Chapter 12 Informal Risk Capital, Venture Capital, and Going Public

McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Hisrich Peters Shepherd

Financing the Business

Criteria for evaluating appropriateness of financing alternatives:
Amount and timing of funds required. Projected company sales and growth.

Three types of funding:

Early stage financing. Development financing. Acquisition financing.

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Table 12.1 - Stages of Business Development Funding

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Financing the Business

(cont.)

Risk capital markets provide debt and equity to no secure financing situations. Types of risk capital markets:
Informal risk capital market-market consisting mainly of individuals .e.g. Business Angels Venture-capital market- consist of formal companies. Public-equity market-risk capital consisting of publicly owner stocks of companies.

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Financing the Business

(cont.)

All three can be a source of funds for stageone financing.

However, public-equity market is available only for high-potential ventures.

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Informal Risk Capital

It consists of a virtually invisible group of wealthy investors (business angels). Investments range between $10,000 to $500,000. Provides funding, especially in start-up (first-stage) financing. Contains the largest pool of risk capital in the United States.

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Table 12.2 - Characteristics of Informal Investors

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Table 12.2 - Characteristics of Informal Investors (cont.)

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Venture Capital
Nature of Venture Capital
A long-term investment discipline, usually occurring over a five-year period. The equity pool is formed from the resources of wealthy limited partners. Found in:
Creation of early-stage companies. Expansion and revitalization of businesses. Financing of leveraged buyouts of existing divisions of major corporations or privately owned businesses.

Venture capitalist takes an equity participation in each of the investments.

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Figure 12.1 - Types of VentureCapital Firms

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Figure 12.3 - Percentage of Venture Dollars Raised by Stage in 2008

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Venture Capital

(cont.)

Venture-Capital Process
Objective of a venture-capital firm - Generation of long-term capital appreciation through debt and equity investments.

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Venture Capital

(cont.)

The Venture Capitalist expects a company to satisfy three general criteria: 1. The company must have a strong management team who individually must have solid experience and backgrounds Have a strong commitment to the capabilities. Capabilities in a specific area of expertise. The ability to meet challenges.
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Venture Capital

(cont.)

The flexibility to scramble whenever necessary. Each spouse of each management team member must also be committed to the new venture. 2. Is the product and/or market opportunity unique? Will the venture have a differential advantage in a growing market? Securing a unique market niche is essential.

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Venture Capital

(cont.)

This niche must be spelled out and is even stronger when it is protected by a patent or trade secret. 3. The business must have significant capital appreciation. The venture capitalist generally expects a 40 to 60 percent return on investment in most situations. This is both art (intuition) and science. (business plan)
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Figure 12.4 - Venture-Capital Financing: Risk and Return Criteria

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Venture Capital

(cont.)

Venture-capital process can be broken down into four primary stages:

Stage I: Preliminary screening Initial evaluation of the deal. The screening is the initial evaluation of a deal. Begins with the receipt of the business plan. The plan must have clear cut mission, in depth industry study and a strong pro forma income statement and balance sheets. The Executive Summary is critical to the Venture Capitalist because it will tell if this fits the firms meet the long term policy and short term need to balance 12-17 a portfolio.

Venture Capital

(cont.)

Stage II: Agreement on principal terms Between entrepreneur and venture capitalist. Stage III: Due diligence This is the longest stage and can last from 1-3 months. The upside and risk potential are assessed. Complete background of all management members is completed. Thorough evaluation of the markets. Stage IV: Final approval - Document showing the final terms of the deal.
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Venture Capital

(cont.)

Locating Venture Capitalists

Venture capitalists tend to specialize either geographically by industry or by size and type of investment. Entrepreneur should approach only those that may have an interest in the investment opportunity. Most venture capital firms belong to the National Venture Capital Association.

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Valuing Your Company

The problem confronting the entrepreneur in obtaining any investment is determining value of the company Factors in Valuation 1. The nature and history of the business. Provides strength and diversity from the outset. 2. Examination of the financial data of the venture compared with that of other companies in the industry. Included are the outlook of the economy and the outlook of that particular industry.

