1 Cambridge Judge Business School Raising financial capital Simon Stockley Senior Teaching Faculty in Entrepreneurship
2 Objectives: Planning your funding strategy key questions Appropriate funding sources Cash burn rate - the Valley of Death Valuing new ventures Structuring equity investments Sources of equity Venture Capital Debt finance
3 The bootstrapper s mantra. Never buy new what can be bought second-hand Never buy what can be rented Never rent what can be borrowed Never borrow what can be begged Never beg what can be salvaged
4 The difference between species Venture Capitalist Corporate Banker Both are dangerous, but at least VCs are predictable
5 Planning your funding strategy - ten key questions: i. How much do you need? ii. iii. iv. When do you need it? How long will it take to raise the money? How long will it last? v. What will it be used for? vi. vii. viii. ix. What type of money do you need? From whom will you raise it? How expensive is the money? How and when do you plan to repay it? x. Is the business actually fundable?
6 Additional factors to consider when raising money 1. The type of business you are starting affects the type of financial capital you can access 2. What stage of development your business is at and how soon you are likely to generate sales revenue affects 3. The perceived risks determine the returns expected by financiers 4. Your attitude towards sharing ownership and control 5. Your bargaining power relative to the providers of capital If you cannot convince an investor that they will get six to ten times their money back after 5 years they are VERY unlikely to invest
7 Debt vs. Equity Key Features: Equity Debt Dilution of ownership Cost of money Time taken to raise money Cost associated with raising money Available to lifestyle businesses Disadvantage for founders Advantage for founders Paid back if business fails Smart money Requires regular repayments Can be raised pre-revenue Security taken over assets Directors guarantees required Increases fixed costs and BEP
8 Who assumes the risk? Equity invested by business angels Risk Risk Angel Founders Perform due diligence Require warranties from founders Require founders to invest their own money Funds released in stages based on the achievement of agreed milestones Money borrowed from a bank Only lend to established businesses with sales revenue Take security (a legal right to sell) against the assets of the business Insist on personal guarantees from the Directors of the business Sometimes use the Enterprise Finance Guarantee Scheme (EFGS)
9 Perceived risk must be balanced by returns Risks - (MMIST) Management will the team fall apart, can they execute? Market - is there a growing market, will customers buy? Industry - will competitors kill you, do you have a protectable advantage? Supply chain - will suppliers and distributors deal with you and on what terms? Technology - does it work, can you make it work, how much will this cost? Risk Risk Risk Prerevenue start up Start up with growing revenues Established business with growing revenues Retur n 45-60% IRR + Return 30-45% IRR Return 20-30% IRR
10 Risk and cost of equity capital + Seed 1 st Round 2 nd Round Growth capital 60% IRR % IRR 30-40% IRR 20-30% IRR Cash flow Valley of death Promised land Time _ RISK
12 Health Warning Do not try to finance your business with debt until you have reliable cash flow from sales
13 Early Stage Funding Options Initial Ideas Feasibility Prototyping Commercialisation Own savings, earned income, friends & family, Grants (TSB, EU, Regional), Accelerators Start-up loan scheme Equity crowd funds, Seed funds (SEIS) Business Angels Until you have a workable business model your options are extremely limited especially without secure IP Venture Capital Bank Loans Real Sales!
14 Financing the journey to the promised land + Break even point (Avg. 36 months) Promised land Bank balances $ 0 Cash break even point (Avg. 60 months) Time _ Valley of death Amount of external finance required
15 Different Firms, Different Profiles Technology firm Large investment required Late break-even Huge upside (Microsoft) Bank balance Time Consulting firm Low investment required Early break-even Modest upside
16 A guaranteed method for putting off investors! We have a virtually risk free investment opportunity offering HUGE returns..! + ve Bank balance 0 - ve We are going to build the next Facebook, all we need is 100,000! Valley of death (risk) Promised land (return) Time What you re actually communicating: We are un-investable because we haven t got a clue what we re doing!
