THE FINANCING PROCESS IN INNOVATIVE STARTUP FIRMS

Transcription

1 THE FINANCING PROCESS IN INNOVATIVE STARTUP FIRMS TALES FROM THE ENTREPRENEUR PERSPECTIVE EIGHT SWEDISH CASES PhD Anna Söderblom, PhD Mikael Samuelsson & PhD Pär Mårtensson Stockholm School of Economics November Version 3.0 The study outlined in this report constitutes one part of a larger research project set up by the Stockholm School of Economics, Center for Entrepreneurship and Business Creation. The aim of the larger project is to increase our understanding about companies choices of early financing as well as about possible connections between funding sources and future firm performance. The project is managed by PhD Anna Söderblom and PhD Mikael Samuelsson. The project started in July 2012 and will run to December The project is funded by the Handelsbanken s foundations and VINNOVA.

2 1. INTRODUCTION Young innovative firms as engines for economic growth have garnered substantial attention during the last couple of decades. Much of this focus stems from the wide-spread view that such businesses account for a significant share of job creation, innovation, and economic growth (e.g., Storey, 1994; Birch et al., 1995; Henrekson and Johanson, 2010). Hence, the possibility for innovative startup firms to develop and prosper has become a major objective for most economies, whereby policy makers put lots of energy into finding direct or indirect methods to stimulate this type of efforts. In this context, the lack of funding facing young and innovative ventures is an ever-occurring theme (e.g., Berger and Udell, 1998; Cassar, 2004; Vanacker and Manigart, 2010). That is, given their liability of newness due to an absence of track record and a high default risk (Stinchcombe, 1965; Hannan and Freeman, 1977; Baum, 1996), potential financiers are skeptical to provide funding. Hence, innovative startup firms are considered more financially constrained than other companies, which in turn restrain their development and growth paths. As a consequence the area of finance for startups has enjoyed an increasing interest from scholars, resulting in a substantial body of research over the years. A vast majority of these studies concerns startup funding from the supply side, first and foremost focusing on venture capitalists (Tyebjee and Bruno, 1984; Fried and Hisrich, 1989; Wright and Robbie, 1998), and to some extent business angels (Amatucci and Sohl, 2004; Paul et al., 2007). Meanwhile, our understanding of the entrepreneurial view on financing issues is still limited (Cressy and Olofsson, 1997; Paul et al., 2007; Sorheim and Rasmussen, 2010). This study aims at contributing to the small stream of research investigating startup financing from the perspective of demand, where we particularly explore entrepreneurs opinions on, and approaches to, financing. More specifically, we study the four stages in the financing process, i.e., planning, search, evaluation/negotiation and post-investment activities, from the entrepreneur s viewpoint. The aim is to widen our understanding of similarities and differences among entrepreneurs of innovative startups regarding their approaches to funding. Moreover, the paper examines the relevance and applicability of well-established theoretical explanations in the field. Due to this scarcity of research, an explorative inductive research design in the form of case studies was called for. Therefore, we have conducted in-depth interviews with eight entrepreneurs were we were able to get a deeper understanding of the entrepreneurial perspective on financing processes. Our results show that more experienced entrepreneurs in general have a more strategic approach to funding based on predefined funding plans, while less experienced entrepreneurs manage funding on a more ad hoc basis. Furthermore, we found that entrepreneurs exercise high levels of control in their relations with equity investors both ex ante and ex post the investment. We also found a path dependency pattern in the choice of funding, where the firms tend to use the same types of funding over and over again. One significant finding regarding funding sources is that capital arriving from family and friends is absent in our study and that formal VC investments are highly limited. Söderblom, Samuelsson & Mårtensson 2

3 2. THEORETICAL FRAMEWORK The lion part of studies about investment processes in startup firms occur in the venture capital (VC) and business angels streams of research. Typically, investor processes are split into three phases (Tyebjee and Bruno, 1984; Fried and Hisrich, 1994; Wright and Robbie, 1998; Paul et al., 2007). First the pre-investment stage, which involves investor activities related to the search, initial screening and thereafter more thorough due diligence activities. Second, the investment stage, which concerns the negotiation of contractual terms and conditions as well as of firm valuation. Third, the post investment stage concerning the activities taken place after an agreement has been settled, including control and coaching of investee firms, management of future rounds of financing, and exiting. In one of few studies that shift perspective, Amatucci and Sohl (2004) explored the investment decision process involving women entrepreneurs and business angels from the perspective of demand. They split the process into three stages, search, contract/negotiation, and post investment. In this report, we structure the discussions around Amatucci and Sohl s (ibid.) proposed process stages, but also add a fourth component, planning. This stage concerns activities and decisions made before the entrepreneurs start to search for external financiers, i.e., their approaches to, and preferences for, various funding sources. Figure 1 below illustrates the four stages. Planning Search Evaluation & Negotiation Postinvestment Figure 1. The financing process from the perspective of entrepreneurs 2.1. PLANNING One of the more influential ideas in the finance literature used for explaining firms capital structures is the pecking order theory (POT) a theory about hierarchical financing order stemming from a presence of information asymmetries between companies and their potential financiers (Myers and Majluf, 1984). According to this theory external finance is costly, and therefore managers prefer to finance new investments with internal funding as far as possible. Only when internal funds are insufficient to meet a firm s financing needs, managers will turn to the more expensive outside funds. Of the external sources, the theory stipulates that debt financing is preferred to equity since the former will suffer less from information asymmetries and, hence, is subject to lower premiums (Myers, 1984; Myers and Majluf, 1984). This hierarchy is referred to as a financial pecking order. While the pecking order theory was originally developed to explain financial strategies of large and mature companies, several scholars acknowledge that the traditional pecking order hierarchy applies also to startup firms (Berger and Udell, 1998; Huyghebaert and Van de Gucht, 2007; Robb and Robinson, 2010; Vanacker and Manigart, 2010; Minola and Giorgino, 2011). Just as larger companies, small and emerging firms prefer to finance new projects with internal means, and thereafter, if necessary, seek external debt capital and only lastly look for expensive external equity given the high costs associated with giving up ownership stakes. Hence, using external equity funding would be a signal of low quality since this is the last resort for firms. Other scholars, however, maintain that the traditional pecking order is reversed for startup firms due to two Söderblom, Samuelsson & Mårtensson 3

4 reasons. First, the rank order is likely to be distorted if the investors have superior knowledge about the commercialization of an entrepreneur s innovation. Second, external equity may also be ranked higher in case the investors are able to add value to their investment projects (Garmaise, 2001; Carpenter and Petersen, 2002). Another theoretical model used for investigating determinants of financing sources for firms is based on the company life cycle paradigm, with the proposition that different capital structures are optimal at different points in a firm s lifetime (Berger and Udell, 1998). The basic idea is that financial needs and options are likely to change as the venture grows, gains more experience and becomes less opaque. According to Berger and Udell (ibid.), smaller and younger firm have to rely more on insider finance, trade credits and angel funding. As they grow, equity finance will also be available from venture capitalists, as well as debt capital from banks and other financial institutions. Eventually, if the firm continues to grow, it may gain access to public equity through an IPO. Figure 2 presents Berger and Udell s (ibid.) illustration of the financial growth cycle for small businesses (somewhat simplified). Firm size Firm age Very small firms, possibly with no collateral and no track record. Small firms, possible with high growth potential but limited track record. Medium-sized firms. Small track record. Collateral available, if necessary. Large firms of known risk and track record. Owner Angels VC Public equity Trade credit Bank loan Figure 2. The financial growth cycle of firms according to Berger and Udell (1998, p. 623), somewhat simplified In addition to explanations based on the POT theory and the lifecycle perspective, a growing stream of literature has identified other factors that affect startup firms funding structures related to the characteristics and desires of the entrepreneurs, including their backgrounds, growth ambitions and reluctance to lose control (Howorth, 2001; Sapienza et al., 2003; Eckhardt et al., 2006), their knowledge about finance alternatives (Seghers et al., 2012), and their established networks and existing relationships (Atherton, 2009). Taken together, the literature has identified a large variety of factors that will impact startup firms funding portfolios. Söderblom, Samuelsson & Mårtensson 4

