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Early Stage Sources of Capital 1

Early Stage Sources of Capital


Stages of Entrepreneurial Development

• Seed $5,000 to $100,000

• Startup $20,000 to $400,000

• Growth $500,000 to $3,000,000

• Late Growth $1,000,000 to $5,000,000

• Harvest $2,000,000 to 20,000,000


Capital Source by StageDevelopment Startup Growth Late Growth Harvest

Entrepreneur

Friends, Family

Angels

Strategic Partners

Venture Capital

Asset Lenders

SBA Loan

EDC

SBIC

Commercial Lenders

Suppliers & Customers

Private Placement

Investment Bankers

Private Equity Fund

Institutional Investors

IPO

M & A

Public Debt


Sources of Seed Capital

• Entrepreneur

• Friends and family

• Angels

• Strategic partners


Sources of Startup Capital

• Venture investment clubs

• Economic development agencies

• Asset-based lenders

• SBA loans


Sources of Growth Capital

• Commercial lenders

• Suppliers & Customers

• Private placements

• Venture capitalists

• Small business investment companies


Sources of Late Growth Capital

• Investment bankers

• Private equity funds

• Institutional investors


Sources of Harvest Capital

• Initial public offerings

• Mergers and acquisitions

• Public debt


Entrepreneur

• Personal savings

• Credit cards

• Home equity

• Retirement accounts

• Life insurance


Angels

• Checkbook angels • $5,000 to $25,000

• Capital A angels • $25,000 to $250,000

• Superangels • $250,000 to $2,000,000


Angel OrganizationsManaged Funded Active

Investors

Angel Networks

Pledged Funds

Angel Clubs

CEO

Angels


Incubators

• Advantages• Increased survival rate

• Non-monetary resources

• Disadvantages• Lengthened startup

time

• Low number of growth firms


Economic Development Agencies and Community Development Corporations

• Arkansas Certified Development Corporation

• Arkansas Development Finance Authority

• Southern Development Bancorporation

• Economic Development Corporation


Ten Tips for Bootstrapping

1) Accelerate Startup• Plan as if time is money

• Imitate competitors

2) Focus on Cash Flow• Focus on income generation

• Track weekly cash flow

• Manage payables and receivables



3) Be Frugal• Control growth to control cash needs

• Avoid low value-added expenses

4) Rent versus buy• Use licensing versus development

• Use franchise versus marketing

• Use leases versus purchasing



5) Pay with Equity• Professional services

• Warrants

6) Use Underused Assets of Others• Use equipment during off-peak hours

• Use meeting space of professionals

• Use unused space of other businesses



7) Find Non-cash Solutions• Give managers compensation time

• Pay with in-kind services

• Pay with unused assets

8) Use Professionalism Sparingly• Maintain an Internet web site

• Use business centers



9) Share Resources• Strategic partnerships

• Complimentary cooperation

10) Lead by Example• Sacrifice personal assets

• Suggest ways to avoid cash outlays


UALR“Entrepreneurial

Financing”February 9, 2004


Demand for Funds - Classifications of firms

• Lifestyle Firms – provide a reasonable living for their founders, account for more than 90 percent of all start-ups it is unlikely that these firms will attract equity funding from external parties. These business ventures typically have five year revenue projections under $ 10 million.

• Middle Market Firms – Have growth prospects of more than 20 percent annually and five year revenue projections between $10 and $ 50 million. These firms are attractive to business angel investors, but they also depend heavily on bootstrapping to fund initial growth. These firms typically make up less than 10 percent of all start ups.

• High Potential Firms – Typically plan to grow into a substantial firm with fifty or more employees within five to ten years, have five-year revenue projections in excess of $ 50 million and anticipate annual growth rates in excess of 50 percent. Typically financed by business angels and later by venture capitalists. These firms typically make up less than 1 percent of all start-ups.

• On market projections, need to verify with top down and bottom up calculations. Can not say market is $x and all we need is x%. Investors want to see large growth opportunities that scale quickly.