17 A typical lean start up cash flow profile Customer creation and growth can consume a huge amount of cash + ve Bank balance 0 Break even Time - ve Customer discovery Customer validation Customer creation Growing the business
18 Filling the Valley of Death + ve Founders funds Bank balance 0 - ve Grant Equity crowd funding Valley of death Angel syndicate Promised land Time
19 Your relative bargaining power when raising money from equity investors Your relative bargaining power High Med/High Medium Low 100,000 for a 20% equity stake Pre-money valuation = 400,000 Assuming you sell the business for 4.0m in five years time: Selling 20% leaves 3.2m Selling 30% leaves 2.8m Selling 50% leaves 2.0m 100,000 for a 30% equity stake Pre-money valuation = 233,330 7 months cost you 1.2m! 100,000 for a 50% equity stake Pre-money valuation = 100,000 Zero 12 months 9 months 6 months 3 months Out of cash Cash reserves in bank
20 How long does it take to raise money? Venture capital 12 to 18 months Angel equity 6 to 9 months Crowd funding 3 to 6 months Bank debt 2 months Off Balance Sheet finance 1 month It always takes longer than you anticipate!!
21 Cambridge Judge Business School Valuation Simon Stockley Senior Teaching Faculty in Entrepreneurship
22 The VC valuation method Most Angels and VCs wish to exit after 5 years (the target year) The internal rate of return required (discount rate) will depend on the level of perceived risk. Let s call it 45% The multiple (M) of the investment required by the investor is simply calculated as follows: the target year M = (1 + internal rate of return) Thus M = ( ) 5 = 6.41
23 The capital return (CR) is simply the multiple (M) times the original investment (I). Lets call I 1.1m giving us: CR = 6.41 x 1.1 = 7.05m The percentage ownership (PO) expected by the investor will be: PO = Capital Return Market Valuation (in target year) X 100% Our task is now to estimate a market value (MV) in year 5 (the target year). The most common way of doing this is to use the *price to earnings ratio (PE) for comparative firms. Thus: Market value = PE x projected earnings in target year (NPBIT) *Note: PE ratio = share price/earnings per share (EPS = NPBIT/number of shares)
24 Let s assume that the PE ratio for similar quoted firms is 26 and that projected NPBIT in year 5 is 1m The unadjusted Market Value in year 5 is thus 26 x 1.0m = 26.0m The required percentage ownership is, therefore: X 100% = 27.1% In practice, however, the PE of quoted companies may be subject to a discount by the investor. This can easily amount to 30% but is a matter for negotiation.thus: PE (adjusted) = PE (PE x discount rate) So PE (adjusted) = 26 (26 x 0.30) = 18.20
25 Thus, if a discount rate of 30% is applied the percentage ownership required rises: X 100% = 38.7% Therefore, it is in your interests to persuade the investor that: 1. The risks (managerial, market, industry and technological) are low so that the required annual rate of return (which reflects financial risk) can be reduced 2. That earnings in the target year are realistic so as to avoid too heavy a discount 3. That the PE ratio is indeed comparable.
26 What does your business have that justifies your pre-money valuation? Rapid traction and (better still) real sales Investors understand that success is 1% inspiration and 99% effort Investors respect passionate, focussed and hard working teams that deliver tangible results quickly... 80% Action 20% Analysis (unlike Business School) Your past and present achievements (e.g. tangible business results) count for more than wishful thinking. The value of your business is what someone is prepared to pay!
27 Building Enterprise Value Enterprise valuation ( ) Business with a patent Value adding activities Grant funding obtained Patent Founding team recruited Proof of concept Prototype (MVP) Strategic alliances & partnerships Proof of market Beta test Early customer traction Seed funding obtained Adoption by reference customer First round investment Sales growth Lifestyle business 0 Time 1. In the absence of defensible IP a business idea has no value 2. Understand precisely what adds value from the POV of an investor 3. Spend your time working on these things!