5 2.2. SEARCH The next step in the financial process concerns how entrepreneurs identify and approach various funding providers, including subsidy providers, governmental debt providers, banks and other financial institutions, business angels or other private investors, and venture capitalists. While there is limited research on startup firms financial search process in general, some studies about business angels exist. Sohl (1999) identifies five touch points for business angels and entrepreneurs: (i) venture capital clubs, (ii) angel alliances, (iii) physical matching networks, (iv) internet matching networks, and (v) loosely organized referrals from for example other entrepreneurs, lawyers and service providers. Paul et al. (2007) recognize three major sources of business angels investment opportunities: business associates, business angel networks and investment syndicates. How entrepreneurs search processes for other types of funding, e.g., subsidies, governmental debt, private debt, funding from corporations, are structured is still largely unknown EVALUATION & NEGOTIATION When the entrepreneur has identified an investor who potentially is interested to invest in the firm, an evaluation and negotiation phase takes place. In the venture capital and business angel literature, agency theory has been the dominant theoretical perspective used to explain the process (Sahlman, 1990; Sapienza and Gupta, 1994; Van Osnabrugge, 2000). Agency theory puts forward that the entrepreneur (the agent) has more and better information compared with the investor (the principal). Hence, the principal seeks ways to mitigate any risks involved (Jensen and Meckling, 1976). Van Osnabrugge (2000) argues the business angels and venture capitalists differ in their approaches to mitigate risks. He suggests that venture capitalists seek to decrease asymmetries of information primarily through extensive investment screening and due diligence of the potential investee firm followed by constructions of optimal contracts, i.e., they base their control through an ex ante approach. Business angels, on the other hand, mitigate uncertainties primarily through ex post control, referred to as an incomplete contract approach. Supporting this view, Wong et al. (2009) find empirically support for that venture capitalists and business angels differ in their ways of overlooking investee firms. While venture capitalists primarily use terms in the shareholder s agreements, such as board rights, staging of investment and contractual provisions, to control their investee firms, business angels exercise control by post investment activities and assistance. Besides terms and conditions in the shareholders agreement, the valuation of the firm is usually a central part of the negotiation between investors and entrepreneurs. Entrepreneurs are considered to strive to obtain as high valuation as possible, i.e., minimizing giving away equity, while the investors seek a lower valuation, enabling them to obtain more equity for their money. Finding a reliable valuation of a startup firm can be challenging. Four major corporate finance valuation methods are: transactional comparisons, discounted cash flow (DCF) method, price earnings multiple and the net asset method. However, these methods to a high extent depend on strict theoretical assumptions and require information that young ventures cannot easily provide. Hence, arguments for that their applicability is limited in valuating early-stage ventures have been put forward (Miloud et al., 2012). There are even claims that startup valuation to some extent remains a guess. Particularly for business angels, where the angel and the entrepreneur try to feel their way to an agreement (Paul et Söderblom, Samuelsson & Mårtensson 5

6 al., 2007). That is, some angels tend to approach the issue of firm valuation intuitively, unable to provide rationales for final valuation decisions POST INVESTMENT The post investment phase concerns the interactions between investors and the investee firm after an investment has taken place. Also here the venture capital and business angel literature dominates, while the post-investment relations between other types of financiers and entrepreneurs remain relatively unclear. It is argued that the ex-post involvement differs between venture capitalists and business angels. Venture capitalists are considered to take on formal roles such as strategic sounding boards and financial advisors (Manigart and Sapienza, 2000). In contrast, business angels typically expect not only to contribute strategically, but also to interact with the entrepreneurs on a more operational, day to day, basis (Madill et al., 2005; Paul et al., 2007). 3. METHOD The aim of this study is to describe and explain the financing process in innovative startup firms from the entrepreneurs perspective. Due to a scarcity of research, an inductive explorative research design in the form of a multiple-case study was called for. The case-study approach is considered appropriate when addressing the whys and hows (Yin, 2003) and facilitates analyzing when patterns are sought for (Patton, 2002). Accordingly, in-depth interviews with eight founders of innovative Swedish firms were carried out with the purpose to reveal the subtleties of the financing process. The eight cases were identified from applications to the VINN NU program at VINNOVA (the Swedish Governmental Agency for Innovation Systems). VINNOVA aims at promoting sustainable growth by improving the conditions for innovations and by funding need-driven research. Every year VINNOVA invests about 2 billion SEK through various programs. The competition program VINN NU, targeting young innovative firms, is one of them started in The purpose of the program is to support new innovative firms to prepare and clarify commercially-interesting development projects in an early phase in order to promote further development, including attracting additional funding and, in the long term, become viable and successful companies. Given the exploratory nature of this study, the cases included in the study were selected with broad variation, enabling analysis of different ends of the spectrum, as well as identification of important themes (Eisenhardt, 1989; Yin, 2003). The interview process can be described as qualitative interviewing (Rubin and Rubin, 1995) or active interviewing (Holstein and Gubrium, 1995), where the interviewing is built on three types of questions: (i) main questions to begin and guide the interview, (ii) probes to complete and clarify an answer or ask for further examples, and (iii) follow-up questions to pursue implications of answers to main questions. In six cases the interviews were carried out by two researchers, and in two cases they were conducted by one researcher. All interviews were held in May and June 2013 at the premises of the respective firm, with one or two of the founders. The lengths of the interviews ranged from 45 minutes to two hours. During the interviews we tried to create an open atmosphere in order to make the communication as open as possible (ibid.). With the permission of the entrepreneurs, the interviews Söderblom, Samuelsson & Mårtensson 6

7 were recorded and assurances given that the identity of the individuals and the firms would not be disclosed. The empirical material was collected through the interview process described above, which was based on an interview guide (see Appendix 1). Given our primary unit of analysis, being the financing process in innovative startup firms, the interview guide focused on aspects of this process. Examples of the main questions included (i) How did you identify possible sources for funding?, (ii) Who were involved in the discussions and decisions about funding?, and (iii) How was the valuation of the company done? The information collected from the interviews was first summarized case by case. The summaries of the eight cases were displayed in multiple tables with the purpose to give an overview and facilitate the comparison between the different cases. Each researcher read summaries and looked for patterns (Patton, 2002). In workshops with the three researchers, cross-case analyses were carried out. We were searching for commonalities as well as inconsistencies within the context of the research question. In this analysis we identified patterns, which will be discussed later. 4. CASES In this section, empirical findings are presented. Each presentation follows the same basic structure: (i) a background presentation of the company and founders, (ii) presentation of their planning phase, emphasizing the founders attitudes towards various funding sources, (iii) empirical findings with regards to the search phase, (iv) empirical findings with regards to the evaluation and negotiation phase, (v) empirical findings with regards to the post investment phase, and (vi) initial interpretations from the case. In order not to reveal identities of the respondents, names in the case descriptions have been replaced with pseudonyms. Table 1 presents an overview of the eight cases included in the study. Söderblom, Samuelsson & Mårtensson 7

8 Table 1. Overview of the eight cases included in the study Product Alpha Beta Gamma Delta Epsilon Zeta Kappa Omega SW for internet services SW B:B Consultancy & SW Internet service Internet service Manufacturing Manufacturing Manufacturing Firm founded Founders education Mix of master s in techn. & business adm. Master s of techn. entrepr. school Mix of master s in techn. & business adm. Master s in business adm. Mix of master s in techn. & business adm. Entrepreneurship school Master s of technology Startup experience Some extent No High extent Some extent No No No No Cooperation within the founder team PhD in Medicine High level Low level High level High level High level High level High level Single entrepreneur Business and/or financial plan Number of external owners Responsible for dev. of shareholder s agreem. Customer/financing orientation View on financial portfolio High extent Limited extent No No No Some extent High extent No ~ Founders (initiated by investor) Financing 30%, Customers 70% Relatively broad portfolio Has no agreement Financing 80% Customers 20% Business angels major route Founder Financing 15% Customers 85% Customer financing, debt & factoring Has no agreement Primarily customers Customers and subsidies Founder Founder Founder Founder Primarily customers Public funding, business angel Primarily customers today (before financing) Mainly governmental subsidies Financing 70% Customers 30% Subsidies Financing 15% Customers 85% Subsidies, public loans

9 T H E F I N A N C I N G P R O C E S S I N I N N O V A T I V E S T A R T U P F I R M S 4.1. ALPHA Background Alpha develops software targeting internet businesses. The firm was founded in 2011 by a group of friends, whereof two founders joined the team after the firm had been set up. As a group, the team possesses solid financial and engineering expertise. Planning The founders were all well aware of the need for external funding, i.e., that the firm could not survive on customer revenues in the early phase. Already at the start, venture capital was the preferred choice. Two of the founders had financial backgrounds and their knowledge of, and contacts within, the VC industry was relatively good. But also business angel investments were discussed. Before the CFO entered the firm, some discussions were ongoing with potential business angel investors. However, the CFO was concerned of diluting the existing owners in case the company was forced to fund the company on a low valuation. Hence, he also advocated capitalization from other sources such as governmental subsidies and various types of debt. Which was a strategy that was approved by the other founders. Search As a result of the decision to fund the firm with a relatively broad spectrum of funding sources, the CFO took the lead to investigate the funding market. In a nascent stage, the firm got a seat in an incubator, was awarded a few subsidies and also received an innovation loan from ALMI. In parallel, the Alpha founders explored the VC market. Since one of the founders made a study of the VC market before starting Alpha, he had developed a few contacts in the Swedish as well as in the UK VC markets. The CFO complemented the list with information from the trade associations SVCA and EVCA. Taken together, they worked with a list of about 30 potential VC investors. In the beginning of 2012, the founder team started to approach VC firms. The response was rather poor. Although the VCs showed interest in the proposed business idea, the general feedback was that the firm was too young with an unproven business idea. Therefore, the VC track was closed after a few months. Instead, various debt providers, subsidy providers and small investment companies were approached. Alpha managed to get funding from a few of these sources. After one year in business, the founders re-started the process to look for external equity. This time not only venture capitalists but also business angels were approached. Identifying business angels was significantly more difficult than finding VCs. Through personal connections and by utilizing the incubator s network, the founders managed to identify a few business angels who were approached. Finally eight investors showed an interest to invest in Alpha, whereof six business angels and two smaller investment companies. Evaluation and negotiation When negotiating with the investors, one issue concerned how to arrive at a reasonable firm valuation. One of the founders proposed the usage of traditional valuation techniques such as DCF or multiple Söderblom, Samuelsson & Mårtensson 9

