Planning a New Business

Planning a New Business

& the EntrepreneurSession 5

Funding & Finance

Presented by

Scott Wilson

February 2004

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Session Agenda

Entrepreneurs’ Discussion. Funding Needs and Options. Venture Capital Industry. The Financial Plan. Financial Assumptions. Business Plan Update.

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Entrepreneur’s Discussion:

What is/will be your #1 business start-up expense?(in the first year; fixed or variable)

P a y c h e c k f o r

D e p t. of T r e a s u re r

J o h n D o e

P a y c h e c k f or

D ate

D e p t. of T re

a s u rer

J a n e D o e

Da te

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Class Assignment:What are Your Funding Needs?

What are your financial projections for this venture for the first 3-5 years?

Are these projections based on debt or equity financing?

How do these projections compare with industry norms?

What assumptions are the projections based on?

What are the venture’s most significant costs? How much money do you need?

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Funding Options

Your Personal Finances. Friends and Family Members. Federal or State Loans. Venture Capital Industry.

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Small Business Administration Programs

The SBA Offers Three Loan Programs: 7(a) Loan Guarantee Microloan 504 Certified Development Company loans

The SBA does not currently have funding for direct loans nor does it provide grants or low interest rate loans for business start-up or expansion.

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Banks

Most are very conservative. Often reluctant to deal

with start-ups. Look for a good credit history,

personal assets, and income within company.

Reluctant if the owner has little or no experience running a business.

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Overview of Private Investors

Potential Private Company Investors. Factors to Determine Most Appropriate Investor. Factors Influencing Fundraising Success. The Venture Capital Process:

Operational Mechanics, Financial Operations, Motivations Needs.

What VC’s are looking for??? What a Company should look for

in a VC. Investment Process Time Line.

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Overview of Private Investors

Mike Frank’s 10 Commandments (GP of Advanced Technology Partners).

Florida VC’s Top 10 Pet Peeves. Angel Investing:

Facts/Nature of Angel Investments. Disadvantages. Initial Considerations/Angel Motivators. Types of Angels. Where Do You Find Angels???

VC Industry. Deal Terms/ Sample Term Sheet.

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Potential Private Company Investors:

Owners, Friends & Family.

Angel Investors. Venture Capital Firms. Private Placement

Institutional & Individual Investors.

Corporate Partners.

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Owners, Friends, and Family Benefit of speed and maintaining control. Favorable valuation/terms to “known & friendly”

people. Delay dilution until, a later & higher valuation

reached. Owners Investment demonstrates founder’s

commitment to business (critical to a VC who wants owner to have skin in the game).

Downside: Possibly creating personal conflict or “taking

advantage” of persons who may lack investment sophistication & experience and may have unrealistic expectations of returns.

Investors usually not helpful to business or future fundraising efforts.

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Angel Investors

Usually wealthy and experienced business individuals who desire and are willing to invest time and money. (Will expand later)

Studies show more money invested by angels than VC’s in the seed and early stage of a business, many VC’s have minimum first round, thus angels fill void.

Less due diligence and documentation than a VC, can close financing quickly.

Usually, invest close to home. May or may not bring added value to business i.e.

strategic relationships. Usually lack significant capital for follow-on investment.

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Venture Capital

VC’s typically bring extraordinary value to it’s portfolio companies.

Very difficult to obtain. Extensive due diligence and documentation,

so house must be in order. Substantial equity dilution. Loss of control, especially if milestones not

met. Not as patient as angel investor, need exit

from investment in 3 to 5 years. Very time consuming, is not the best path for

many businesses.

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Private Placements

Can be cost-effective means of raising capital. Be wary of field of placement agents/investment bankers,

must be a broker/dealer under Florida and Federal law. Company must comply with exemptions under Federal

and State blue sky laws, these laws regulate offering process, publicity and communications, disclosure and information requirements and the offer and sale of the securities in question, so experienced counsel needed.

Be wary of significant “upfront fees”. Requires preparation and significant documentation

(subscription documents and private placement memorandum).