28 The investment lifecycle of a start-up Angel Angel + Equity crowd fund Angel + Equity crowd fund + Venture Capital Founders? Seed 1 st Round 2 nd Round Exit..? Time
29 Cambridge Judge Business School Structuring equity investments Simon Stockley Senior Teaching Faculty in Entrepreneurship
30 Structuring the deal: The business was founded in 2005 with shares split between Liz (7000) and Simon (3000) At this point we do not know the value of these shares After 18 months an investor, Bob, offers to invest 18,000 in return for a 45% equity stake in the business. Stage 1. The first step is to calculate the pre-money valuation (its value before the investment is made): Pre-Money Value = (Amount of investment/equity stake) amount of investment So: Nosh Ltd. ( 18,000 / 0.45) - 18,000 = 22,000 The share price (or value) of an unquoted company is only known at the time the deal is done
31 Stage 2. We now need to calculate the value of each share which is simply: Pre-money valuation/number of shares. So, 22,000/10000 = 2.20 Note: The share price (or value) of an unquoted company is only known at the time the deal is done You need to understand that equity investments are negotiated in percentages (e.g. 45% for 18,000) but structured using shares. When a business raises money by selling equity it issues new shares to the investor. The investor does not take a proportion of the shares that already exist (e.g. 45% of 10,000 shares) Stage 3. Calculate the number of new shares to be issued. The deal share price is 2.20 and 18,000 is being invested. The number of new shares will, therefore be: 18,000/ 2.20 = 8182 The total number of shares is now 10, = 18182
32 Post-money = 40,000 Pre-money = 22,000 Liz Simon Bob Liz Simon 30% 45% 38% 70% 17% In summary: 1.Calculate the pre-money valuation 2. Calculate the deal share price by dividing the premoney valuation by the number of shares 3. Determine the number of new shares to be issued by dividing the investment amount by the deal share price.
33 Second round investment In early 2009 Liz, Simon and Bob agreed to sell 30% of the equity in Nosh to Johnston Press for 165,000 Structuring the deal: Stage 1. Calculate the pre-money valuation (its value before the investment is made): Pre-Money Value = (Amount of investment/equity stake) amount of investment So: ( 165,000 / 0.30) - 165,000 = 385,000 Stage 2. Calculate the deal share price Pre-Money Value /number of shares = 385,000/18182 Deal share price is therefore 21.17
34 Stage 3. Calculate the number of new shares to be issued Investment amount/deal share price = 165,000/21.17 Number of shares issued to Johnston Press = % 27% 30% 45% 38% 12% 70% 17% 31% Liz Simon Liz Simon Bob Liz Simon Bob Johnston Press 22,000 40, ,000 Bob is happy because his 18,000 is now worth 170,500 even though his ownership share has been diluted from 45% to 31%
35 A Bad Second round investment Down Round In early 2009 Liz, Simon and Bob agreed to sell 30% of the equity in Nosh to Johnston Press for 15,000. They are not happy about this but they have no choice, without the investment the business will become insolvent. Structuring the deal: Stage 1. Calculate the pre-money valuation (its value before the investment is made): Pre-Money Value = (Amount of investment/equity stake) amount of investment So: ( 15,000 / 0.30) - 15,000 = 35,000 Stage 2. Calculate the deal share price Pre-Money Value /number of shares = 35,000/18182 Deal share price is therefore 1.92 (Down from 2.20)
36 Stage 3. Calculate the number of new shares to be issued Investment amount/deal share price = 15,000/1.92 Number of shares issued to Johnston Press = 7792 Bob has protected himself with a full-ratchet anti-dilution clause...! He will be fully compensated for his loss by the re-allocation of shares from Liz and Simon Stage 1: Calculate the financial loss to Bob 8182 x ( ) = 2250
37 Stage 2: Calculate the number of shares required to compensate him 2250 / 1.92 = 1169 Stage 3: Calculate the number of shares reallocated from Liz and Simon Liz = 1169 x 0.7 = 818 Simon = 1169 x 0.3 = 351 Stage 4: Calculate the new ownership percentages Liz = % Simon = % Bob ( ) = % Johnston Press % The value of Bob s original investment ( 18,000) has been maintained...
38 Cambridge Judge Business School Early stage equity finance Simon Stockley Senior Teaching Faculty in Entrepreneurship
39 Sources of Equity Finance Your personal wealth (savings, equity in house) and that of business partners Family Crowd funding < 1m Business Angels < 1m (some syndicates may do more) Venture capital > 2m Corporate partners
40 Crowd funding The democratisation of capital? New platforms are launching with increasing frequency Crowd funding transactions in the UK are currently growing at over 100% per annum! Much of this is due to: The inability (or reluctance) of commercial banks to lend to small businesses since the financial crisis of 2008 Low rates of interest available to savers Regulatory reform by the UK Government Tax incentives (such as SEIS) which reduce risks for investors The relatively low barriers to entry associated with launching a crowd funding platform
41 Types of crowd funding Four broad categories: 1. Equity Money is invested in then business in return for an ownership stake (e.g. Seedrs, Crowdcube, Syndicate Room) 2. Debt Money is lent to the business (e.g. Funding circle) 3. Reward Money is given in return for non monetary rewards such as the goods or services to be produced by the business (e.g. Kickstarter) 4. Donation Money is given to support good causes (e.g. Justgiving, Spacehive) Crowd funding helps to validate your ideas and gain exposure for your business
42 Equity crowd funding platforms Average success rate is approximately 20% Transaction sizes have grown significantly in 2014 Valuation On most platforms you decide the valuation! All-or-nothing vs. keep what you get? Nominee structure? Fees usually in the range of 5% to 7.5% of sum raised Due diligence Basic legal checks but not into the idea or tech!