10 approaches. Something that the others thought was more or less impossible given the early phase and hence difficulties to make reliable financial forecasts We thought it was high chaparral to make a DCF. Instead, two factors were included in the equation when calculating a valuation capital needed and the entrepreneurs dilution willingness: We needed 10 msek and were willing to give away 10 percent. This led to a rather high valuation. However, after receiving negative responses from the investors, the founder re-thought the setup, We realized that we could take half [of the capital] from ALMI, halving the valuation and still give away only 10 percent. Still, the valuation level was met with hesitation from the business angels. Therefore, the entrepreneurs tried to get the investors to state their expected valuation level instead. This turned out to be a bit confusing and in hindsight lengthened the process. Finally, one person in the loosely connected consortium of eight business angels and smaller private investors, took lead in the negotiations with Alpha. A valuation of 25 msek was finally set, giving the external investors 20 percent of the company. For the development of a shareholder s agreement, the entrepreneurs were referred to one of the largest Swedish law firms by the lead investor. The firm became the legal advisor for the entrepreneurs and drafted the contract, originating from a standard agreement. While the contract was far from as strict as a traditional VC-contract, according to the respondents, a few terms were of particular importance to the investors: (i) the entrepreneurs salary levels, (ii) veto right with respect to stock option programs above a level of 10 percent, and (iii) terms concerning potential future financing rounds. But the investors did not get any preference shares, other veto rights were not stipulated, and the total amount of investment was made at the same time, i.e., not due to fulfilling any particular milestones or similar. That is, it seems like the entrepreneurs had a large portion of control of the terms stated in the agreement, It was our contract since we had drafted it. We started on our half of the battle field. After all parties had accepted the valuation, a due diligence was taken place. According to the entrepreneurs, this was to a high extent a tick in the box -exercise. The founders consider the due diligence to be rather detailed given that it was a business angel investment, not a venture capital ditto. Post investment After the investment had been carried out, the board was complemented by members from the investor group. Thereby a formal board work started, which up to then had been considerably more informal. In addition, each month investor reports including financial prognoses are sent to the investors. The entrepreneurs consider that this is of great value to the firm, since it forces the entrepreneurs to keep good control of their financial situation. Or as one of the founder says, One cannot underestimate how important it is to be whipped. Interpretation Alpha offers standardized software to a limited number of business customers. The founders have kept to their original business idea, and have not developed alternative revenue streams such as providing software consultancy services. Hence, the company has clearly been in need for external funding. The founders have good financial skills although limited startup experience. While equity capital is the preferred financial strategy, the founders have strived to keep dilution levels down by Söderblom, Samuelsson & Mårtensson 10

11 minimizing costs as well as capitalize their venture also by subsidies and debt. This has led to a rather broad portfolio of financial sources already from start, as depicted in Figure 4a, We have not followed the school book step by step, starting with family and friends. [ ] Because of the free premises at the [incubator], the VINN NU-subsidy, the ALMI innovation debt, and the currently low office rent, we have managed to develop the company to an attractive position without becoming too diluted. Alpha was able to attract capital from rather professional business angels, who have contributed to the development of the company. The financing activities have taken lots of time and effort, which seem to under a period of time have had a somewhat negative impact on the founders focus on core activities such as sales and market development. Alpha. Year 0-2. Founders Venture capital Friends and family Biz angels/private Subsidies Commercial loans Public loans Figure 4a. External funding sources Alpha (SQR of investment) 4.2. BETA Background Beta was founded in august 2003 by Peter Landström. The company develops and sells software that hinders illegal activities on the Internet. Peter invited three former colleagues as co-founders and management team, while taking on the role as the CEO himself. From the interview it is clear that he takes the vast majority of decisions in the company concerning the overall strategic direction including financial related matters. Peter has a master s degree in entrepreneurship as well as an engineering education in software development. Peter states that the three major takeaways from the entrepreneurship education were: (i) the skill how to write an attractive business plan, (ii) how to find soft money, and (iii) getting the legitimacy associated with graduating from the school. Beta had a seat in an incubator. In an early phase, Peter was in contact with the World Childhood Foundation and received high interest. Not only did the foundation donate some money, but also provided legitimacy to the idea and contributed with important connections. Furthermore, dialogues were initiated with the Swedish police authority and with Interpol early on. Söderblom, Samuelsson & Mårtensson 11

12 Planning Peter did not have any financial plan for the company, i.e., a written strategy for how to fund the business. Neither did he have a clear view on how much money that was needed to develop the firm, but rather a pragmatic we just raised as much money as possible. However, one key learning that Peter brought from his education was to apply for as much soft money as possible. Hence, Beta applied for various public subsidies, and was successful. In those applications the entrepreneur learnt how to adjust the idea to fit the requirements from various sources. In a similar vein, public loans were considered useful leading to an approval of an ALMI loan. But the major financing source was from business angels, or private persons. The issue to be diluted has not bothered the entrepreneur more than that dilution is ok as long as not too much. To date, seven financing rounds from up to 180 private investors have taken place, typically with rather small amounts per investor. Revenues from customers have been scarce until recently, with only a few exceptions. Paying customers have to high extent been identified through the network, not least through the contacts with the World Childhood Foundation. The good cause characteristic of the product was the factor that convinced the CEO of Telia, as well as a few others corporations, to enter into an agreement with Beta. The software has not been used though to any high extent in these organizations. Over time, Peter s interest to raise venture capital has increased. Besides the infusion of money, the competence and network associated with venture capitalists are sought for. However, two factors have hindered the firm to attract venture capital according to Peter: (i) the high valuation (see below), and (ii) the large number of owners. The possibility to get industrial corporations as investors has been considered as well. However, the interest from large organizations such as Microsoft and MacAffee to invest has turned out to be limited. Commercial loans have not been an alternative since such institutions, according to Peter, demand personal securities that he is not willing to provide. Hence, the company has no commercial debt, not even a trade credit. Search Instrumental in the search for business angels and private persons willing to invest was the chairman of the board, Kerstin Larsson. With a financial background, Kerstin had a broad network of potential investors that she invited to invest in Beta. In preparation for each round of investment, Peter put together a prospect. In each round, the existing investors helped in the process by identifying additional investors. Over time Peter wanted to complement the investor base with venture capitalists. Peter went to the US where he managed to meet a few well-known venture capitalists. Existing investors helped in the process to open doors to these firms. Also in Sweden, Peter identified a few venture capitalists. When approaching the Swedish VCs, Peter engaged a small corporate finance advisor. Currently, Peter is negotiating with a Swedish VC, which was identified though through recommendations. Söderblom, Samuelsson & Mårtensson 12