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Valuing Your Company

3. The book value is the owners equity which is the acquisition cost (less depreciation) minus liabilities. This is built over time. 4. The future earning capacity of the company is the most important factor in valuation. 5. The dividend paying capacity of the venture. 6. The assessment of goodwill and other tangibles of the venture. 7. Assessing any previous sale of stock. 8. The market prices of the stocks of companies engaged in similar lines of business.
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Valuing Your Company

Ratio Analysis

(cont.)

Serves as a measure of financial strengths and weaknesses of the venture but should be used with caution. It is typically used on actual financial results. Provides a sense of where problems exist in the pro forma statements.

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Valuing Your Company

(cont.)

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Valuing Your Company

(cont.)

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Valuing Your Company

(cont.)

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Valuing Your Company

(cont.)

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Valuing Your Company

(cont.)

General Valuation Approaches

1. Methods to determine the worth of the company. 2. Present value of future cash flow is based on future sales and profits. 3. Replacement Value is the cost of replacing all assets of the company. 4. Book value is the indicated worth of the assets of the company. 5. Earnings Approach determines value by looking at present and future earnings.
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Valuing Your Company

(cont.)

6. Factor approach uses the major aspects of the company to determine its worth. 7. Liquidation value is the worth of the company based selling everything today.

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Going Public
Selling some part of the company by registering with the Securities and Exchange Commission (SEC).
Resulting capital infusion provides the company with:
Financial resources. A relatively liquid investment vehicle.

Company consequently gains:

Greater access to capital markets in the future. A more objective picture of the publics perception of the value of the business.
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Table 12.8 - Advantages and Disadvantages of Going Public

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Timing of Going Public and Underwriter Selection

Timing
Is the company large enough? What is the amount of the companys earnings, and how strong is its financial performance? Are the market conditions favorable for an initial public offering? How urgently is the money needed? What are the needs and desires of the present owners?

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Timing of Going Public and Underwriter Selection (cont.)

Underwriter Selection
Managing underwriter - Lead financial firm in selling stock to the public. Underwriting syndicate - A group of firms involved in selling stock to the public. Factors to consider in selection:
Reputation. Distribution capability. Advisory services. Experience. Cost.
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Registration Statement and Timetable

All hands meeting - Preparing a timetable for the registration process. First public offering requires six to eight weeks. The SEC takes six to 12 weeks to declare the registration effective.

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Registration Statement and Timetable (cont.)

Reasons for delays:
Heavy periods of market activity. Peak seasons. Attorneys unfamiliarity with federal or state regulations. Issues arising over requirements of the SEC. When the managing underwriter is inexperienced.

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Registration Statement and Timetable (cont.)

SEC attempts to ensure that the document makes a full and fair disclosure of the material reported. Registration statement consists of:
Prospectus. Registration statement.

Most initial public offerings will use a Form S-1 registration statement.

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Registration Statement and Timetable (cont.)

Prospectus
Cover page Prospectus summary Description of the company Risk factors Use of proceeds Dividend policy Capitalization Dilution

Selected financial data Business, management, and owners Type of stock Underwriter information Actual financial statements.
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Registration Statement and Timetable (cont.)

Procedure
Preliminary prospectus (red herring) can be distributed to the underwriting group. Deficiencies are communicated through telephone or a comment letter. Pricing amendment - Additional information on price and distribution is submitted to the SEC to develop the final prospectus. Waiting period - Time between the initial filing and its effective date is usually around 2 to 10 months.
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Legal Issues and Blue-Sky Qualifications

Legal Issues
Quiet period 90-day period in going public when no new company information can be released.

Blue-Sky Qualifications
Blue-sky laws - Laws of each state regulating public sale of stock. May cause additional delays and costs to the company. Many states allow their state securities administrators to prevent an offering from being sold in their state.

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After Going Public

Aftermarket Support
Actions of underwriters to help support the price of stock following the public offering.

Relationship with the Financial Community

Has a significant effect on the market interest and the price of the companys stock.

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After Going Public

(cont.)

Reporting Requirements
The company must file:
Annual reports on Form 10-K. Quarterly reports on Form 10-Q. Specific transaction or event reports on Form 8-K.

Company must follow proxy solicitation requirements.

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