43 Raising money on equity crowdfunding platforms 1. Research - Study successful campaigns and the many online guides 2. Plan your campaign carefully 3. Set a realistic valuation It increases the odds of success 4. Build awareness use your personal and professional networks, social media and promote through your website (no spam though)! 5. Build momentum by pump-priming the campaign 6. Make a professional video pitch 7. Proactively manage your campaign Campaigns are quickly becoming FAR more professional..!
44 Business Angels Business Angels ( Angels ) are high net worth individuals who invest their own money into early stage new ventures. Often (but not always) experienced entrepreneurs Often (but not always) provide smart money by providing advice and making introductions to suppliers, distributors and customers k is usual investment but some super angels and angel syndicates may invest far larger amounts ( 1m +) They use their contacts and angel networks to find investment opportunities Increasingly using angel led crowd funding platforms such as Syndicate Room There are approximately 8,000 active angels in the UK To be considered by angels, your investment should (must) be eligible for the Seed Enterprise Investment Scheme (SEIS)
45 Seed Enterprise Investment Scheme (SEIS) For companies Maximum total SEIS investment 150,000 Must be under two years old Fewer than 25 employees Gross assets of under 200,000 Be in an approved sector UK registered with UK operations Funds must be used within 3 years For investors Max investment 100,000 50% income tax relief Returns are free of CGT Losses written down against tax Can have ordinary shares only Scheme closes 5 th April 2017 To avoid delays in closing your funding round, apply for your SEIS certificate well in advance
46 Returns to angel investors They understand that a high percentage of new ventures fail or underperform Even with experience and due diligence it is very difficult to pick winners To manage this risk they build a portfolio of investments (8 to 10) They are unlikely to invest unless the upside potential is 6 to 10x their money back Overall, returns average 2.2x (an IRR of 22.4% after 4 years) This compares very favourably to later stage venture capital funds! 1 Super star (10 to 15x) A typical angel portfolio Acceptable returns (3 to 4x) Get money back (1x) Total loss! The big question Will this investment give me at least 6 times my money back inside 5 years?
47 Business Angel resources Angel networks and service providers News and information about angel investing A useful introduction to angel investing k/member/directory HMRC site on SEIS Enterprise investment scheme association
48 Cambridge Judge Business School Venture capital Simon Stockley Senior Teaching Faculty in Entrepreneurship
49 So...you want to raise venture capital? My name is Rupert Although I am cultivated I am utterly ruthless You are not my customer You are not my friend I do not care about you or your hirelings If you fail me I WILL ruin you Now...how may I help you?
50 Venture Capitalists are Intermediaries Investors (limited partners) Companies e.g. Investment banks, pension funds, wealthy individuals, family offices VC Fund VC Firm (General partners) e.g. Amazon.com, e-bay, Ceres Power
51 VCs think in milestones and dream of EXITS Nobody makes real money until the exit!
52 The Venture Capital Cycle Investors in fund: Pension funds Investment funds Wealthy individuals Return distributed as cash or shares Fund 50m 10 years 500m VC firm raises, invests and manages fund VC firm keeps 20% of any return over 100% (Carried Interest) + charges a 2% management fee
53 Venture Capital - Some basics Equity is invested in rounds (seed, 1 st Round, 2 nd Round, etc.) Each round is released in tranches based on the achievement of milestones Be prepared for founder share vesting clauses! Some terms will alarm you They always require a board seat Deal structures vary widely, you need to take professional advice
54 VC Share Rights The convertible, redeemable, preferred ordinary share... They get their money back first and foremost under all circumstances...! Example: A VC invests 2.0m in return for a 50% stake in your company. After 5 years the business is sold for 4.0m, what is the return to the investor?