13 Evaluation and negotiation There have been seven rounds of equity financing from an increasing group of business angels and private investors. In the first round, six external business angels, or rather private persons, decided to invest. Peter proposed a valuation of 32 msek, a valuation level that was not based on any particular calculation: Why 32 msek? I don t know. When the potential investors argued that the level was too high, Peter responded What about 16 msek?. And thereby the valuation was set. The investors were interested to invest for two reasons: to make a good investment with potentially good returns, but also because they liked the good cause angle. Also in the next round the same valuation level was kept. Thereafter the valuation has increased in each round. Not because the company has developed according to plan, rather the opposite since the product has been constantly delayed and the list of customers has been unsatisfactory low. Instead, the valuation has been based on the valuation set in the previous round with an abundant increase each time. That is, existing investors have been keen to keep a high valuation with the expectation that it must be a higher valuation given the time factor. When the investors started to buy and sell shares amongst each other, the expectations on valuation raised even further. In the end, the valuation reached remarkably high levels around msek. Despite the fact that about 40 msek has been invested in the company from business angels and private investors, the founder team still owns 50 percent of the company. In the last round of funding, i.e., at the exceptional high valuation, also more professional investors in the form of investment companies and venture capitalists were invited to participate. For the first time, the proposal and financial forecasts were scrutinized in more details. These more professional investors did not accept the high valuation and proposed a significantly lower level. Furthermore, an existing base of 180 investors was considered a major issue. Hence, none of the venture capitalists were interested to invest. Finally, the company managed to get funding from the existing investors on a valuation between 250 and 280 msek. Up to now, all negotiations had been managed and to a high extent controlled by Peter, i.e., he has been the one to suggest the valuation levels and the level of funding needed to his large base of private investors. There has never existed any shareholder s agreement among the shareholders. However, the set valuation has become a major obstacle for the firm since new investors do not accept such a high level, while existing investors have a hard time to accept that their shares have lost in value. In the current negotiations with a new VC, the VC has reduced the valuation significantly in comparison with the previous round. This requires a lot of negotiations with current owners, and is still not settled. Peter is willing to proceed though, despite a heavy dilution in ownership, since other alternatives are limited. Furthermore, he look forward to bring in more professional and active investors. In this negotiation, it is the venture capitalists that have the negotiation power and the numbers are more scrutinized. Still, a valuation based on traditional valuations techniques is difficult, according to Peter: They have to base their calculation on my numbers and these are not real, we know that for sure. If the deal that is currently negotiated will be carried out, the founders will have about 30 percent of the shares after this round. Peter believes that they made a big mistake by not rising more funds when the valuation was on a very high level: We should have realized that we had an exceptional high valuation. People Söderblom, Samuelsson & Mårtensson 13

14 accepted it. It was not linked to our performance. [...] We should have taken the opportunity to raise considerable more money. Post investment The company had since its foundation an external board of directors. While Peter represents the founders, the chairman of the board Kerstin used to represent the external investor group. The latter are passive owners, where the only contact is through a newsletter sent occasionally. Interpretation Beta is to a high extent a one man show, where the CEO has the control of all major decisions in the firm. The early decision to capitalize the firm by business angel/private money has clearly had the effect that other funding sources hardly exist in the firm (see Figure 4b for an illustration). Moreover, the financing process has taken lots of energy and time from the CEO, where he has spent much time on searching for funding rather than on other core activities such as sales. An overall feeling is that product development has constantly been delayed paved with some quality issues, while investor expectations have remained high. Beta.Year Founders Venture capital Friends and family Biz angels/private Subsidies Commercial loans Public loans Figure 4b. External funding sources Beta (SQR of investment) 4.3. GAMMA Background Jacob Ullström, Peter Rundberg and Rasmus Larsson had been working for a number of years in a startup firm, founded by a well-known Swedish entrepreneur, when they in 2004 decided to start their own venture, Gamma. Initially the idea was to develop software but when Jacob decided to leave, the strategy shifted into offering IT consultancy services. Today Gamma is once again more of a software company, with a portfolio consisting of mobile applications, e-commerce platforms and other softwarebased solutions. Peter is an engineer and Rasmus has a university degree in business administration. Peter took on the role as the CEO of Gamma, while Rasmus is the chairman of the board. The founders work close and share decision making in, and control of, the company. Or, as Rasmus puts it, my wife refer to Peter as my second wife. Söderblom, Samuelsson & Mårtensson 14

15 During a period of time, Gamma was partly owned by a Finnish corporation. After a few years, however, the entrepreneurs bought back the company. Today, Peter owns 78% of the firm, Rasmus 21% and the remaining 1% of the company belongs to the employees in Gamma. Planning It was to a large extent their experiences from the dot com boom and bust that led to Peter and Rasmus strong views on how to finance their venture: (i) customer funding should always be a vital part in development projects, (ii) as far as possible, money should be earned before spending, and (iii) the ultimate control of the business should be kept in the hands of the founders. Or, as Rasmus puts it: We learned the hard way that if you spend [other people's] money without making yourself worthy of them, you will live on others' merits and that is never sustainable. Keeping solid financial control of cash-flows, liquidity status, etc. and continuously evaluating various funding alternatives have always been important. Initially the founders financed Gamma to some extent by governmental subsidies. The entrepreneurs view on subsidies is however rather negative, and today considered a waste of time. Rasmus says: When applying for subsidies you write the application to get funding. However the money needs to be assigned to certain pre-specified projects, which turns out to be problematic for a startup that constantly needs to adjust the business to meet market needs. Taking on external investors such as business angels or venture capitalists have not been an alternative due to the founders unwillingness to lose control and ownership, If you take on a venture capitalist or a business angel [...] you know that they have a different agenda: they make money by lending money. And it is not certain that it matches your needs at any given time - it's more likely that it does not. Instead, the major funding sources in Gamma are early customer payments, factoring and lines of credit. Search Rasmus continuously evaluate banks and other credit providers to find the best deals. The company has changed bank a number of times, where the terms are the only thing that matters when choosing providers of commercial loans, lines of credit or factoring services. The founders are willing to sell Gamma in case the price is attractive enough, but have never been actively seeking a buyer. In 2007, a Finnish corporation approached them and presented a bid to acquire the company. Evaluation and negotiation When it comes to negotiations with banks and factoring companies, Rasmus spends significant efforts to get the best deals. The negotiations with the Finnish corporation started in Since the acquiring company had limited experience from acquisitions, the entrepreneurs managed to take control of the process, including the responsibility to draft the contract with some help from a lawyer. Rasmus was surprised, or as he puts is They did, in my eyes, a blunder when they asked us to draft the purchase agreement. According to Rasmus, the founders of Gamma suggested a rather high valuation, close to 40 msek. Söderblom, Samuelsson & Mårtensson 15

16 The valuation was not due to any particular valuation method, but rather: We wanted 20 million SEK, and ended up at 19.7 million after the negotiations. Moreover, the terms were favorable for the founders. Payments for the first 51% was delivered immediately, while the remaining part should be paid after three years. However, if the Finnish company decided not to carry out the second part of the deal, the entrepreneurs would be offered to buy back their shares on favorable terms. In the final negotiations, the Finnish corporation had only a few objections to the terms in the proposed contract. For example, the entrepreneurs needed to accept a lock-in period of three years, which they willingly accepted as a way to keep control of Gamma throughout this period. The acquirers then accepted the purchase agreement, which gave the Finnish company 51% of the shares immediately with an option to buy the remaining 49% within two years. The shareholder s agreement was clearly to the founders favor, since it gave them control of the company even though they were minority shareholders. Post investment Gamma continued to operate as a separate entity, a subsidiary of the Finnish company, also after the acquisition. There were no plans to integrate it with the acquiring corporation. In the deal, the Finnish company had the right to staff two board seats, which they did with own personnel. The entrepreneurs consider these three board members ability to contribute to the development of the company as nonexistent. After a few years, the Finnish corporation filed for bankruptcy and Peter bought back the company. Rasmus had during this time left the company, but soon after joined Gamma again. The entrepreneurs have throughout the company s history been keen to develop a board with external high-professional, independent board directors. The board meetings, about 10 per year, are relatively formal and structured and are kept primarily on a strategic level. Interpretation The founders of Gamma had experience from startup firms previously and had a very clear strategy about how to finance their venture, i.e., primarily based on customer revenues. Their guiding star has been not to lose control, and therefore they have preferred to modify the business idea in order to develop alternative revenue routes rather than capitalize the company from external equity sources. Hence, Gamma s funding is based on customer payments, factoring and commercial debt as illustrated in Figure 4c. Söderblom, Samuelsson & Mårtensson 16

17 Gamma. Year 0-9. Founders Venture capital Friends and family Biz angels/private Subsidies Commercial loans Public loans Figure 4c. External funding sources Gamma (SQR of investment) 4.4. DELTA Background Early spring 2010, three of the founders of Delta is preparing a presentation for the Swedish Dragons Den in the cellar of the incubator they currently have a seat in. The CEO of the incubator is invited to listen and comment on the pitch. The idea is innovative and highly scalable for a global market. The pitch is pretty awful at this time. However, after a full day of preparations they present to the Dragons, and manage to convince one of them to invest in Delta. The investor is experienced, with a long and proven track record both as an entrepreneur and investor. From now on, it s full throttle. The team goes into sales mode. Among their first customers is a large international company and the deal is closed over the phone. Delta is also quick to double the Dragon funding with soft money, loans, price money from competitions, and also later on by more formal capital. Delta thereafter enters an international market and is in 2013 a market leader within its niche. Planning The four founders have, despite their young age, experience from various startups and from capitalization of young firms. Before founding Delta, they knew that they needed some kind of muscles, based on earlier experiences from being underfinanced. The plan was simple: go out and get money. Venture capital, loans, soft money, and price money from competitions anything goes. By coincidence, they got an invitation to participate in the Swedish version of Dragons Den, We were six months down the road and needed to get some kind of funding. We thought that venture capital could be an alternative. The team hesitated because we got all to lose and nothing to win. However, they decided to go ahead, which resulted in that one of the business angels actually closed the deal on prime TV. An early valuation was also made during the TV show. The team had a plan, but it was more of an ad hoc plan. Delta focused from the beginning on sales and customer funding. The company got a large international customer on board early on, where the deal was closed over the phone. This provided Delta with a proof of concept. Söderblom, Samuelsson & Mårtensson 17