• Key Point - not every firm is suitable for outside equity investment based on the financial economics of the investment.

• Typically, the Middle Market or High Potential firm definition would be the target market for outside equity capital. These firms account for less than 10% of the aggregate firms.

• At any point in time approximately 700,000 companies are actively trying to raise capital .• Arthur Andersen’s 1995 national study 36 % of small, fast growing companies reported an

inability to meet their capital needs.


Main Sources of Capital for Entrepreneurial Firms:

• Source First Round Second Round Third Round

• Founder 74 % 7 % 13 %• Family & friends 5 % 4 % 0 %• Business angels 7 % 34 % 29 %• Venture capitalists 5 % 13 % 6 %• Banks 6 % 15 % 16 %• Nonfinancial institutions 0 % 15 % 10 %• IPO’s and equity markets 3 % 10 % 26 %


Business Plan

• Business plan should be clear, professional, realistic and to the point.• Refine your sales pitch Prepare a 15-20 minute presentation in addition to the

plan. Really hone the presentation it is as important as the plan.• Entrepreneur develops the plan and should use plain English avoid technical

jargon.• Investors want a plan for profit not an invention. Recurring revenue model and

scalability are important factors• Business plans get your company in the door but it does not sell the deal -

Business plans do not get funded people get funded. • Borrow added creditability – Board of Directors and Press Releases are examples• Set up formal communication channels and define the roles for investors• Memo vs. book • Poorly developed assumptions are a main reason proposals are rejected. Other

trouble spots include large salaries, back salaries, old loan obligations or buy out of prior investors. Also investors want to see some investment by the founders, percentages are important (% of net worth)

• Sweat Equity may be an issue. The investor wants to know what can you do to create value from this point on and how far along your are in the process helps determine valuation (risk/reward)

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Executive Summary Outline

1. Our Business2. Market Opportunity3. Value Proposition4. Proprietary or Distinguishable Position in the Marketplace5. Competition & Market Positioning Summary6. Our Customers7. Funds Requested and Why8. Use of Funds with Expected milestones9. Exit Strategy for Providers of Capital10. Conclusion


Bootstrapping

• Bootstrapping is the most likely source of initial equity for 94 percent of new technology based firms. It was initially used by more than 80 percent of the five hundred fastest growing privately held entrepreneurial firms in the United States.

• Examples:• Obtain Research Grants (SBIR etc.) or have customer funded R&D• Commercialize University Technology• Reduce/Delay Compensation• Work from home• Buy used equipment instead of new• Borrow or lease equipment instead of buying• Hire personnel for short periods instead of permanently• Coordinate purchases with other firms• Speed up invoicing• Cease doing business with slow payers• Bartering for unused equipment/people • Paying people with stock or with phantom stock


Bootstrapping

• Strategies• Get operational quickly – copycat idea in small target market to

get off the ground fast.• Look for quick, break even, cash generating products• Offer high value products or services that sustain direct personal

selling• Forget about the crack employee team• Keep growth in check• Focus on cash (not profits, market share or anything else)• Cultivate banks before the business becomes creditworthy

• Try to finance and bootstrap as long as possible until the need for external growth finance becomes evident and unavoidable

• Bootstrapping does not work for companies that are growing fast. Also bootstrapping is like zero inventory or JIT it reveals hidden problems and forces the company to solve them.


Success Rates for Obtaining Investment

• Venture Capital• 77% of proposals rejected at the initial screening stage• 20% rejected during the due diligence stage• 1-3 % funded

• Angels:• Typically receive 36 investment proposals per year• Interested in 8• Offers made to invest in 2, Typically find that 5% of deal flow

result in a deal.


Angel Investors

• Angels are typically wealthy individuals/families willing to invest in high risk deals offered by entrepreneurs whom they admire and with whom they wish to be associated.