55 If the company is sold for 4 million VC receives its 2 million back (like a loan) 2 million remains VC receives its 50% share of remaining 2 million (= 1 million ) = 3 million for VC = 1 million shared out by other shareholders VC receives 75% of the proceeds
56 And if the company is sold for 10 million VC receives its 2 million back (like a loan) 8 million remains VC receives its 50% share of remaining 8 million (= 4 million) = 6 million for VC = 4 million shared out by other shareholders VC receives 60% of the proceeds
57 But..beware of the Liquidity Preference Company is sold for 4.0m and there is a 2x liquidity preference in the term sheet VC receives its 2 x 2 million back (like a loan) = 4m zero remains = 4 million for VC = zero for the other shareholders VC receives 100% of the proceeds
58 And if the company is sold for 10 million VC receives its 2 x 2 million back (like a loan) = 4m 6 million remains VC receives its 50% share of remaining 6 million (= 3 million) = 7 million for VC = 3 million shared out by other shareholders VC receives 70% of the proceeds
59 VC decision making Plans submitted After quick scan After few hours study 3.1 minutes After full investigation After price negotiations % Remaining
60 What VCs say they look for. The team - Especially positive if they have worked together before Clean IP portfolio - Especially in early stage tech firms Sector - Investors back what they know (so check out their portfolio). Traction in large, growing markets Financial indicators - Gross margin is a favourite Entry valuation - A black art Exit route - Can I get out? When? How? Valuation? Due diligence - any skeletons?
61 Top deal killers Poor quality management - leave positions vacant rather than recruit the wrong people Insufficient market size the best plans address huge opportunities Insufficient critical mass to the technology - VCs will not back a one-shot wonder Problems with intellectual property portfolio But.It depends heavily on the individual investor
62 Cambridge Judge Business School Debt finance Simon Stockley Senior Teaching Faculty in Entrepreneurship
63 Those aged 18+ living in England and looking for finance to start a business Average loan size is around 2,500, but the final amount will be determined by the business plan. There is no definite limit It is a personal loan, which means if 4 or 5 people from the same company apply for a loan, all are eligible for an individual loan up to invest in their business Paid back within 5 years at a fixed-rate of interest (currently 6%). Capital repayment holidays are available, but interest must be covered monthly throughout Start-up loans are accessible to anyone who had a business in its initial phase (up to 1 year from founding)
64 Corporate bankers When it matters most they are likely to let you down They are allergic to risk Trust is an alien concept Everything is negotiable Beware of personal guarantees They hate surprises Communication is the key!
65 CAMPARI : The Banker s Maxim Character - respectable & trustworthy? Ability - track record, team, potential Margin - % above base rate Purpose - expansion, rescue or buying toys Amount - is this realistic, too much or too little? Repayment - can you pay the interest and repay the principal Insurance - if required, is there security?
66 Enterprise Finance Guarantee (EFG) scheme The government will underwrite 75% of the loan An additional 2% is chargeable on the loan and paid to the Department of Business, Innovation and Skills Loans range in size from 1,000 to 1m The term of the loan can be from three months to 10 years EFG applies to: New term loans Refinancing an existing loan Converting an overdraft into a fixed term loan Guaranteeing an overdraft Guaranteeing invoice financing Lending decisions are made by the bank who will only turn to the EFG if the usual security criteria cannot be met by the business Lenders will still usually require a personal guarantee! This personal guarantee cannot include your principal private residence
67 Invoice Discounting Your customers will not be aware that you are using an invoice discounter... Your customer Invoice discounter Day 60: Customer pays you Day 1: You invoice customer Day 1: Customer and invoice details sent to discounter Day 2: discounter pays you 80% of the invoice value Your business Goods sold to customer on 60 days credit Day 60+: You repay the discounter the 80%, plus interest. Interest rate: 1.5% to 3% above base Credit management fee: up to 0.5% of invoice value
68 Factoring Day 60: Customer pays factor Your customer Factor Day 1: Invoice sent to customer by factor Day 1: Customer and invoice details sent to factor Goods sold to customer on 60 days credit Day 2: Factor pays you 80% of the invoice value Your business Day 60+: Factor pays you the remainder of the invoice, less charges. Interest rate: 1.5% to 3% above base Credit management fee: up to 2.5% of invoice value
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