18 Search The Delta team searched through all types of soft-money schemes and developed almost a profession in getting soft-money, We went on all sources and especially soft money and competitions. But also other sources of funding were sought for, We doubled with ALMI. Then we looked at business angels, and some kind of partners. Delta also thought of capitalizing the firm from providers of larger investments, but hesitated, We always thought that a big investment would be great. However, the business model is constantly changing so it was difficult to go for the big money. All founders were initially involved in the funding process together with the board of directors. Later it was two of the founders, the CFO and the CEO, who did most of the work. During the first years, the company used four major funding sources, i.e., various types of business angel investments, public grants, price money from competitions, and governmental loans. No money did arrive from friends and families, neither from formal VC firms in the early startup phase. The team met with a number of VC firms but did not really have a solid case for spending the amount of money that such investors would commit. Evaluation and negotiation Delta got a valuation at the Dragons Den show, which was both god and bad. The problem was that it was a fast, paper-based valuation, rather than based on more thorough analyses. The first agreement was also made during the show, which obviously is different compared to most investment deals. The valuation level set on Dragons Den was subsequently used during discussions with governmental funding organizations as well as in discussions with VC firms and business angels. The relation with investors is rather informal, We never have had any contract. It is a handshake and then back to work. Delta considers it difficult to negotiation with governmental authorities regarding funding, and hence the founders have been forced to make a few modifications of their business idea in order to fulfill criteria stipulated for some of the governmental subsidy programs. Delta is today a more mature company and have come to a position where the management team can present a case based on a stable business model and a plan to use a larger investment, Now we can sit down and make a budget for a valuation of 20 msek. We have a proof of concept, some key metrics, a large database of users, and therefore a real value. Negotiations with private investors are based on informal information and trust rather than on any type of formal due diligence. They used the Dragon as a sign of legitimacy. Post investment Delta is still young and is learning from their own processes. The Dragon has been, and still is, an important sounding board to the entrepreneurs. A new business angel has made an investment and also taken a seat in the company board. Today Delta has a more stable organization and a strong professional board of directors. Söderblom, Samuelsson & Mårtensson 18

19 Interpretation Getting a deal in the Dragons Den was important for the founders since it provided them with money to kick-start the venture, legitimacy through the Dragon, and an active business angel. It is also typical for the case. The plan and search is ad hoc rather than planned, where also funding decisions are made based on urgent needs rather than on formal plans and prognoses. This has resulted in a range of small and large subsidies, loans and also business angel investments (see Figure 4d). It has been a time consuming process, which has forced the team to tweak the business model and from time to another lose focus on other core activities. Today, the founders are confident with their situation, Now we know what we are doing, and it is possible to approach an international VC with a solid plan. Over time, Delta has developed a better governance structure. There are no written shareholder agreements and no formal post investment control though. Clearly it is a learning process where the founders continuously develop their business, gain more confidence and also knowledge. In the beginning everything was trial and error. Delta. Year 0-3. Founders Venture capital Friends and family Biz angels/private Subsidies Commercial loans Public loans Figure 4d. External funding sources Delta (SQR of investment) 4.5. EPSILON Background Epsilon started out with three founders from two leading universities in Stockholm. Together they could be considered a dream team: One tech person, one sales person and one person that could structure the business. The team was young but highly motivated with a clear sales focus. They did not have a product but they sold their vision to large Swedish companies on a dummy product. The strategy was to develop the technology as fast as possible, which turned out to be more complicated than the founders anticipated. We meet the company s representative in the new offices downtown Stockholm, The business model is changing and I am leaving the company says the representative. We are moving closer towards coupons and a more promotion based business model compared to our initial plan. It is early in the life of the business and the team is young. Change is part of the game for Epsilon. Söderblom, Samuelsson & Mårtensson 19

20 Planning Epsilon is a sales focused company, where the team was able to sell a dummy version of their product to a number of large corporations. The team members divided the work between themselves early on and also recruited external board members. The planning process was rather ad hoc, We just went along. We had a plan about what we wanted to do and we started to sell it. We got positive feedback and just kept going. The first employees were paid with a promise of future salaries and ownership. Few papers were signed. Neither was the process of securing funding planned and far from straight forward, or as one of the founders puts it: We started without thinking of the future and had to solve each obstacle when is arose. Epsilon managed to get a micro loan, a subsidy from the VINN NU program and also a somewhat larger loan from ALMI. Search The search process was also ad hoc. The CEO basically went out to meet with all kinds of investors, including providers of public subsidies, ALMI, venture capitalists, business angels, etc. A price in the venture cup competition helped them with some money and more importantly connections, i.e., as price winners they had no problems to set up meetings with potential investors. Furthermore, Epsilon had customers from day one even though the company did not have a product to deliver. The development process took much longer time than they expected. The management at this point met with a few VC firms, but we know we were not ready. Instead business angels were approached. A lot of referrals were used and networking was important in the search process. The founders got an early investment proposal from a business angel that they turned down. Currently, the team once again seeks formal venture capital. Evaluation and negotiation The team had an early shareholder agreement that was developed by one of the founders with input from a lawyer. The founders set firm targets for themselves in the contract with a vesting scheme, but otherwise the funding was not dependent on fulfilling particular milestones or similar. The contract was accepted by the investors and the board of directors. There was really no negotiation of the terms and conditions, The investors bought the big picture. Epsilon needed a sum of money, rather small at this point in time, and that was it. Epsilon used the investment as co-funding required for getting governmental loans. Since then, this agreement has been used over and over again. Given their limited experience from valuation, the founders of Epsilon got outside help in their first negotiation with investors. Thereafter the board of directors have been helpful in the valuation process. Post investment The Epsilon team is still young without a stable business model. A professional board of directors were recruited early on to balance the founders limited experience. Epsilon has formal board meetings and the board invested an initial small stake in the company. The board also guaranteed the larger equity investment. Söderblom, Samuelsson & Mårtensson 20

21 Interpretation Epsilon did not plan their funding process. It was an ad hoc exercise, where demand drove the funding activities. Figure 4e shows the funding portfolio for Epsilon during their first two years. Early public funding in terms of subsidies and loans was later balanced with business angel investments. Getting the VINN NU-subsidy was a breaking point for Epsilon. It gave them legitimacy, acknowledged their innovative skills, and also had a positive impact on their possibility to attract other types of funding. The team regret saying no to a business angel in an early phase, If you can get funding take it! During the early days we thought it would go better than it did. It s hard to be under-capitalized as a startup in Sweden. Epsilon. Year 0-2. Founders Venture capital Friends and family Biz angels/private Subsidies Commercial loans Public loans Figure 4e. External funding sources Epsilon (SQR of investment) 4.6. ZETA Background Zeta was founded in 2003 by a researcher at Chalmers University of Technology, where after he invited a student mate as cofounder. The company produces unique innovative products. The two co-founders have alternated on the CEO position over time. The major owners in Zeta is today the co-founder and a few larger business angels, while a small share of ownership is spread among approximately 40 smaller investors. In 2008, the company expanded and was established in several European countries as well as in the US. Planning There was no plan in the beginning other than applying for as much soft money as possible in order to get a proof of concept and then go for larger investments. The CEO shows a binder with all their funding sources, amounts and dates. It is a long list, We went for all kinds of subsidies and grants in the beginning and we financed ourselves with student loans. The VINN NU-program and Venture Cup was also appreciated funding sources used for developing the business. Söderblom, Samuelsson & Mårtensson 21

