Transcript IENG 345 Entrepreneurship

Sources of Capital
Disney Productions
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Entrepreneurial endeavors started when 10
“doctoring” German helmets in WW I
$250 started Iwerks & Disney
1937 - success of Snow White
1940 - sold 755,000 shares common stock
raising $8 million
Sold Mickey Mouse to ABC for $5 million for
Disney Land
Funding Stages
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Seed or Start-up
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Development
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SBIR, Venture Capital (A)
Growth
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Bootstrapping, Angel Investors
Debt, Venture Capital (B, C)
Competitive or Maturity
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Debt, IPO
Bootstrap Financing
75% of start-ups are self-financed
Advantages
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Low pressure on
valuation
Easy terms on
ownership
Control by founders
No time spent on
finding investors
Disadvantages
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Unable to fund growth
phase
Lack of funding
commitment for future
Loss of advice from
professional investors
Angel Investors
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Wealthy, experienced entrepreneurs who
invest in start-ups in exchange for equity in
the new ventures
Angles invest about $16 billion per year in
early-stage U.S. companies
Examples
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Jeff Bezos (Amazon) raised $1.2 million from
angels
Mike Markkula invested $91,000 and guaranteed
$250,000 line of credit for Apple Comp. Start-up
Angel Investors
Criteria for Investing
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Within Industry Angel has experience
Within geographic vicinity
Recommended by trusted Bus. Assoc.
Entrepreneur w/right characteristics
Good market growth potential
Investment of $100,000 – 1,000,000 with
40% ownership
Venture Capital
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Managed by investment professionals
on behalf of venture capital fund
Stage Funding
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Seed – team formation / business plan (seldom)
Series A – product development completed
Series B – product test and customer acceptance
Series C – Launch product into market
Venture Capital
Investment Requirements
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Industry is well known to Venture Fund
Investment > $1,000,000
Company is in appropriate stage of progress
Potential return is 40% or more annually
Venture Capitalist Functions
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Obtain finance capital for start-ups
Evaluate projects for other participants
in the venture
Provide expertise for the development
of the firm
Central coordinator for participants
involved in firm
Venture Capital Firms
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National Venture Capital Assoc.
http://www.nvca.org
Silicon Valley Social Venture Fund (SV2)
http://www.sv2.org
Social Enterprise Alliance
http://see-alliance.org
Venture Capital Deal
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Determine cash needed & its use
Locate venture capital investors
Determine risks that can be reduced
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Team risk
Capital risk
Technology risk
Market risk
Agree on valuation & ownership structure
Agree on contract
Existing Operations
Corporate Venture Capital
Advances strategy Allows exploration
Tight of current business: of new business:
Microsoft
Agilent
Loose
Complements
current business:
Intel
Strategic
Provides potential
financial returns:
Dell
Financial
Corporate Investment Objective
Valuation (capital return)
CR  Capital Return
 (1  G ) x I
N
where
G  annual return expected ( gain)
I  Investment required
N  expected harvest time
Valuation (capital return)
Investor invests $1.1 million in the series A
stage, expects an annual return of 45%. If the
harvest time is 5 years, then what is the capital
return ?
Year
1
2
3
4
5
6
Sales
0
1,000
2,500
5,000
8,000
10,000
Profit
(600)
(10)
400
650
1,000
1,200
Cash Flow
(1,100)
0
500
1,200
1,500
1,800
Valuation (market value)
MV ( N )  Market Valuation of firm in year N
 PE x E( N )
where,
PE  price  to  earnings ratio for industry
E( N )  expected earnings in year N
Valuation (market value)
MV ( N )  Market Valuation of firm in year N
 PS x S( N )
where,
PS  price  to  sales ratio for industry
S( N )  expected sales in year N
Valuation (market value)
Based on average earnings growth and
industry, investor estimates PE ratio of 16 and
PS ratio of 2.3 for a 5 year period. Estimate
Market Value for firm.