If not conducted by experienced placement agent or investment banker, high risk of not being consummated after significant time and expense.

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Corporate Partners

“Strategic alliance” or partnership with an established operating company may serve as means to raise capital. Joint venture. Licensing agreement. Marketing or distribution arrangement.

Capital can also be provided through strategic arrangements and relationships with customers, vendors and suppliers.

Tread carefully: Strategic partners often have far greater resources than you. i.e. resources used against you if dispute or conflict arises.

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Corporate Partners

Can limit your flexibility to engage in other alliances, acquisitions and transactions; you may find yourself controlled, or your future substantially affected or limited, by a much larger company with its’ own agenda and priorities (which may not include the successful development of your business).

Be careful regarding protection of confidential and proprietary info.

Probably should not enter into relationship if doing it to primarily raise capital.

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Factors to Help Determine Which Type of Investor is Most Appropriate: Amount of money you need. Proposed use for money. Size and profitability of company. Anticipated rate of company growth. Projected future value of company.

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Factors within Management’s Control that Influence Fund Raising Success: Timing and planning of fund raising campaign. Quality and completeness of management team. Quality of company’s plan for

expansion. Company’s historical results of

operations. Strength or weakness of

company’s internal systems. How well company uses outside advisors. How well management understands the fund

raising process, as evidenced by the quality of it’s fund raising plan.

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Outside Factors that Influence Fund Raising Success:

Volume of money available for investment.

Popularity of company’s business sector to investors.

Activity level of public markets. Investor familiarity with your industry. Intensity of competition in your market. Stage of your company’s development.

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How does Venture Capital Work?

A Venture Capital firm invests time, energy, advice, and money in private companies in the early stages of growth.

These investments are made in exchange for a percentage of the ownership in the company.

Money is a commodity. The real value in a gaining support from a VC

lies in their ability to to provide support with the growth, management, and competitive position of the business.

More than just money...

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To understand how VC’s make decisions, it is important to understand their operations and motivations.

VC’s create unique investment vehicles called “funds”.

VC’s solicit investment from a variety of sources including wealthy individuals, pension funds and university endowment funds. This money is “committed” but not immediately sent to the VC.

Over time these funds are paid in the form of installments called “draw downs” or “capital calls.”

Operations

University Endowments

Fund “n”

Pension Funds

Wealthy Individuals

Cash

Investors

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Capital calls are requested as the VC identifies targets in which to invest.

Money is invested in a company in exchange for a portion of the equity (ownership) in that company.

When all of the money is invested, a VC firm will seek investment to create a new fund.

Typically, a fund may have a limited period of time to invest (2 to 3 years).

A typical VC firm will undergo fundraising every other year - or more frequently if needed.

Fund “n”

Start-up

Start-up

Start-up

Cash

Endowments

Pension Funds

Wealthy Investors

Investments

Operations

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The goal of a VC is to grow the value of the companies in their respective portfolio and exit their investment either in a sale or IPO.

Portfolio companies might be purchased in exchange for cash or securities.

In either case the resulting cash and securities is distributed back to the Partnership.

Operations

Fund

Venture Partners

Limited Partners

Investors

Cash and/or securities

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Although the ROI is significant, the percentage invested is not consistent with the percentage of the fund returned:

For their expertise the Venture Partners are handsomely rewarded with a disproportionately large share of the results, referred to as a “carried interest” usually around 20%.

2-3% of the value of the fund is paid annually to the management company to cover operations and employee salaries.

How does Venture Capital Work?Operations

Amount Invested

10%

Limited Partners

Fund90%

Amount Returned

Venture Partners

29%

Limited Partners 69%

2%

VC Management Company

Venture Partners

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What does all of this mean? Like mutual fund managers, Venture Partners are

investing other peoples money and are rewarded based on their ability to identify the potentially brilliant ideas and help make them successful.

Also like Mutual fund managers, future success is based on the ability to draw investors and create a larger fund next year.

