Entrepreneurial Finance in Less than One Hour Michael Dearing Stanford University 2010 Copyright 2008 Michael Dearing

Entrepreneurial Financein Less than One Hour

Michael DearingStanford University 2010

Copyright 2008 Michael Dearing.

WARNING

• TONS of details are missing from this• You have to do a lot more reading and

learning• You should get a lawyer to help you• But you will know more than most people

at the end of this


Promise

• This is mostly seventh grade math and basic common sense

• It's wrapped up in a vocabulary created by elites who like to stay elite by making this sound hard; it's not hard at all

• You will annoy the finance priesthood with your knowledge

• If you learn these concepts, read a few suggested books, practice with a calculator and spreadsheet, you can handle anything related to financing a new venture


Agenda

• I. Five Basic Concepts

• II. Four Nouns

• III. Three Rules of Thumb


I. Five basic concepts

• Cash is life• Cash comes from debt, equity, or operations • Growth eats cash• Risk goes down in chunks• Value = f (all future cash flows)


Cash is life

CASH

ASSETS

SALES

BILLS

“PRODUCTS”

LEFTOVER CASH


ACME Lemonade Stands


Balance Sheet

=

AssetsLiabilities &

Shareholders' Equity

Where does the money come from?


Balance Sheet

=

AssetsLiabilities &



Cash + What we buy with the capital to be in business


Balance Sheet

=

AssetsLiabilities &



• Debt• Shareholders• Operations

Cash + stuff we buy with the capital to be in business


Balance Sheet

=

AssetsLiabilities &



• Debt• Shareholders• Operations

Cash + stuff we buy with the capital to be in business

• Lemons• Sugar• Water• Stand


Profit & Loss2009Comment

Revenue $250# Glasses x price/glass

Cost of goods sold $125How much did you pay for the lemonade you sold?

Gross profit $125Left over to pay the bills

Operating expenses

$115The bills; other stuff you had to do to run the lemonade stand

Operating profit $10How much did you make on the business?

Taxes $4

Net income $6~Internally generated capital


Financial Plumbing

RIGHT SIDE(where $ came from)

LEFT SIDE(the stuff we need) =

Sales

Gross profit

Expenses

Op profit

Taxes

Net Income

P&LBalance Sheet

Turn Net Income into Cash Flow*

* See Higgins for a great explanation of how to calculate cash flow from net income; we don't have time to do it now!


Financial plumbing

• Cash raised on right side of balance sheet• Cash invested in stuff to make the business run

on the left side of the balance sheet• Humans use stuff on the left side of the balance

sheet to make revenue• Revenue pays bills• Profits turn into cash• Cash comes back to the balance sheet


Growth eats cash

• Go back to the lemonade stand financial statements


Growth Eats Cash?

RIGHT SIDE(where $ came from)

LEFT SIDE(the stuff we need) =

Sales

Gross profit

Expenses

Op profit

Taxes

Net Income

P&LBalance Sheet

Turn Net Income into Cash Flow*

* See Higgins for a great explanation of how to calculate cash flow from net income; we don't have time to do it now!


Growth eats cash

• Go back to the lemonade stand financial statements

• If you grow sales, expenses or assets faster than you grow internally generated cash flow to pay for them you *must* raise cash from outside the company.(1)

(1) Robert Higgins, Financial Analysis for Managers, Chapter 4, "Managing Growth."


Raising capital

• When?• How?• How much?


Risk goes down in chunks

• Can I make lemonade?• Will anyone buy it?• Can I advertise to increase sales?• Can I produce enough to satisfy

demand?• Can I reduce my costs in order to

increase profits?• Can I expand from one stand to many?

t = 0


Risk goes down in chunks

• Can I make lemonade?• Will anyone buy it?• Can I advertise to increase sales?• Can I produce enough to satisfy

demand?• Can I reduce my costs in order to

increase profits?• Can I expand from one stand to many?

t = 0 SEED

SERIES A

SERIES B


Value = f (cash flows)

• Robert Higgins – Analysis for Financial Managemento Why cash drives valueo What is present value and the time value of moneyo How to incorporate these concepts into your plans and actions


II. Four Nouns

• Convertible debt

• Preferred stock

• Angel investors

• Venture capitalists


Back to the Balance Sheet (R)

• Debt financingo Trade credito Bank loanso Convertible debt **o Public debt

• Equity financingo Common stock o Preferred stock **

• Retained Earnings


Convertible debt

• Borrow money from one or more entities• Converts to equity when equity is raised at

some future date• Converts at a discount to the price paid by

the new equity investors


Preferred stock

• Ownership in the company in exchange for cash

• Price (value of the company) is negotiated: “pre” money

• “Post” = “pre” + new capital raised• Staged in series (seed, A, B, C …)• Better liquidation rights than common• A bunch of other terms – rights, resale,

conversion to common


Angels

• Wealthy individuals• Range of sizes – small ($25-50k) to

large (up to $1 mil)• Some do notes, some do “priced

rounds” (preferred stock)• Some are active, some are passive• Silicon Valley has lots of them


Venture capitalists

• Typically operate a fund made of other people’s money: pensions, endowments, rich people, institutions

• Focus on equity investments, rarely do convertible debt

• Invest larger sums than angels on average• Make money via carried interest and a

management fee on the fund


Investor and security type

Convertible debt Preferred stock

Angels Often (smaller) Sometimes (larger)

Venture capitalists Rarely Almost always


III. Three Rules of Thumb

• Match your financing to your milestones to your strategy to your values and dreams

• Know what is “market” – what has happened in other deals -- it will level the playing field and simplify the process

• You will make money by building great products and a great business – not by negotiating “great” terms on your financings (this goes for both sides of the deal!)


Documents

Entrepreneurial Finance in Less than One Hour Michael Dearing Stanford University 2010 Copyright 2008 Michael Dearing