Year
1
2
3
4
5
6
Sales
0
1,000
2,500
5,000
8,000
10,000
Profit
(600)
(10)
400
650
1,000
1,200
Cash Flow
(1,100)
0
500
1,200
1,500
1,800
Valuation (market value)
Based on average earnings growth and industry,
investor estimates PE ratio of 16 and PS ratio of 2.3 for
a 5 year period. Estimate Market Value for firm.
MV = 16 x E(5)
= 16 x $1,000,000
= $16,000,000
MV = 2.3 x S(5)
= 2.3 x $8,000,000
= $18,400,000
Valuation (Ownership %)
PO  percentage ownership required by investor
CR
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x 100%
MV
7.05
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x 100%  44.0%
16.0
7.05
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x 100%  38.3%
18.4
Venture Capital (Terms of Deal)
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% ownership of investors
Timing of investment
Control exerted by investors
Rights to require an IPO
Type of security
Reservation of ownership (stock options)
Antidilution provisions
Milestones of achievement
Debt/Equity Financing
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Debt financing
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Long term > 1 yr.
Short term < 1 yr.
Equity Financing
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sale of assets
reduction in working capital
extended payment terms
inventory reductions
Financing Sources
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Commercial Banks
Small Business Administration
Research & Development Limited
Partnerships
Government Grants
Private Placement
External Financing
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Evaluation Basis
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length of time funds are available
the costs of the funds
amount of company control lost
Commercial Banks
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Asset Base (Collateral)
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Accounts Receivable
- up to 80% of A.R.
- factoring
Inventory Loans
- finished goods up to 50%
Equipment
- 50 to 80% of equipment value
- lease financing or sale-leasback
Real estate
- 75% of value
Commercial Banks
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Cash Flow Financing
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Line-of-Credit
Installment loans
- 30-40 days, need a track record
Straight Commercial loans
- 30-90 days
Long-term loans
Character loan
- usually requires personal collateral
The 5 C’s
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Character
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Case Tractors in CA
Capacity
Capital
Collateral
Conditions
Small Business Admin.
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SBA Guaranty Loan
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SBA guarantees 80% of amount loaned
new buildings up to 20 yrs.
existing buildings up to 15 yrs.
equipment, inventory, working capital up
to 10 yrs. (5 yrs. common)
See SBA Loan Application Procedure
Government Grants
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Small Business Innovation Research (SBIR)
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Fed. agencies with > $100 million in R&D award a
portion to SBIR grants program
typical 700 projects totaling $40 million
Three Phases
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Idea Phase I
(SBIR funds up to $50,000)
Product Stage - II
(SBIR funds up to $500,000)
Business Stage - III
(private sector funds)
Government Grants
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Participating Agencies
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DOD
NASA
DOE
HHS
NSF
USDA
DOT
NRC
EPA
DOI
DOED
Dept. of Defense
Natl. Aeronautics and Space Admin.