22 Search The Zeta team lacked experience from raising funds, although they received support from a somewhat more experienced member of the board of directors. The company used all kinds of financing sources. Everything was used to try to proof the business and the technology. At first they went for subsidies and soft money but also business angels and more formal investors were approached. Finding investors was a rather informal process. The first equity investment was made through an emission with new shares that paid for an existing company with an IP right. This deal brought approximately 40 private investors from the other company into Zeta. Zeta made seven to eight new rounds of equity investments. Then sales kicked in was the best year and Zeta generated a solid profit. Evaluation and negotiation In the first equity-based financing round, Zeta was funded by a ratio of 1 to 3 msek on a pre-money valuation around 3 msek. The founders developed all paper work and all contracts using templates found on the Internet. They also developed a stock option program. Also here the founders designed the legal documentation. Over time, new stock option programs have been reviewed by the company s auditor, although the existing agreement has been used as the template. Post investment Zeta has a relatively large number of owners due to the early investment round. That has imprinted the post investment process. It is almost as a public company with a lot of information gathering, information diffusion, and formal board meetings. They have had a strong board of directors continuously and the board has been instrumental in negotiations with other investors. Later the bank has played an important role, both as a provider of capital but also helped with contacts and networks. Interpretation The CEO believes that the process would have been different if carried out today. In retrospect, the deal should have been embedded in a larger environment and with the aim to close a larger first investment. The founder thinks that they should have been more confident in their negotiations, We thought a million SEK was a lot of money. The founders of Zeta also had a different starting point since they were not majority owners. They developed the business from scratch and had only a small share of the company. In the beginning this was never an issue but has become so over time, We were a bit naïve. The two founders could have negotiated a larger equity stake earlier. Now they introduced stock option programs later in the process instead. Zeta has used over 20 sources of capital (see Figure 4f). The early stages were dominated by public funding, where all sorts of governmental subsidies were used to get the first proof of concept. Thereafter, Zeta has been able to fund their expansion mostly through equity investments. Later in the process, they also used commercial bank loans for investments in machinery. Söderblom, Samuelsson & Mårtensson 22

23 Zeta. Year Founders Venture capital Friends and family Biz angels/private Subsidies Commercial loans Public loans Figure 4f. External funding sources Zeta (SQR of investment) 4.7. KAPPA Background Steven Sandström was working as an engineer at a Swedish company where they introduced Japanese quality work principles. He thought this was interesting and started to read about these principles and soon found out that he did not think that the Swedish company really had understood what this kind of quality work was all about. Steven decided to start studying Japanese at a Swedish university, I planned to move to Japan, start working for Toyota, and then come back home again and tell them what this really is about! He left his work and started to study Japanese and at the same time he also studied more at the engineering school. During his studies he spent one year in Japan to learn the language. When Steven did his final project at the engineering school, he got in touch with a company producing compact discs (CDs). He then started to work for this company, both in Sweden and later in the US. When the CD market declined, he thought of other ways of using his expertise in this production technology. Together with three friends, Steven decided to start working on an idea for alternative usage of the production technology for CDs, but now in the energy sector. Planning Steven and his colleagues started to look for various way of funding their new idea and someone gave us the idea that we could apply for EU funding. But the procedure to apply for this grant was quite complicated, there was a lot of documentation to read. We spent 2-3 months reading about how to apply and writing our application, which became a pages long detailed plan. The founders hesitated, since the call included a demand for a consortium of two to three different organizations from various countries. But they found a way to organize this and to attract international partners, We would have preferred to do it all by ourselves, but we needed to have international partners for the application. The application for the EU grant forced the founders to formulate a detailed three-yearplan from day one. This meant that they had a clear structure laid out for their business activities from the very beginning. Kappa was successful in the EU application and got a positive reply in the beginning of The EU grant not only meant financial support, but also gave them legitimacy. However, the EU grant Söderblom, Samuelsson & Mårtensson 23

24 was conditioned and hence, the founders needed to find other financial sources to combine with the grant. Another aspect of the EU grant was that it also meant a lot of bureaucracy for the company. Search At an early stage Steven and his co-founders were considering bank loans, but this route turned out to be difficult, There was no way for us to get loans from banks. After the positive response from EU, however, the Swedish Energy Agency provided some funding to Kappa. When Steven was searching for additional financial sources, he realized that a startup course the founders had attended earlier became useful. The main usefulness was that they now could pitch their business idea in a professional way. Through this course, they also got in touch with investors willing to invest in Kappa. During the search process, one of the founders was responsible for constantly look for public subsidies. Given that they had received the EU funding, they found it easier to receive other grants, The EU grant gave some kind of quality assurance. When Kappa had received the first funding, and became operational, things changed. Suddenly people called and wanted to invest in the company. The Swedish Energy Agency also provided loans and grants to the company. They also received material support from a Japanese customer, who provided an expensive production machine. Evaluation and negotiation In their first round of financing, ten investors were willing to invest in Kappa. The question was how to value the company. First no one wanted to suggest a valuation level. Then Steven and his colleagues suggested 30 msek. It was a level that they just came up with without any particular analysis. In the negotiations, the investors then offered 6 msek. The four founders replied that they wanted 7 msek, which the investors accepted. That was the negotiation. In 2007, the company needed more capital, and the founders engaged a consultant to calculate a valuation of their company. He first came up with 500 msek, which later was adjusted to 150 msek and they raised 18 msek from private investors (one investing 15 msek and the other 3 msek). By now the founders of the company owned 65% of the shares. Steven and his colleagues continued to successfully search for different grants. Most of the grants were conditioned so they also needed other funding. Next funding round took place in when they raised 20 msek, based on a valuation of the company of 280 msek. The founders now owned 55%. This turned out to be a fairly high value of the company and partly as a compensation for this, they put a very low valuation of the company in their next round of financing, amounting to 10 msek, which took place in The valuation of Kappa was now set to 30 msek and the founders owned 40% of the company. Throughout the different rounds there were no real negotiations about the different valuation levels of the company. The founders suggested something that was accepted by the investors. Söderblom, Samuelsson & Mårtensson 24

25 Post investment The work in the board of directors has been a smooth process. The board meetings are mainly used for informing the board about the current situation. In practice the four founders are running the company more or less without involving the board, and they make all major decisions. When there are, for example, strategy meetings, these are only held with the four founders. The legal competence in the board is perceived as an important contribution, but besides that the four founders do not perceive (or feel that they need) much support from the board of directors. When managing their company they focus mainly on one thing: We only look at the cash flow we have kept track on that since day one. The capital that the founders have managed to attract has not only contributed financially and with legitimacy, but also been important in building Kappa s brand. During the process of developing the company, the employees of the company were given 3% of the shares as a bonus. In retrospect the founders thought this was a mistake. They did not value the shares. Instead it became a discussion about who received what. In the end it became the opposite of a motivator to give them these shares. Interpretation Although the founders of Kappa have applied for many grants over time they do not claim that they have changed their business activities to adapt to the applications, perhaps just tweaked it a bit sometimes. The four founders have throughout the financing process managed to find quite complex financial solutions, where they have combined different forms of financial support to the company. They have been successful in finding and receiving grants. Even if there is no emergent need for more funding at the moment, they still continuously look for new opportunities to search for grants. They have developed a competence in applying for grants and creating innovative solutions to combine various forms of funding. The funding of Kappa started with a grant and then the founders continued on that path and they have had a strong focus on finding, applying and receiving grants. This process also forced them to produce a detailed plan for their business activities at a very early stage, which helped forming a structure for the company from the beginning. See Figure 4g for an illustration of funding sources used in Kappa. Söderblom, Samuelsson & Mårtensson 25

26 Kappa. Year 0-9. Founders Venture capital Friends and family Biz angels/private Subsidies Commercial loans Public loans Figure 4g. External funding sources Kappa (SQR of investment) 4.8. OMEGA Background When Alison Andersson was about to conclude her doctoral program in medicine, she took a course in entrepreneurship. She thought that this knowledge might be helpful when she was about to start applying for a job. During one lecture there was a slide showing ten characteristics of an entrepreneur. Alison remembers this slide it was a very weird aha-moment I had all ten of them!. This course or lecture, or perhaps even slide became the starting-point for Alison to become an entrepreneur. She talked to the only entrepreneur she knew her grandfather. She had two more years to complete her dissertation and she decided to test her idea during these years, without starting anything before she had completed her doctoral work. After having defended her thesis she was offered a post-doc at a top-university in the US. But she felt that it is now or never and decided to decline the offer and instead start her own business. Her thought was: If I do not do this now, someone else will do it. Planning Her business idea was in the healthy food sector. She knew a lot about her idea and what she wanted to do. But she did not know much about other aspects of starting a company. So when Alison started her business the first thing she did was to read a book about fundamentals in business administration. She did not have any financial resources when she began, so she started to engage students who were about to do projects during their education, as she had previous experience from working with students. She says: I had zero in budget. Meanwhile Alison attended various courses and searched for input from mentors. Her private economy became very strained and when she felt that she really suffered from her choice to start her own business, one mantra kept her focused on her goal: I will be financially independent!. Search From her time as a researcher, she had experience from applying for grants. She therefore started to apply for grants and when she had received her first 250 tsek, she formed a company and hired the first Söderblom, Samuelsson & Mårtensson 26

