Chapter 2

Chapter 2

An Overview of New Venture Financing

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Learning Objectives• Learn new venture financing terminology.• Understand the value of tying financing to

performance milestones• Recognize the distinguishing characteristics of the

various stages of new venture development• Identify the financing sources available to a new

venture and the factors favoring one over another• Learn the basic structures and availability of various

financing sources• Identify the key elements of deal structure and the

functions they serve

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Some Milestones for New Venture Planning

• Completion of concept and product testing• Completion of prototype• First financing• Completion of initial plant tests• Market testing• Production start-up• First competitive action• First redesign or redirection• First significant price change


Block and Macmillan (1992)

Stages of New Venture Development

• Development stage• Start-up• Early growth• Rapid growth• Exit



Figure 2-2

Stages of New Venture Development

Sequence of New Venture Financing

• Bootstrapping• Seed financing• R&D financing• Start-up financing• First-stage financing• Second-stage financing• Third-stage financing• Mezzanine financing• Bridge financing• LBO, MBO, IPO


Sources of New Venture Financing

• Self, friends, and family• Business angels• Venture capital investors• Small business investment companies (SBICs)• Trade credit and factoring• Asset-based lending• Mezzanine capital• Private placements of equity (relational investors)• IPOs• Public debt


©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter2

Sources of New Venture Financing

Figure 2-3

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter2

Figure 2-3

International Venture Capital and Business Angel Investment 2000-2001 Averages

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Venture Capital

Informal Investment


Venture Capital Commitments by Limited Partner Type

Figure 2-4


Figure 2-5

Venture Capital Investments by Industry


Venture Capital Investments by Region

Figure 2-6


How Changes in the Stock Market Relate to New Equity Capital

RaisingFigure 2-7

Deal Structures• “The deal”• Term sheet• Pre-money valuation• Post-money valuation• Investment agreement

– Representations and warranties– Covenants and undertakings– Affirmative covenants– Negative covenants– Registration rights– Preemptive rights– Ratchets or anti-dilution provisions


End of Chapter Questions

Question 2-1

Use the Internet to locate some websites of venture capital firms and angel investors

– Based on your search, what are the characteristics of investments sought by these two types of investors?

– What are the main differences in investment characteristics between the two types of investors?

– What differences in investment objectives, if any, do you see within each type of investor?


Question 2-2

In activities such as education and healthcare, profit and non-profit enterprises compete with each other

• What do you think it means for an enterprise to be organized as non-profit?

• Why do you think non-profit enterprises sometimes compete aggressively for business?


Question 2-3

• What is “limited liability” in terms of total risk and risk allocation? • If equity investors have limited liability and the venture fails, how

does it affect the equity investors, creditors, employees, suppliers and customers?

• Do you think it would matter to other stakeholders whether equity investors have limited liability? Why or why not?


Question 2-4

The following table contains financial information from the business plan of a new venture, LaserGolf, Inc, that makes a portable device that uses Laser technology for measuring distances with great precision.

(Amounts in thousands of dollars and in intervals of six months)


* Equals cash flow available to investors

Question 2-4 (Cont’d)

• How would you propose to identify the stages of new venture development?

• How much cash is the venture expected to need in total? Why?• Would your proposal for staging be different if you were advising

the entrepreneur as opposed to a prospective investor?• What would you suggest as useful milestones for evaluating

progress?• What kinds of investors are best suited for investing at various

stages of development?• Suppose, after your group makes an initial investment in the

venture prior to month 18, the venture fails to achieve the next milestone you had agreed for making the next cash infusion, what would you do? Why?


Question 2-5

An existing biotechnology venture has a prototype of a device for using ultrasound to shatter kidney stones. The venture is seeking an infusion of $5 million to carry it to the next milestone. The $5 million is needed to complete the testing required for FDA approval. Three alternatives are under consideration:

• Scenario 1: An investor is proposing to provide the capital in exchange for $2 million shares of common stock

• Scenario 2: The investor will accept 1.8 million shares of preferred stock, convertible to common on a 1 for 1 basis

• Scenario 3: The investor will accept 1.5 million convertible preferred shares, along with warrants to acquire an additional 1.5 million shares for a nominal price. The warrants can be exercised only if the venture fails to achieve the revenue level projected by the entrepreneur in 2 years



• Compute the pre- and post- money valuations for each scenario.

• If you were the entrepreneur, what factors would you consider in deciding which offer to accept?

• If you were the investor, how would you interpret the entrepreneur’s choice?

• In any case, entrepreneur would own 2.5 million shares of common stock


Question 2-6

In a previous round of financing for a resort spa, an investor contributed $2 million in exchange for 1 million shares of common stock with the entrepreneur retaining 2 million shares.

Due to massive delays and cost overruns, the entrepreneur needs another $1 million with which he hopes to complete development.

However the existing agreement includes a ratchet provision for the prior investor. Under the terms of the ratchet, the investor will receive enough new free shares so that his average cost per share is same as that of any new investor



a) Suppose that in the absence of the ratchet provision a new investor would be willing to accept 1.25 million shares in exchange for the $1 million of investment. Compute the post-money valuation

b) Now based on valuation in previous part, giving effect to the ratchet provision, what price per share would the new investor seek and how many shares would the existing investor receive?

c) Suppose the ratchet agreement has a floor that limits the average cost of the existing investor to a minimum of $1 per share. How would the limitation affect the price per share for the new investor and the number of new shares to the new investor?

d) What fraction of the equity would the entrepreneur end up retaining under each of three scenarios?


Question 2-7

Define “term sheet” and “investment agreement”. What are the differences between the two?


Question 2-8

Search the Internet or print media sources to find a prospective

invention that may lead to a marketable product in the future

(Popular Science is a good source, among others,

www.popsci.com).

a) Briefly describe the product.

b) As a potential investor, identify four milestones that you might want to use as bases for staging investments and evaluating progress.

c) Referring to Figure 2-2, identify the stage of development.

d) Based on your reading of the chapter, what types of financing would you select for the product and for which development stage(s) would you employ each financing type? Explain.


Question 2-9

Hacker Inc., a software developer, is considering a financing deal

with an investor. They have agreed on a $2 million investment for 2

million shares. Hacker has developed promising gaming software

to use with popular game consoles. But has been stymied by the

closed architecture of the consoles. If the architecture opens up

and interest in the software takes off, Hacker will need considerably

more money to continue its line of software.

a) Design a ratchet provision, to include in the investment agreement, which will protect the investor against dilution in subsequent funding rounds.

b) Why would the entrepreneur agree to the provision?

c) What are the costs, direct and indirect, of such an anti-dilution provision? Explain.


Question 2-10

Why do you think convertible preferred stock is so common in investment deals between entrepreneurs and venture capital investors? Why not use common stock? Why not use convertible debt?


Question 2-11

When would you organize as an S Corporation instead of a C Corporation?


Question 2-12

As an entrepreneur, when would you seek business angel financing as opposed to venture capital financing?


Question 2-13

Explain the advantages of basing financing on attainment of milestones. What problems might milestones create?


Chapter 2

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