• Speak with securities attorney before approaching outside investors, there are legal issues at stake. Investors may not know about the rules but they impact how the company raises capital over the subsequent 12 months. Typically equity sales to angel investors will fall under three rules of Reg D:• Rule 504 for offerings of up to $ 1 million• Rule 505 for offerings up to $ 5 million• Rule 506 for offerings over $5 million

• Angel capital is not only about the money, it has to do with the resources angels bring to fledging companies. Over 80% of angels have started a company on their own so they understand the process.


Angel Investors

• Angels and Venture Capital are not interchangeable.• Angels are part time investors – VC are full time• Angels invest on their own behalf - VC invest on behalf of

others• VC generally invest in higher amounts and have more

money• Angels make investments in virtually all industry sectors.

• Business angels fund thirty to forty times more ventures each year than venture capitalists. The National Venture Capital Association has suggested that angels may actually invest around $ 100 billion annually. According to the Center for Venture Research there are 400,000 angels.


Angel Investors

• Angels tend to have less risk aversion and lower expectations of return than other types of investors. Their cost of finance is often cheaper for the entrepreneur and their funding is received more quickly than from other finance sources. Angels are more flexible in their financial decisions than venture capitalists.

• Downsides include that angels are not likely to do multiple rounds, they may want a hands on role and be unqualified and they do not have the national reputation or prestige when trying to get Investment Banking assistance.

• Angels are more geographically dispersed. Location is important, 65% of angels invest in deals reasonable close to where they live, within 300 – 500 miles. Interesting point is that 35% do not have this need they will invest as long as a lead investor lives geographically close to the enterprise.


Angel Investors

• Angels tend to be men from 46-65 years of age. Age does seem to influence investors to this activity. In the 56-65 year old bracket investors tend to trust their own judgment rather than that of brokers or intermediaries. These investors tend to have postgraduate degrees. They have a wealth of business experience.

• Investment Size• 20% indicate they invest $ 25,000 per deal • 40 % indicate the invest $25,000 to $99,999 per deal • 25% indicate the invest $ 100,000 – $250,000 per deal• 15% indicate they invest more than $250,000 per deal.

• Active investors invest in 1-4 deals per year with a mean of 3 deals. Holding period ran from 5-10 years. 5-15% of their portfolio is for private equity deals. Angels can also offer loan guarantees

• Angels provide 84 percent of rounds under $250,000 and 58 percent between $250,000 and $500,000 while overall rounds of less than $500,000 business angels will offer, in dollar terms, four times as much as venture capitalists.


Investors Investment Criteria (Rough Order) for All Investors

• Criteria Angels VC• Enthusiasm of Entrepreneur 1 3• Trustworthiness of the Entrepreneur 2 1• Sales potential of the product 3 5• Expertise of the Entrepreneur 4 2• Investor liked the Entrepreneur upon meeting 5 9• Growth potential of the market 6 6• Quality of product 7 10• Perceived financial rewards 8 4• Niche Market 9 13• Track Record of Entrepreneur 10 8• Investor’s strength filling gaps in business 14 26• Overall competitive protection 21 11• Local venture (geography) 23 27• Investors understanding of the business/industry 24 17• Potential exit routes (liquidity) 24 12• Presence of (potential) co-investors 26 25• Formal competitive protection of product (patents) 27 20


Perfect Angel Investors

• Investing expertise• Industry Experience & Contacts• Entrepreneurial Experience• Risk tolerance• Patient Money• Additional Investment – Deep –but not to deep- pockets. Idea

angel has personal net worth of $2 million to $50 million. If an angel has more than that your company may fall below their radar screen. If they have less you may be out of luck if you need follow on financing.

• Congruent Exit Strategy• Active Participation• Cheerleader Potential


Investment Criteria for Angel Investors

• Important• Investor’s strengths in filling

gaps• Investors involvement possible• Trustworthiness of entrepreneur• Quality of product• Low initial capital costs• Investor liked entrepreneur

upon meeting• Niche market• Low cost to market initially• Track record of entrepreneur• Sales potential of product

• Lesser Importance

• Growth potential of Market• Venture is local• Ability to break even without

further funding• Formal competitive protection

of products (patents)• Overall competitive position of

product


Catching an Angel Investor

• Step 1 - Sourcing. • Step 2 - Evaluating• Step 3 - Valuation• Step 4 - Structuring• Step 5 - Negotiating• Step 6 - Support• Step 7 - Harvesting


Sourcing

• Word of mouth. You want to come recommended.