27 employee on a part-time basis. They had apparently met at a course about how to write CVs a couple of years earlier. Alison also received a grant to conduct a first customer survey to learn more about the market situation. She attended different types of competitions where she was competing with her business idea and gradually did better and better in these competitions. She continued to search for different grants and was successful. Beside these grants, she also managed to get some loans from an organization supporting new businesses. She decided to move from the south of Sweden to Stockholm. Her idea was to join a business incubator but she found it very difficult to get an opening. After a while she found an office space and continued to develop her idea. Finally she was offered a seat in a business incubator. She also won a few awards that gave her and her business some PR. At the same time she did not want to attract too much attention, as she did not want to reveal details about her business idea. In the process of developing her business, Alison has found one issue far more difficult than anything else to find funding. She says: Money is the key. [ ] it has taken SO much time. The first round of capitalization took much longer than expected. The goal was to bring in 3 msek, but Alison managed in the end only to get 1 msek. Alison dealt with this round on her own without help. The business incubator did to not support her in this process. After being turned down by a number of parties, she succeeded to attract capital from six external investors where she had a personal relation with only one. During this period, Alison had limited time to spend on developing the business. Evaluation and negotiation Alison made the valuation of the company herself. She simply calculated the value based on the restriction that she wanted to own 51% of the stocks after the third round. There was no negotiation about the valuation and after the first round Alison still owned 90% of the company. She says: I was surprised that no one of them wanted to discuss the valuation of the company. When contracts were to be set up, Alison got hold of two different templates of typical contracts for these purposes. Based on these templates, she put together a contract herself. She now had great use of one of the courses in entrepreneurship that she had attended earlier. No negotiation took place about the contract either. She says: No one asked about the contract. Post investment The next phase for Alison is to start building the brand. Even after the capital infusion the financial situation is challenging. The dips are significant from time to time. There is some support from the board of directors, although the board is playing a rather passive role. The six investors contribute mainly with capital, not with non-monetary support. The loans that she has received have been under the condition to increase the turnover in the company with a certain pace. Now Alison is struggling to meet these demands. Too much time has been spent on raising money from investors and searching for grants. There has not been enough time to approach new customers. Alison is upset with the conditions they have put on the loans: I am so frustrated so I do not know what to do, [ ] there is a Catch-22-situation. Söderblom, Samuelsson & Mårtensson 27

28 When the focus is shifting more towards marketing and sales, there is also a need to improve organizational structure, to work with CRM-systems, and particularly to increase sales and the number of customers. Alison is now facing the challenge to strike the balance between focusing on the second round of funding and developing the company. The company's financial situation is severely strained, and so also Alison s private finances. At the same time, a partly new business idea has turned up that potentially could change the direction of the company. The pressure on Alison is obviously tough from several perspectives and time is a scarce resource I work 60 hours a week, [ ] I usually work until 10 pm on Friday nights. Interpretation Alison is an example of an academic who has learnt from courses and books how to start a company. There has been a very strong wish for her to keep the majority of the company and not to give up too much of the shares. The price she has paid for this in terms of stress and financial challenges seems high. Throughout the process, the issue of funding has taken much of her effort and time. Which in turn has meant that the time to focus on building the company and approaching customers has been more limited than she would have wished. She has been rather alone in the funding process. Figure 4h illustrates the external funding sources used in Omega during its first four years of existence. Omega. Year 0-4. Founders Venture capital Friends and family Biz angels/private Subsidies Commercial loans Public loans Figure 4h. External funding sources Omega (SQR of investment) 5. RESULTS AND DISCUSSION All case companies in this study can be classified as innovative firms with growth ambitions, situated in either Stockholm or Gothenburg, and managed by entrepreneurs with higher educations. Concerning these entrepreneurs approaches to financing, this study reveals both commonalities as well as differences. Table 2 presents a list of some of those, which will be discussed further below. Söderblom, Samuelsson & Mårtensson 28

29 Table 2. Commonalities and differences among the eight cases COMMONALITIES The financing process is central and takes lots of time and efforts The use of financial sources follows to a high extent the life cycle model, while a clear support for the POT-theory cannot be found All make use of governmental debt and public subsidies Financing from family and friends is non-existing Formal venture capital is almost non-existing Funding arrives from on average more than 8 sources in the first 3 years There is some type of path dependence, meaning that founders continue to use the same type of funding throughout the early years of existence The founders have large power in negotiations with investors/buyers No traditional techniques are used when setting a value on the ventures DIFFERENCES The entrepreneurs differ in having either an ad hoc or a strategic approach to funding Differences between the cases in terms of opinions of the importance of ownership dilution and losing control The importance of customer funding and focus differs The financing portfolios differ dependent on earlier experience and the entrepreneurs preferences 5.1. PLANNING For all firms included in this study, funding is a question of vital importance, and a process that the entrepreneurs put considerable efforts and time on. This tends to have negative effects on attention given to other core activities such as sales and product development. To what extent funding is an ad hoc, often short-term, activity or rather a strategic, more longterm, concern differs. The entrepreneurs in our study who could be classified as ad hoc entrepreneurs, do not have a clear plan for their funding but rather arrange funding along the way. To a high extent they have a strong ability and drive to convince financiers to invest in the company, even before a viable product/service has been developed. Often these entrepreneurs also have support from an institution such as an incubator or school. The other entrepreneurs in the study may be classified as strategic entrepreneurs. This group typically have more startup experience, have a funding plan and a clear view of the types of funding that is preferred, what amounts that are needed and how the relationship with investors should be set up. Of the companies included in the study, Beta, Zeta, Delta, Epsilon, Omega and Kappa have more of an ad hoc and short-term approach to external funding, while Alpha and Gamma have more of a strategic, long-term attitude. When it comes to what type of funding that is used, the companies share a similar funding pattern, which to a large extent is in line with the life cycle model outlined by Berger and Udell (1998). A clear support for the POT, or the reversed POT, theory could not be found though (Myers, 1984; Myers and Majluf, 1984). That is, Gamma seemed to support the POT-theory and Alpha the reversed POT theory, while the others did not have any clear strategy for their funding in the early phase. Söderblom, Samuelsson & Mårtensson 29

30 Figure 4 below depicts the financial sources used at different periods in the firms life-time. First the founders invested a small sum to establish the company. Then they typically used a broad range of capital arriving from public sources, ranging from subsidies, price money from competitions, public loans, and line of credits, to private investors, business angels and finally loans from commercial banks. Capital from private sources almost always came after the public money. Commercial bank funding, in the form of line of credits are used early in the process for cash and rescue purposes, and more traditional bank loans late in the process for larger investments and/or cash management. One source frequently mentioned in the literature is friends and family. This category is absent in our study, which is rather interesting. The same pattern is evident for formal venture capital, which is almost non-existent as a funding source for these ventures. This is also somewhat surprising, since our study include innovative high potential ventures spanning over 12 years of operation. Furthermore business angels, or smaller private investors, invest somewhat earlier than stipulated in the life cycle model (Berger and Udell, 1998). Governmental funding, in the form of subsidies and grants, is perceived as rather inflexible, but still a highly interesting source of low cost money a source of funding that is not discussed in Berger and Udell s (1998) life cycle model to any large extent. Private capital is difficult to get early in life cycle. Instead, public money is used to create legitimacy, get a proof of concept and, thereby, reduce risks. Getting funding from governmental sources provides a positive signaling effect to private investors, and thus increases the likelihood to get funded from private sources. Besides the life cycle model, entrepreneurs background and preferences seem to have a clear impact on the choices of funding alternatives. We also see a path dependency pattern in the funding portfolios, where the firms tend to use the same types of funding over and over again. This is in some cases due to own choices, but for others due to that other options are not easily available given an earlier choice of one particular financing type. For example Beta had problems to attract venture capital because of their high number of investors and their high valuation. For the eight cases in this study, the average funding per deal is approximately 635 tsek, while the companies average annual burn rate is approximately 1.7 msek. This small amounts of money to a high extent forces the entrepreneurs to start looking for new financing within a period of three to six months after funding has been obtained. The firms use a large number of funding sources, on average 8.3, during the initial three years of operation. This could be a sign of an intentionally aim to build funding portfolios. However, it seems rather to be an unintentional result of the small amounts provided in each funding round and thereby a necessity to look for more funding SEARCH Whether the firm has an ad hoc or a strategic approach to funding, also affects the search process. The ad hoc entrepreneurs spend more time, have a broader search area, and are constantly searching for more financing. They are in addition more prone to change/adapt to funding schemes. The strategic group balances their funding sources with personal preferences and what they consider to be most efficient strategy for their firm. They may also allow alternative development strategies for their ventures just to avoid a certain type of funding. Söderblom, Samuelsson & Mårtensson 30