Dept. of Energy
Health & Human Services
Natl. Science Foundation
Dept. of Agriculture
Dept. of Transportation
Nuclear Regulatory Commission
Environmental Protection Agency
Dept. of Interior
Dept. of Education
Debt Financing
Advantages
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Can result in lower cost
of capital
Allows for leverage
Retention of ownership
Disadvantages
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Decreases firm’s drive
to make money
Availability of capital
increases impulse to
spend
Can decrease
company’s flexibility
May cause more
disruption & problems
than was present
without it
Financial Leverage
Firm with No Leverage
Balance Sheet
Assets
Liabilities
Owner Equity
Total Liability &
Owner Equity
Income from Operations
Interest Expense
Net Income
$100,000
$0
100,000
ROA 
$100,000
18,000
 0.18
ROE 
100,000
$18,000
0
$18,000
18,000
 0.18
100,000
Financial Leverage
Firm with Leverage
Balance Sheet
Assets
Liabilities
Owner Equity
Total Liability &
Owner Equity
Income from Operations
Interest Expense
Net Income
$100,000
$50,000
50,000
$100,000
$18,000
4,000
$14,000
Note: ROI = 18,000/100,000
ROA 
14,000
 0.14
100,000
14,000
 0.28
ROE 
50,000
Initial Public Offering (IPO)
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IPO – public issue of stock made by a
company
Total cost to the firm can be 10-15% of
funds raised
Typical offering raising $50 million or >
Initial Public Offering (IPO)
Advantages
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Raises new capital and
provides for later,
additional offerings
Liquidity: converts
ownership to cash
(potential of harvest)
Visibility: builds brand
reputation
Disadvantages
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Substantial cost & effort
Disclosure requirements
(scrutiny)
Pressure to achieve
short-term results
Loss of control to a
majority shareholder
BCD Company
BCD Company
Current Assets
Fixed Assets
Total Assets
15,000
30,000
45,000
Current Liabilities
Common Stock
Retained Earnings
Total Liab & OE
7,000
10,000
28,000
45,000
Net Sales
EBIT
Interest
Earnings Before Tax
Tax (34%)
Earnings After Tax
Preferred Dividends
Earnings Avail
115,000
9,000
0
9,000
3,060
5,940
0
5,940
Shares Outstanding
EPS
Common Dividends
Retained Earnings/Sh
Retained Earnings
1,000
5.94
2.50
3.44
3,440
BCD Company
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Wish to raise 10 million (10,000) to
fund new product line
Bond debt; 20 yr, 11.5% financing
0-4 yrs $ 0
5-19 yrs $400,000
yr 20
$4,000,000
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Expected incremental revenue =
$2,000,000 / yr
BCD Company
Net Sales
EBIT
Interest
Earnings Before Tas
Tax (34%)
Earnings After Tax
Preferred Dividends
Earnings Avail
Shares Outstanding
EPS
Common Dividends
Retained Earnings/Sh
Retained Earnings
Change in EPS
% Change in EPS
Current New Debt New Prod
115,000
115,000
115,000
9,000
9,000
11,000
0
1,150
1,150
9,000
7,850
9,850
3,060
2,669
3,349
5,940
5,181
6,501
0
0
0
5,940
5,181
6,501
1,000
5.94
2.50
3.44
3,440
---
1,000
5.18
2.50
2.68
2,681
(0.76)
-12.8%
1,000
6.50
2.50
4.00
4,001
0.56
9.4%
Impact of debt
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After tax cost of debt = 1,150(1-.34) =
759
Incremental revenue of 2,000 sufficient
to cover increased debt cost of 759
Immediate loss of 76 cents per share
As product sells, increased revenue
results in 56 cent (9.4%) increase in
EPS
BCD Company
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Wish to raise 10 million (10,000) to
fund new product line
Preferred Stock 12.5%
Expected incremental revenue =
$2,000,000 / yr
Preferred Stock
BCD Company
Net Sales
EBIT
Interest
Earnings Before Tas
Tax (34%)
Earnings After Tax
Preferred Dividends
Earnings Avail
Shares Outstanding
EPS
Common Dividends
Retained Earnings/Sh
Retained Earnings
Change in EPS
% Change in EPS
Current New Debt New Prod
115,000
115,000
115,000
9,000
9,000
11,000
0
0
0
9,000
9,000
11,000
3,060
3,060
3,740
5,940
5,940
7,260
0
1,250
1,250
5,940
4,690
6,010
1,000
5.94
2.50
3.44
3,440
---
1,000
4.69
2.50
2.19
2,190
(1.25)
-21.0%
1,000
6.01
2.50
3.51
3,510
0.07
1.2%
Impact of Preferred
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After tax cost of preferred = 1,250 (vs 759)
After tax revenue = 2,000(1-.34) = 1,320
Little opportunity for growth
Immediate impact = 1.25 decline in EPS
As product sells,