• Determine the ideal investors for your firm and follow a rifle approach.

• Target lead investors• Check out potential investors – due

diligence is a two way street• Local Angel Group. Most will not

take cold calls so you will need a referral but once you are in angel groups offer an opportunity to present you company to several angels.

• Professional Networks. Talk to professional service providers who may know angels.

• Investee firms. Firms that have received angel money in the past introduce you to their angels

• Personal Networks. Explore your network of friends, acquaintances and friend of friends. • Recent US research confirms that

angels are widespread, at least 2.8 percent of US households have at least one angel in the family.

• More than 50% of private equity investors deal flow comes from family, friends, associates and colleagues.

• Snowballing. Find one business angel can lead to them knowing others. One caveat it is quality not quantity. For every venture no matter how unusual there is an angel out there willing to fund the idea.

• Matchmakers. Be careful, ask for references and will they take the fees when you have the money.


Evaluating - Four Main Areas

1. People – you, the management team, other investors, advisors and significant stakeholders, anybody that has a stake in your companies success. Unique Talent or Knowledge Contacts Willingness to Hire Professional Management Chemistry with Investors Professional Advisors: Attorneys, Financial Advisors and

Accountants2. Context – external factors that could impact your business

including available technology, customer needs, the overall economy, regulations and competitors

3. Deal – the price of the deal you propose and its structure. Price starts with valuation. Structure refers to the terms of the investment and other factors – board seats, salary limits, etc.

4. Business Opportunity – Your business model, market size, potential and actual customers and timing of your opportunity. Investors want to invest in a company not a single product remember the objective is to create wealth, not make a living


Evaluating - When making the pitch

Show Passion and Be Yourself Focus on your team its not about just

you, you do not have enough time or the skills to do everything. Sell the Team as a Team

Show you have sales or can get them. Make sure the deal you are proposing

makes sense from the investors point of view. Tell the angels what is in it for them. Think through what the investors need to get out of the deal in terms of ownership and potential returns. Do not aim to squeeze every last nickel out of them.

From the beginning, you want investors always to feel as if they're making money

Discuss the exit strategy. Sell the company, go public et al and let them know the time frame for such an event.

Have the necessary documents in hand, business plan, financials, corporate bios etc.

Respect the angels time. Be punctual. Ask how much time they have for the meeting keep your answers short and to the point. If you do not know the answer don't fake it say you will find out and do it within a certain time frame.

Magic Words: “I Don’t Know.” Know What Can Bite You and

Say So Address Tough Questions

Before Asked/Answer the Questions When Asked

Never Oversell or Shade the Facts

Listen and Enjoy the Process


Search Tips

• Weigh the pros and cons of angels before you being the search for and discussions with private investors. If angel investors are deemed appropriate form realistic expectations of roughly how much money you will need and how much equity you are willing to surrender

• Learn about angels before you go after them. Figure out the role you want them to play for example if you need accounting help find an angel that can bring money and accounting assistance

• Contrary to popular belief relatively few lawyers, doctors and other professionals are currently involved as angels.

• Create Excitement around the Investment - After a handful of angels have expressed any degree of interest, you, the entrepreneur, should move interest into action and investment. Set a realistic deadline for the investment, then tell investors that the supply of available equity is fast dwindling.


Valuation

• Angels price the company based on its potential capital return in the future but realize their are non financial returns that accrue to the angel. Excitement of a start up, sense of contributing, opportunity to give something back to the entrepreneurial world, new economic opportunities for a community.

• Angels value the deal less than the entrepreneurs will. Ideas are cheap its the execution that adds value. Potential investors do not have a clue at this point whether you and your team will be able to execute.

