Financing your business. Dr. T. R. Heidrick Poole Professor in Technology Management Faculty of Engineering/School of Business U of A

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Martin McCormick
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1 Financing your business Dr. T. R. Heidrick Poole Professor in Technology Management Faculty of Engineering/School of Business U of A

2 Risk Capital ct. d Earns returns through participation in the future growth in the value of your business Conventional financing earns returns in the form of interest and principle payments

3 Risk Capital Non conventional financing not provided by lending institutions such as banks Assumes more risk than providers of conventional financing Do not have security for their investment Risk losing their entire investment in exchange for an ownership interest

conventional financing Do not have security for their investment

4 Risk Capital ct. d Earns returns through participation in the future growth in the value of your business Conventional financing earns returns in the form of interest and principle payments

5 Risk Capital ct. d Candidates for risk capital Potential for high growth and profits Well constructed plan to exploit a market opportunity Capable management and leadership that can execute a well defined (flexible) plan Potential rate of return that adequately compensates for risk Viable exit mechanism

constructed plan to exploit a market opportunity Capable management and

6 Conventional financing Candidates Sufficient collateral or security against the debt instrument and/or sufficient cash flow to service the debt.

7 Financing Growth Understanding Investors Needs

8 Investors Needs Risk and return Exit strategies Confidence in management Ability to monitor and control investment

9 An Acceptable Return in Exchange for Assumed Risk How much can you make if you invest? How much can you lose Is there protection against loss E.g.. Drilling write-offs

10 An Acceptable Return in Exchange for Assumed Risk High-return expectations High rates of business failures Long periods before capital is returned to the investor Inability to control operations Low liquidity of investments

failures Long periods before capital is returned to the

11 An Acceptable Return in Exchange for Assumed Risk Risk associated with the specific industry and company Size of the business or stage of the investment Larger businesses have less risk Startups high risk Uncertainty regarding the market Earnings history (if any) Industry segment assessment

investment Larger businesses have less risk Startups high risk

12 The Flow of Equity Financing for SME s Private Angels VC s Corporate Banks Institutional Public Flow Incentives Flow Incentives Flow Incentives Flow Incentives Flow Incentives Seed Start up First Expansion Second Expansion IPO

Flow Incentives Flow Incentives Flow Incentives Flow

13 Investment Stages Seed Prototypes built, market opportunities are assessed, ideas exchanged with friends <$250,000

14 Investment Stages Start-up Vision becomes a functioning organization Find a location Hire employees, management Secure suppliers Commence marketing $250,000-1 or 2$ M

15 Investment Stages First expansion Rapid growth Working capital to address sales Production process enlarged Markets beyond initial are targeted $2-5 M

16 Investment Stages Second expansion Further growth New products processes etc. $5-20 M

17 Investment Stages IPO or Acquisition Securities and exchange commissions Prospectus etc. 5$-100$ M raised

18 The Flow of Equity Financing for SME s Private Angels VC s Corporate Banks Institutional Public Flow Incentives Flow Incentives Flow Incentives Flow Incentives Flow Incentives Seed Start up First Expansion Second Expansion IPO

19 Cover your equity Balance the need for start-up and growth capital with preservation of equity Hold on to as much as you can for as long as you can The earlier the capital enters the more costly it is Do not want parsimony to slow down the venture s progress

can for as long as you can The earlier the capital enters the

20 Obtaining risk capital Does the venture need outside equity capital? Do the founders want outside equity capital? Who should invest? Remember: A smaller percentage of a larger pie is preferred to a larger percentage of a smaller pie

Do the founders want outside Who should invest?

21 In the majority of hightechnology and start-ups and early-stage companies, some equity investment is normally needed to fund research and development.

22 The need for outside equity capital Would loss of equity adversely impact the company and the ability to manage it effectively? An equity investment requires that the management team firmly believe that investors can and will add value to the venture. This requirement helps identify potential investors.