The impression of investors is based not only on the ROI of the fund, but on the visibility of “home run” wins within the fund portfolio.

Think of it like a wacky mutual fund

for the rich and powerful...

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In search of Funding

A Venture Partner will use a variety of criteria to assess and analyze both the entrepreneur and the idea. What many look for is a combination of: A High Quality Entrepreneur. HOME RUN potential. A compelling Model. An Experienced Team. A Company that has been

DERISKED. Financial Viability. Personality & Fit.

What are VC’s looking for ?

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The Funding Process

What should a company be looking for in a VC partner? An investor with the right connections. Industry Knowledge. National and or Global Reach. Fit. Prestige.

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The Investment Process Time Line

Initial Contact: After entrepreneur's homework, investigation and assessment of appropriate VC, executive summary sent via “trusted source”.

Screening: Most opportunities submitted (75-80%) screened out and eliminated, after brief review (don’t fit VC objectives, criteria and preferences, most because of stage of development, location, man. depth or track record, market or industry focus, competitive dynamics, amount required to invest).

Closer Look: (20-25%) Some level of further review i.e. full read of business plan, financial information and projections; inquiries and background checks with local contacts and others, telephone calls to respond to specific questions, less than half will get opportunity to meet with lead VC.

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The Investment Process (continued) Due Diligence; Valuation: (4%) subjected to some greater level of “due diligence”, meetings with key management, perhaps customers, office/facility tours, competitive and market analyses, more intensive business, financial and technical inquiry and review, typically a discussion regarding Valuation.

Term Sheet: (less than 2%) presented with term sheet or “letter of intent”, ensures parties are on the same page regarding key terms

Definitive Agreements & Funding: (1%) result in signed definitive agreements and funding. Timing will depend upon level of detail in term sheet, business owner and it’s counsel prior preparation, sophistication and experience, the VC’s approval process and schedule and absence of surprises.

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“10 Commandments” for Companies Seeking Financing1. “Thou shalt focus, focus, focus thy

plan” make sure strategy is a rifle shot, not a

shotgun blast. carve up target markets finely and

restrict yourself to two or three well defined segments.

2. “Thou shalt weave a story” create excitement around plan. show energy, enthusiasm and

excitement when you present. cover long term vision, then spell out

short term practicalities of its implementation.

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3. “Thou shalt understand thy audience” research and understand target audience – both

for plan and pitch. understand prospective investors job, history,

area of expertise, prior areas of investment, etc.

4. “Thou shalt arrive via referral” reference will instantly give you credibility,

visibility and the investors attention.

5. “Thou shalt be crisp in thy plan” keep business plan succinct. typically 25 pages, executive summary no more

than 2 pages.

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6. “Thou shalt fine-tune thy presentation” plan your pitch and pitch your plan (one

bite at apple!). no more than an hour. have back-up slides for common questions. prepare in advance reference list .

7. “Thou shalt thoroughly research and evaluate current and prospective competition” all start-ups have competition of one sort

or another. honestly assess relative status. openly discuss management team’s

background strengths and weaknesses.

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8. “Thou shalt get real about financial projections” they may come back during the structuring of

deal.9. “Thou shalt not obsess on valuation”

it is important, but don’t be penny-wise and pound-foolish. By understanding this hopefully everyone gets a piece of a much larger pie.

10. “Thou shalt understand potential exit strategies” investors need to know how they are getting

out of investment. be explicit about potential buyers and

rationale for their interest in your company.

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Top 10 Pet Peeves of Florida VC’s1. Not specifying in the Business Plan the amount of capital

being sought.

2. Not providing contact information.

3. Not explaining how the company’s technology works.

4. Not mentioning if there are patents.

5. Using too broad of a market to show market size (i.e.) showing a market size of the computer market when the company makes keyboards.

6. Executive bios that don’t list companies worked for and titles held or Business Plans focusing on one founder and not the management team.