• Valuation methods include:• sales multiples, • price-earnings ratio, • free cash flow multiple,• book value, • liquidation value, • replacement value, • Comparables, • discounted cash flow


Valuation Examples

• Sales Forecast (Year 5) Under $ 50,000,000 Over $ 50,000,000

• Risk High Low High Low• Founder:

• Inexperienced $300,000 $500,000 $600,000 $1,000,000• Experienced $600,000 $1,000,000

$1,800,000 $3,000,000

• Every deal is different but some ballpark pre money valuations are as follows:

• Sound idea $1 million max.• Prototype $1 million max.• Quality Management Team $ 1 -$ 2 million max.• Quality Board $ 1 million max.• Product Rollout or sales $ 1 million max.• Total Potential Value $ 1 - $ 6 million max.


Actual Returns to Investors

• IRR (%) Angels (%) VC (%)• Negative 39.8 64.2• 0-24 23.8 7.1• 25-49 12.7 7.1• 50-99 13.3 9.5• 100+ 10.2 12.0

• Arkansas examples:• An investor made a $20,000 investment into Wal-Mart now

worth +$91 million• An investor made a $400,000 investment in 1968 into

Systematics, now worth +$1 billion


Target Multipliers

• The targeted rates of return on individuals deals have to be higher so that the portfolio can net acceptable returns. As a general rule investors target the following annual IRR’s:

• Years to Exit Development Stage Rate of ReturnMultiplier

• 6 Seed 66% 21X

• 5 Start-up 60% 10.5X

• 4 First Stage 53% 5.5X

• 3 Second Stage 47% 3.2X

• 2 Mezzanine 41% 2.0X

• 1 Mezzanine – Pre-exit 35% 1.35X


Structuring

• First on what terms are the angels investing? Debt/equity, what type of debt/equity, will investors get cash before entrepreneurs, will angels have right to invest in future rounds?

• Second what role will the angels play in your companies future? Will they be silent partners or active ones?

• Three fundamental ways angels invest in companies:• Common Stock

• Easiest & Simplest• Same risk as founders• Little Structural Flexibility• Valuation set for future

• Preferred Convertible Stock with various terms• Most Common Investment• Structural Flexibility• Can Manipulate IRR• Upside guarantees, downside protection

• Convertible note with various terms• Protection of principal• Interest as current return• Warrants as sweetener• Limited Upside


Structuring

• Everything is negotiable, time to negotiate is before the term sheet gets signed. Everybody needs to know how the relationship is going to work up front.

• Downside Protective Strategies• Liquidation Preference

• Straight• Participating – rare in early deals

• Antidilution Protection• Weighted Average• Full Ratchet - Draconian

• Dividends


Structuring

• Management issues• Affirmative Covenants

• Accounts and Reports• Approval of Budgets• Board of Directors• Independent Public Accountants• Financial Statements

• Class Voting Rights• Investor Can block important corporate transactions• Should disappear if preferred holds less than a certain percentage of company

• Investor/Founder Issues• Sweat Equity vs. Financial Investor• Vesting/Buy Back at Cost• For Cause vs. “No Fault Divorce”• Tag Along Rights• Right of First Refusal/First Offer• Baskets for Management Shares• Non-competitive/Non Solicitation Agreements• Employment/Service Agreements


Structuring

• Early In Issues• Preemptive Rights• All vs. Pro Rata• Pay to Play

• Liquidity Opportunities• IPO’s

• Registration Rights• Conversion

• Acquisition• Liquidation Preference• Conversion

• Redemption• Lackluster Investments


Negotiating

• How much of the company are you going to give up?• The trick is to align everyone's interest. The position you want to

end up with is its you and me against the world as opposed to its you against me.

• During negotiations angels will tend to focus on the numbers, specifically their initial ownership stake. They believe that will have the greatest impact on the future return on their investment so many will bargain hard over it.

• Angels have the advantage of time, you may need to move quickly they do not face the same time pressure. On the contrary many angels prefer to take their time during negotiations not least of all in the hope that you will eventually come around to their terms.

