchange expertise in areas where they lack core
competencies
A strategic alliance is a legally binding contractual agreement to
share resources on a project for a particular timeframe
11-15
Logistical Advisors and Partners
Logistical advisors and partners differ from the
strategic advisors and partners in that they are
more involved in the day-to-day operations of the
business
–
–
Necessary logistical advisors and partners include
certified public accountants (CPA) and legal counsel
Supporting logistical advisors and partners serve as
outsourced, human-capital leverage for the startup and
may include intermediaries, consultants, and incubators
11-16
Financial Capital
Sources of debt financing (commercial banks, trade credit)
Sources of equity financing (bootstrapping, venture-capital)
Strategic investors are concerned how a certain business
compliments their current activities (exposure to cutting-edge
technology or business model, collaboration in research and
development for a product, etc.)
Financial investors are concerned with return on investment
(ROI), internal rate of return, cost of capital, and return on
equity
11-17
Debt Financing
Trade credit is credit extended to a business by its suppliers.
It is an interest-free loan covering the time period from when
supplies are delivered to when the invoice is due
–
–
Suppliers typically offer trade credit to buyers with an
established track record of making prompt payments
Hidden interest rate cost
Commercial bank loan is, typically, an installment loan in
which the business borrows a certain amount of money for a
specified period with either a fixed or variable interest rate
–
–
Commercial banks evaluate a business’ loan application by
assessing the likelihood of loan repayment
Bank loans can be relatively difficult to obtain, especially for
early-stage businesses with little collateral and no positive
cash flow
11-18
Equity Financing: Bootstrapping
Bootstrapping is the art of using personal resources to
finance the early stages of a startup
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–
–
–
Bootstrapping may include taking a personal loan, mortgaging
a home, using credit cards or savings accounts
Bootstrapping provides the most viable option for the
entrepreneur when the startup is in the earliest stages of
business, especially during the stages that involve proving the
business concept
Bootstrapping allows the entrepreneur to control the company
and refine his business strategy without pressure from outside
investors
The disadvantage of bootstrapping is that it is unlikely to
provide sufficient cash for a good business concept to grow
quickly beyond the earliest stages
11-19
Equity Financing: Venture Capital
Venture-capital firms are usually private partnerships or
closely held corporations that raise money from a group of
private investors
–
–
–
–
–
A venture-capital firm typically invests $250,000 to $10 million
in a business in exchange for a 30 to 40 percent equity stake
and a seat on the board of directors
In addition to receiving cash, the entrepreneur receives
guidance for building the startup
Venture capitalists, typically, charge management fees on the
order of 1 to 5 percent of the capital investment in a startup
A venture-capital firm seeks opportunities that will return 10
times the original investment within five years, but realizes that
each investment is a gamble and that only 10 percent are
likely to succeed
The biggest disadvantage of venture capital funding is the
source’s concern with the bottom line
11-20
Exhibit 11-5: Venture Capital
Investments—Breakdown by Stage
100
90
1999
2000
2001
80
70
60
50
40
30
20
10
0
Startup
Source:
Early-stage
Expansion
$BB
Data from PricewaterhouseCoopers, MoneyTree Survey: Full Year & Q4 2001 Results: US Report.
Later-stage
11-21
Exhibit 11-6: Top 10 Venture
Capital Dealmakers in 2001
New Enterprise Associates
Baltimore, Md.
82
Intel Capital
Chandler, Ariz.
72
J.P. Morgan Partners
New York, N.Y.
69
Bessemer Venture Partners
Wellesley Hills, Mass.
68
Austin Ventures
Austin, Texas
62
U.S. Venture Partners
Menlo Park, Calif
61
Warburg Pincus
New York, N.Y.
53
St. Paul Venture Capital
Eden Prairie, Minn.
52
Technology Crossover Ventures
(TCV)
Palo Alto, Calif.
49
Mobius Venture Capital
Mountain View, Calif.
47
[i] Source: Data from PricewaterhouseCoopers, MoneyTree Survey: Full Year & Q4 2001 Results: US Report.
11-22
Equity Financing: “Angels”
“Angels” are wealthy individuals who invest personal capital
in startups in exchange for equity or sometimes a seat on the
board of directors
–
–
–
–
Its critical for the entrepreneur to develop a network of
individuals within the industry to gain introductions to potential
financiers because “angels” seldom look at unsolicited
business plans
Business plans are evaluated based on the quality of the
management team, market potential for the business idea, and
the track record of the entrepreneur
Typically, “angels” are more flexible in accepting changes in
the original business plan if it is necessary
“Angels” tend to be more involved in the day-to-day”
operations of startups
11-23
Equity Financing: Corporate
Ventures
Large corporations sometimes set up venture funds as a
subsidiary that can make investments on behalf of the parent
company, referred to as either corporate venture or “direct
investors”
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–
–
–
Corporate-venture funds invest in complimentary business for
primarily strategic reasons
In exchange for cash, capital ventures seek an equity stake in
the company and access to the company’s technology or
product
Established corporations can offer the operational expertise as
well as the credibility and visibility that come from associating
with an established high-profile parent
Because the investments are strategic rather than financial, the
pricing of deals with corporations tends to favor the
entrepreneur more than deals with venture-capital firms
11-24
The Business Plan
A business plan should provide the following information to a
potential investor
–
–
–
–
–
–
Description of the product or service that will be offered and
the value proposition for the customer
Summary of the size and nature of the market opportunity
Explanation of the revenue model
Profiles of the management team, advisory board, and board
of director members describing specific relevant skills and
expertise
Clear articulation of the startup’s core competencies and
sustainable competitive advantage
Summary of financials and financing needs
11-25
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
11-26
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
11-27
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
11-28
Exhibit 11-7: Typical Discount
Rates by Funding State
Startup
50% to 70%
First Stage
40% to 60%
Second Stage
35% to 50%
Third Stage
30% to 50%
Fourth Stage
30% to 40%
IPO
25%-35%
Source: Data from James L. Plummer, QED Report on Venture Capital Financial Analysis (QED Research, Palo Alto, CA),
1987
11-29
Negotiations
Principles for Entrepreneurs
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–
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)
11-30
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
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Convertible Preferred
– Redeemable Preferred
– Participating Convertible Preferred
11-31
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
11-32
Exhibit 11-8: Pre- and Post-Money
Valuations Made Easy
Cumulative
%
Received
this
round
VC’s
Share
Founder’s
Share
$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
Round of
Financing
Seedstage
Round
Amount
invested
this round
Implied
Valuation
(Post Money)
11-33
Exhibit 11-9: Venture-Backed IPOs,
1995-2001
248
216
200
Number
of IPOs
143
121
68
21
Source: Data from VentureOne research.
1995
1996
1997
1998
1999
2000
2001
11-34
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
11-35
Exhibit 11-10: 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 currency
Doesn’t necessarily provide a liquid market for all
shareholders because of restrictions on trading the stock
11-36
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
11-37
Exhibit 11-11: Internet Mergers and
Acquisitions in 2001
Number of Deals
400
Total Amount of Deals
16
14
Number
of Deals
per Year
12 Billions of
10
300
8
6
4
2
200
Q1
37
Source: Data from Webmergers.com database.
0
Year 2001
Q2
Q3
Q4
dollars