7. Including unnecessary graphics.

8. Using fuzzy numbers that can be easily researched.

9. Focusing on valuation during the first meeting.

10. Business Plans that begin with “How the Internet has Changed the World.”

In Search of Capital

Understanding Angel Investors

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THE FACTS

The Angel market is the oldest and biggest market for venture capital.

U.S. has close to three million angels, investing more than $50 billion* in entrepreneurial firms each year, National Venture Capital Association suggests it may be $100 billion annually.

Business Angels fund 30 to 40 times as many entrepreneurial ventures as do venture capitalists.

Early-stage deals receive around 60-70% of angel funds invested, compared to around a quarter of all deals for venture capitalist; so who is the real risk taker?

May be difficult to find, as many prefer anonymity; no directories, however, recent increase in angel clubs and organized angel funds.

* Benjamin and Margulis, 1996

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Nature of Business Angel Investments

Most Angels are value-added investors – contribute their business skills.

Angels are more geographically dispersed. Obtaining money has a leveraging effect –

heightens a VC’s interest in the company. Level of Due Diligence minimal compared to a VC. Exiting their investment and rate of return usually

of lesser concern than a VC. May rely more on gut feeling, some rely very little

on financial projections where as VC’s decisions are almost completely based on comprehensive Due Diligence.

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Nature of Business Angel Investments Angels prefer smaller size investments than VC’s. Angels usually invest in start-ups and early-stage

ventures, ones having the most difficulty obtaining outside funds.

Angels make investments in virtually all industry sectors.

More flexible in financial decisions than VC’s: Longer investment horizons (“patient money”). Shorter investment processes, and lower targeted

rates of return.

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Disadvantages of Angel Investors Less likely to make follow-on investments. Prefer to have a say in running of firm, which

may cause an issue if they don’t have experience in the company they fund.

Many turn out to be “Devil,” self-serving motives, rather than promoting good of firm (difficult).

Do not have national reputation and prestige of big-name institution.

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Initial Considerations

Who is this person? What is their motivation

for investing? Make sure they have no unexpected

demands. Avoid conflicts of interest. What does the Angel bring to the table

beyond money?

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What does the Angel Bring to the Table Beyond $$$$?

Alliances with larger corporate partners through technology exchange, OEM or other agreements.

Assistance with equity offerings, financing, joint venture and acquisitions.

Industry contacts with potential customers, vendor and financing institutions.

Assistance in strategy, financing and recruiting issues. Assistance in locating knowledge and functional

experience to help grow business. Management assistance –

day-to-day or periodic. External contact network. PASSION.

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What Motivates the Angel Investor?

Improve self image, self-esteem and recognition.

Obligation to give back. Get “first crack” at next high-rise stock

prior to IPO. Habit, addicted to the high-risk “rush”. Fun and exciting, the “joy of giving.”

“You never know how much you know until a small company turns to you.”

ROI 30% minimum.

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The Value-Added Investor

Very experienced investors and former investment bankers and venture capitalists.

Very strong network of co-investors whom they leverage and who trust their judgment.

Extremely active and involved but only for short periods.

Want to help grow businesses and have fun doing so.

Tend towards industry concentrations. Invest in businesses close to home. Normally invest $50,000 to $250,000 per deal.

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Consortium of Individual Investors

Loose group of private, individual investors (unrelated, typically 3-6).

Significant entrepreneurial experience. Make their own decisions, so may not

always invest as a team. Invest $50,000 to $500,000 per deal. Seek firms with a competitive advantage

in which they can be passively involved.

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The Partner Investor

Buyer in disguise. Very high need for control. Is trying to build network or has

developed some co-investor relationships.

Would prefer acquisition of established company but lacks financial resources. Wants to be president (buy a job).

Able to invest $250,000 to $1,000,000.

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The Family of Investors

Family money is pooled and a trusted, skilled family member coordinates investment activity.

Very astute investor, serves as “Gate Keeper.”

Contribute experience, intense involvement for short periods of time.

Invest $100,000 to $1,000,000.

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The Barter Investor

Provides what you would have used capital to buy in exchange for equity.