• Some angels will enlist a professional to negotiate others will simply reject the deal and move on. There is no reason you can not take the same position put your best deal forward and say politely this is a take it or leave it position. If you are asked why say you do not want to start your relationship off on adversarial footing.


Support

• An angels investment should be just the beginning of the interaction not as an end point.

• Feel free to solicit the angels help any way you can, find customers, follow on investors, key staff, suppliers etc.

• Support should be a two way street. You should provide regular updates to all investors. You may also want to put in key prospects or other key events and one of the investors may have a contact.


Harvesting

• Getting the investors their money back plus a return. Typically in these forms:• Walking harvest – your company distributes cash directly to its

investors on a regular basis.• Partial Sale – your investor sell their stakes to your company’s

management another stakeholder or an outsider.• Strategic Sale – A competitor acquires your company for strategic

reasons, your investors receive a negotiated share of the acquisition price.

• Financial Sale – A buyer outside your industry acquires your company for its cash flow.

• Initial Public Offering – your company sells stock in the public markets. Less experienced angels, overemphasize the IPO as a primary exit route. An IPO is the exception not the rule.

• Negative Harvest - bankruptcy


Venture Capital

• Of the nearly one million firms that are started each year in the United States only one to two thousand actually receive venture capital financing.

• Venture Capitalists are rarely able to fund small start up firms seeking less than $ 5 million, regardless of the quality of the venture because of their specific investment criteria and high costs of due diligence, negotiating and monitoring.

• Key points are have an outstanding Business Model, get Personal Introductions and have a great Executive Summary

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Types of Venture Funds

• Stage of InvestmentSeed/Start-up MezzanineMid-Stage LBOLate-Stage

• LocationRegional CoastalNationwide

• By IndustryComputer Science MedicalTelecom Biotechnology

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Venture Funds as Partnerships

• Object is to create Large, Successful Companies, make Outstanding Returns on the Fund’s Capital - 25%+ IRR for Limited Partners and to Permit the Venture Capitalist to Share in Profits over a typical 10-Year Term

• Investors are Limited Partners• Invest 99% of Capital• No Liability• Receive Capital Return First, Then 80% of Profit• No Role in Decisions

• Venture Capitalists are General Partners• Invest 1% of Capital• Some Liability• Receive 20% of Profits• Make All Decisions


Initial Public Offerings

• An IPO typically has to be in the $20 - $50 million range to create a market for a firm.

• At the IPO stage providing financing for the firms growth is usually not the major motivation, rather procuring exit routes and share liquidity is primary.

• The SBA estimates that fewer than one in a thousand new ventures actually have an IPO.

• In the United States, it is estimated that only 1 percent of corporations are publicly traded and only .25 percent are listed on an organized exchange.

• Around 26-33 percent of all IPOs in the United States are venture capital funded firms.


Lessons

• Never split equity 50/50, and don’t give away equity• Friends and family financing have interesting hidden costs• SBIR funds are like a gift from a wealthy uncle. It gets you to the first

prototype but does not get you to the marketplace• If you are going to get financing outside of friends and family get an

external board.• Investment due diligence is about intgretity. It is about can I trust

you? Will you make the right decisions with my money?• Big money brings big expectations. You may not be with the company

to accomplish those expectations.• Perception is reality – everybody likes a winner and wants to avoid a

losing image.• The business model is more important than the technology• Do not give your family and friends a price when they invest. Give

them some predetermined premium to the valuation set by the first outside money to avoid down rounds.

• Get an external confidant to act as a sounding board, they will help you keep a level plane


Sources

• Inc Magazine – October 16, 2001

• National Association of Seed & Venture Funds handouts

• The Angel Investors Handbook - Gerald A. Benjamin & Joel Margulis

• Angel Investing: Matching Startup Funds with Startup Companies -- A Guide for Entrepreneurs, Individual Investors, and Venture Capitalists - Robert J. Robinson & Mark Van Osnabrugge

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