impact = +.07 (1.2%) increase in EPS
BCD Company
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Wish to raise 10 million (10,000) to
fund new product line
Common Stock
275,000 new shares @ $36.36 /
share
Expected incremental revenue =
$2,000,000 / yr
BCD Company
Net Sales
EBIT
Interest
Earnings Before Tas
Tax (34%)
Earnings After Tax
Preferred Dividends
Earnings Avail
Shares Outstanding
EPS
Common Dividends
Retained Earnings/Sh
Retained Earnings
Change in EPS
% Change in EPS
Current New Debt New Prod
115,000
115,000
115,000
9,000
9,000
11,000
0
0
0
9,000
9,000
11,000
3,060
3,060
3,740
5,940
5,940
7,260
0
0
0
5,940
5,940
7,260
1,000
5.94
2.50
3.44
3,440
---
1,275
4.66
2.50
2.16
2,753
(1.28)
-21.6%
1,275
5.69
2.50
3.19
4,073
(0.25)
-4.1%
Impact of Common
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Immediate –
EPS
greatest dilution in
1.28 (21.5%) decline in EPS
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Long term - still have a dilution in EPS
.25 (4.3%) decline in EPS
Special Financing
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Lease vs buy
Convertible Securities
Stock Rights
Warrants
Lease
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Types
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Advantages
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Operating
Capital
Way to leverage finances
Lease cost tax deductible
Disadvantages
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Lose depreciation
Lease vs Buy
Tax Rate =
MARR =
t
0
1
2
3
4
5
6
7
NPV =
34%
20%
BTCF
MACRS %
(100,000)
23,500
20.0%
23,500
32.0%
23,500
19.2%
23,500
11.5%
23,500
11.5%
23,500
5.8%
28,500
($13,897)
Depr.
Taxable
Income
Tax
20,000
32,000
19,200
11,520
11,520
5,760
0
3,500
(8,500)
4,300
11,980
11,980
17,740
28,500
1,190
(2,890)
1,462
4,073
4,073
6,032
9,690
ATCF
(100,000)
22,310
26,390
22,038
19,427
19,427
17,468
18,810
($22,053)
Lease vs Buy
Tax Rate =
Lease Pmt
t
0
1
2
3
4
5
6
7
NPV =
34%
12,000
BTCF
(100,000)
23,500
23,500
23,500
23,500
23,500
23,500
23,500
($99,998)
Lease
Depr.
Taxable
Income
12,000
12,000
12,000
12,000
12,000
12,000
12,000
0
0
0
0
0
0
0
11,500
11,500
11,500
11,500
11,500
11,500
11,500
Tax
3,910
3,910
3,910
3,910
3,910
3,910
3,910
ATCF
(100,000)
19,590
19,590
19,590
19,590
19,590
19,590
19,590
($29,386)
Convertible Securities
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Ex: $100 convertible preferred with
conversion ratio of 3
Conversion price of $33 > current market
price
Investors hold looking for market growth
Company sells at slightly higher price
Call provision protects company
Stock Rights
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Ex: BCD has 100,000 shares outstanding and
wishes to sell 50,000 new shares. Current
market price is $50/share. Subscription price is
$40/share.
100,000 rights are issued
Investor gives 2 rights + $40 to buy one new share
Limits potential for dilution of control
Direct appeal for funds to group of investors
Warrants
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Entitle holder to purchase common
shares at a fixed price
Often have long or no expiration dates
Strong potential for earnings dilution
from unexpired warrants
R&D Limited Partnerships
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Funds from Investors looking for Tax Shelters
Three major elements
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contract
- company agrees to use funds to develop
marketable technology
sponsoring company
limited partnership
- limited liability
- income & loss allocated to each partner’s tax return
R&D Limited Partnerships
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Three Stages
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Funding stage
Development stage
Exit stage
Exit Stage
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Equity partnerships - partners form new co. based
on partnership agreement
Royalty partnerships - sponsoring co. pays a
royalty (6-10%) on sales of new product
Joint ventures
R&D Limited Partnerships
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Advantages
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minimum equity dilution
limited risks
Disadvantages
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expensive ($50,000 to set up)
typically more expensive than conventional loans
giving up a portion of technology developed
exit from partnership may be too complex