23 Deciding who should invest The single most important criterion for selecting an investor is what they can contribute to the value of the venture-- beyond just capital. Angels or wealthy investors vs. venture capitalists

24 Timing Important to obtain capital before there is a serious cash shortage Lack of planning undermines the credibility of the venture management team

25 Angels and informal investors Wealthy individuals willing to invest in start-ups and emerging businesses Investments range from less than $10,000 to over $50,000--amounts too small for professional venture capital groups These investors may invest alone or in syndication with other wealthy individuals Usually they are experienced in the

26 Angel investors are most appropriate in the following: Ventures with capital requirements of between $50,000 and $500,000 Ventures with sales potential between $2-$20 million within 5-10 years Small, privately held ventures with sales and profit growth of 10-20% per year Very early financing of high-technology inventors who have not developed a prototype

27 Finding angel investors Tapping network of business contacts and associates Seek referrals from attorneys, accountants, business associates, university faculty, fellow entrepreneurs and friends. Concentrate on recruiting one

28 Venture Capital Gold Mine or Tar Pit

29 Value-added investors If all you receive from an investor is money --then this may not be a bargain Seek investors who will add value to the venture beyond money Screen investors to fill any gaps in the founders know-how and networks venture capitalists can be significant in opening doors

30 What is venture capital? The venture capitalist supplies capital and other resources to entrepreneurs in business with high growth potential in hopes of achieving a high rate of return on invested funds The process begins at target investment and ends at crafting and executing harvest strategies

31 Factors affecting availability and cost of capital: Perceived risk-- both the management and the opportunity Industry, market, attractiveness of the technology and the fit Upside potential and downside exposure Age and stage of development Amount of capital required Bargaining position of investors and

32 Only 2 to 4% of the ventures contacting venture capital firms receive financing from them.

33 Criteria of venture capital investors: High growth potential that can quintuple their investment in 5 years High premium placed on the quality of management in a venture

34 Identifying venture capital investors Basically will have to concentrate on Canadian venture capital companies Check library sources and listings Referrals from accountants, lawyers and other entrepreneurs

35 What to look for: Warning signs worth avoiding: Attitude Over-commitment Inexperience Unfavorable reputation

36 Other equity sources IRAP, NRC Joint venture possibilities- ARC Saskatchewan Opportunities Corporation IPO s

37 Investors returns How much of the company does an investor want in return for his money? Example methods VC method First Chicago method

38 Typical ROR s sought Seed and startup % or more First stage 40-60% Second stage 30-40% Expansion 20-30% Bridge and mezzanine 20-30% Public company 5-20%

39 Investors returns Estimate the Terminal Value (TV) of the company after some period of time Discount this value using the desired rate of return to get a discounted TV % ownership demanded= Investment Discounted TV

40 VC Method Calculate terminal value of the company By IPO or acquisition Using typical Price to Earnings (P/E ) for the sector or Using Price/Sales (P/S).or.. Other ratio such as Price/pretax profit Comparison to recent similar IPO s

41 VC Method Terminal value =net income x P/E.or =sales x P/Sales

42 VC Method Determine discounted terminal value DTV= TV (1+ desired ROR)**n % Ownership= Investment DTV

43 VC Method Example Using one of the ratios it is estimated that after 5 years a startup company will be worth 1.6$M What % ownership should I get for investing $50,000? DTV= 1,600,000/(1+0.6)**5=$152,671 Therefore I should get 50,000/15200 or about 33% of the company if I invest at this stage

44 First Chicago Method Expected cash flows are obtained by attaching probabilities to three or more possible scenarios Terminal Value is a weighted average according to the probabilities

45 First Chicago Method Winner-TV=2.0$M Modest Winner- TV=1.6$M Modest loser- TV=0.5$M Total loser-tv=0$ Probability=20% Probability=30% Probability=30% Probability=20%

46 First Chicago Method Average TV =(20%)(2.0)+(30%)(1.6)+(30%)(0.5)+0 =1.03$M

47 Initial Public Offering Once a consideration--find an underwriter who is capable of understanding your venture Have everything prepared Run with it if the market is there--be prepared to run with it at any market opening

Financing a New Venture

Financing a New Venture A Canadian Innovation Centre How-To Guide 1 Financing a new venture New ventures require financing to fund growth Forms of financing include equity (personal, family & friends,