31 Common for both groups is that they approach most available funding sources at some point in time, especially in the early phases. The search process is institutionalized if the startup is located in an incubator or belongs to another formal organization. Furthermore, the funding sources and search processes follow the same patterns for startups from the same type of environment. The early search process is broad and open. All sources are approached simultaneously. Entrepreneurs typically use web search, networks, board members, and other connections. Then meetings are booked and feedback is generated. If one source looks more promising than another, search is intensified for this source. It appears that governmental funding is the most promising area in the early stages. Positive feedback will reinforce the search strategy to one funding area EVALUATION AND NEGOTIATION Negotiation is an important part of the funding process. The companies in this study seem less likely to negotiate with public financiers, i.e., providers of subsidies. There are, however, various opinions among the entrepreneurs concerning whether to adjust to a particular public call or not. Negotiations instead appear for external funding other than subsidies. Not least in discussions with providers of governmental debt, where both amortization plans and interest rates are negotiated to a much higher extent than we expected. Otherwise, the majority of funding negotiations take place between the entrepreneurs and equity investors, here dominated by business angels, or acquiring corporations. A rather surprising finding from this study is that these negotiations to a high extent are championed and managed by the entrepreneurs. Typically, it is either the CEO or the CFO who takes lead in the process, providing the potential investor/acquirer with a rather standardized business plan. Thereafter, in all our cases, the investor agreement is developed by the entrepreneur. Valuation is one important part of the negotiation process but, in these case companies, is not really negotiated. The common valuation method is not a formal discounted cash flow analysis or some other technical solution. It is rather an estimation of how much money is needed, for what and when. For example, Epsilon needs to hire a developer and pay salaries before reaching positive cash flows. That sum is then used as the base for the valuation. The other parameter is how much ownership the founders want to distribute. For example, if case A needs 10 msek and is willing to give away 10% of the equity in the deal, the valuation of case A would be 100 msek. This strategy is used extensively in the first round. If the investors do not agree with the valuation, the firm will typically propose a lower valuation, or seek smaller amounts of money. Here we see variations among the cases. Beta and Zeta did not care about the level of ownership in the beginning, All we wanted was to see if it worked. In other cases, the equity split among owners and founders is of vital concern, not least due to an unwillingness to lose control, We will never let external investors interfere with our business. If control is central, the distribution of ownership will be low. If it is not so, the share of equity given to the new owner would be higher. The first valuation has short-term effects on the venture, but also long term implications since it tends to impact the firm for a long time. Even in situations where the underlying performance Söderblom, Samuelsson & Mårtensson 31

32 indicators are not reached, the valuation is the starting-point for the next round of investments. Getting a too high valuation in round one can be problematic. In case the entrepreneurs do not fulfill set expectations, investors may lose confidence in the case and are not willing to fund the company in following rounds. Or the valuation set in subsequent rounds increases based on vague promises rather than the actual company status. Eventually new investors are likely not to accept such high levels, which could severely limit the firm s ability to get more funding. This is the problem that Beta faces. Getting a too low valuation could obviously also be problematic, typically leading to small investments. The result is scarcely funded young ventures with founding teams constantly seeking for more capital. These activities take away focus and time spent on developing the core business. This is also evident in situations where the company has many owners. The transaction cost per owner is high in the beginning, almost similar to the situation for a public company with many small owners demanding information from the founders. Contracts are supposed to be the investors control vehicle, in order to reduce and prevent agency problems. It is clear from our cases that the investors are not actively involved in shaping and developing contracts or other formal agreements. That is, contracts are often developed by the entrepreneurs themselves, with some help from an accounting or law firm. Beta and Zeta report that they do not have any contracts at all. They have oral agreements, but not written ones. All the other firms in this study developed their own contracts and then invited investors to suggest adjustments. However, the investors tend to accept the proposed terms, conditions and valuations levels to a high extent with only few objections. These contracts are later used in subsequent rounds of investments POST INVESTMENT Since the equity investments in these cases predominantly are made by business angels, the finding that the entrepreneurs have control over the contract process to some extent supports Van Osnabrugge (2000) and Wong et al. (2009) ideas of that business angels typically uses an incomplete contract approach. According to this theory, business angels instead control there investments ex post, meaning that they exercise control by post investment activities and assistance. However, a number of the investors in the current study are not particularly active after the deal has been settled either, which is rather surprising. Hence, the agency risks associated with investing in opaque startup firms are not balanced neither ex ante nor ex post the investment. The dependency on public funding sources is significant in the innovative startup firms nascent phases. Our study clearly shows that there is a funding gap for young firms, which is not catered for on the private market. This leads to high transaction costs for the entrepreneurs. They spend a lot of time searching, writing, and applying for public funding. A general concern is that many of these programs seem too small. 6. CONCLUDING REMARKS This qualitative study has provided new insights about how founders of innovative startup firms view and approach funding. Similarities as well as differences were identified, where the area of financing is one of the more important processes in young firms. Experienced entrepreneurs in general have a more strategic and long-term approach to funding and to a limited extent deviate from their pre-set plans. Söderblom, Samuelsson & Mårtensson 32

33 These entrepreneurs seem to be more concerned about getting early customer payments. Furthermore, in general they are keener to keep control of their ventures. The other group of entrepreneurs, here referred to as ad hoc entrepreneurs, did not have any specific funding plans, and were constantly searching for funding. To some extent, this group was trapped into a situation where the effort and time spent on financing issues tended to have negative effects on the development of their ventures. It was also interesting to note the control that the entrepreneurs in this study exercised not only on contracts and valuation levels, but also on the operations of their firms after a deal had been settled. This contradicts both the agency literature and theories about how business angels and venture capital firms exercise ex ante and ex post control in startup firms (Van Osnabrugge, 2000). The fact that capital arriving from family and friends is absent in the current study, while public funding instead is of vital importance to a vast majority of the firms, seems to point at a particular national characteristic of the Swedish mentality and institutionalization. While US entrepreneurs to a high extent rely on funding from family and friends, Swedish ditto turn to the government for support. We also found a path dependency pattern in the choice of funding, where the firms tend to use the same types of funding over and over again based on a positive early response. For example, it seems like early public funding directs search processes to that source until it is emptied. Then more formal investors are approached, typically business angels, and this source becomes the main funding alternative. The high number of transactions and the low amounts in each funding transaction is also noteworthy. Innovative startups spend a large part of their management resources on searching, applying, negotiating, and reporting in relation to time spent on developing more operational aspects of their businesses. A priority that potentially have a negative impact on the business development process. The results have clear implications on entrepreneurs, policy makers and scholars alike. First, entrepreneurs are better off if they have a clear financing plan from the beginning. Some sources and investors should potentially not be approached in the earliest stages, such as VC firms. It is better to focus on public funding, smaller private investors and business angels. Second, we can to some extent see a market failure that is being corrected by a large number of public initiatives. The challenge for policy makers and entrepreneurs alike is that there are many programs, with slightly different rules and aims, which all distribute fairly small amounts of money. This means that the time spent on each transaction is high from both the governmental agent s and the entrepreneur s side. Potentially a smaller number of programs with larger budgets would be more efficient for both entrepreneurs and policy makers. The scholarly interest in the field is dominated by studies about formal venture capital, and to some extent business angels. Our study shows that venture capital is an almost absent source of capital for innovative startups in Sweden. Researchers could develop new knowledge in case giving more attention to other sources of capital and focus more on the demand side of venture funding. Söderblom, Samuelsson & Mårtensson 33

34 Figure 4. Illustration of funding used over the years in the eight companies. Note that the firms respective ages differs from two to ten years, meaning that the number of cases included reduces over the years. < < <5.000 <3.000 Founder Friends and family Subsidy Public loan Commercial loan Business angel Venture capital <1.000 <500 <300 <100 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

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37 Appendix 1. Interview template 1. Plan o Funding plan Has the company a funding plan? Has it changed over time? How? How has the funding plan been documented? Does the company have a dedicated person responsible for funding? Who? Who are involved in funding activities and decisions? How much time is used for funding related questions today? For what activities? o o Purpose of funding Did the company have an early need for external funding? What should the funding be used for? Choices of funding sources What knowledge and experience did the founder have about various funding sources? What sources of funding was discussed at the time for the company s founding? Why/why not? How important was a particular choice of funding? Why/why not? For whom? 2. Search o o o How did you identify potential financiers? What information sources were used? What did the process look like? Was it structured? Was it formal/informal? Did you follow a predefined funding plan, or was it a more ad hoc process? 3. Evaluation and Negotiation o What is your level of competence/experience related to negotiating shareholder s agreements? o What did the negotiation process look like? Did you make use of any advisors? o What information did the potential investor ask for? o What terms and conditions were particularly important? From your perspective? From the investor s perspective? o Equity capital: How was the valuation made, i.e., what techniques were used? o Why (or why not) did you receive funding? o How long time did it take from initial contact to final agreement? 4. Post investment activities o Describe how the relation with the investor works after a deal has been settled 5. General o How much time is used for funding-related questions today? For what activities? o Do you consider that your funding strategy/situation has affected the development of you company? How? o In hindsight would you have acted differently if you would start over again? Söderblom, Samuelsson & Mårtensson 37