Participative – not passive. Early-stage preference. Offers infrastructure (an incubator

model). Loses interest when you no longer

need what they can provide. Invests up to $250,000.

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The Unaccredited Private Investor

Less experienced, less affluent private investor.

Looking for a role in earlier-stage situations. Not a patient investor – has to get money out

in 3-5 years. Must “really get to know” entrepreneur. “Spreads his/her apple around,” making

multiple small investments. Used to invest in real estate. Has to justify investment to spouse. Invests $10,000 to $25,000 maximum.

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Where Do You Find Angels?

Advisors (Accountants, Attorneys, Brokers).

Country Clubs. Charity Events. Investment Seminars. Investment Clubs. VC Clubs.

The Venture Industry

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The VC Industry has Grown Dramatically in the Past Few Years Investments

7.611.5

14.821.3

54.5

105.9

40.6

21.4 18.2

$0

$20

$40

$60

$80

$100

$120

$ M

illi

on I

nve

sted

1995 1996 1997 1998 1999 2000 2001 2002 2003

Source: VentureXpert™ Database by VE & NVCA

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What’s going on??? VC’s still finding promising opportunities in a

wide range of sectors including: software, communications, internet infrastructure, medical/health and Biotechnology.

However, most VC’s are spending existing resources on current portfolio companies.

Good time for VC’s to invest, valuations are low and talented workers are available.

VC’s may be showing more interest in early-stage and first-round deals, because near-term exit prospects for later-stage weak.

Exit strategy – Mergers & Acquisitions, IPO markets quiet.

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Conclusion Venture Capital will continue to be difficult to raise.

But… Venture Capital has always been difficult to raise

(except for 1999-2000). There is considerable venture capital available to

invest. All essential resources other than capital will be

easier to obtain (talented people, real estate, professional services).

Tight capital will mean less competition and better businesses.

Valuations will drop, considerably. All of this is good for the best VC’s and entrepreneurs

(and the public).

54Microsoft Corporation, 1978

Bill Gates

Would you invest in this company?

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The Financial Plan

Funding Request/Terms of Investment Pro Forma Financial Assumptions

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Pro Forma 5-Year Estimates

Projected... Income (P&L) Statement Cash Flow Statement Balance Statement

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5-Year Profit and Loss (P&L) Pro Forma

Determines Value of Business

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Projecting SalesSource: David Bangs, Jr. “The Start-Up Guide”

Sources Your Accountant or Financial Advisor Trade Association Figures Others in Your Line of Business

Three-Column Approach

Worst Case Most Likely CaseBest CaseA._______________________________________________B._______________________________________________Total: Total:Total:

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5-Year Cash Flow Pro Forma

Identifies Investment Requirements. Growth Can “Eat Up” Cash Flow in First

1-3 Years. Investors Expect to see Red Ink up to

Two Years in Business. Usually Have Increasing Cash Flow

Demands During Growth.

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5-Year Balance Sheet Pro Forma

Shows Early on, What is Happening With The Business.

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Financial AssumptionsFinancial Assumptions

Revenues Cost of Goods Headcount/Salaries Expenses Inventory Accounts Receivable

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Financial Assumptions Common Mistakes

Failing to Provide Assumptions

Unrealistic Projections No Financial Statement Underestimating Taxes

or Operating Expenses Unclear Terms Taking Too High Risk Spending Too Much on

Salaries

Spending too Much on Salaries & “Fringes”

Proposing a Low ROI Failing to Project the

Downside if Sales Don’t go as Expected

Not Showing Tax Benefit Not Having Your

Financial Statements Checked by a Reputable Accountant

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Marketing and Finance Approaches

Marketing... Aggressive Approach

Finance... Conservative Approach

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Managing Your Finances

Do not spend all your time managing the books, hire an accountant.

Financial Management is too important to get it wrong or neglect it.

When starting out you want to seek professional advice.

Take an IRS Tax Seminar and standard financial accounting practices course.

Economy & Finance

Planning a New Business