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Introduction to Entrepreneurship, 8e
Donald F. Kuratko
Chapter 8 The Search for Entrepreneurial Ventures
Chapter Objectives 1. 2. 3. 4.
5. 6.
To differentiate between debt and equity as
methods of financing To examine commercial loans and public stock offerings as sources of capital To discuss private placements as an opportunity for equity capital To study the market for venture capital and to review venture capitalists evaluation criteria for new ventures To discuss the importance of evaluating venture capitalists for a proper selection To examine the existing informal risk-capital market (angel capital)
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Figure
Who Is Funding Entrepreneurial Start-Up
Companies? 8.1
Source: Successful Angel Investing, Indiana Venture Center, March 2008.
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Debt Versus Equity
Debt Financing Secured financing of a new venture that involves a payback of the funds plus a fee (interest for the use of the money). Equity Financing
Involves the sale (exchange) of some of the
ownership interest in the venture in return for an unsecured investment in the firm.
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Debt Financing Commercial Banks
Make 1-5 year intermediate-term loans secured by
collateral (receivables, inventories, or other assets).
Questions in securing a loan:
What do you plan to do with the money? How much do you need? When do you need it? How long will you need it? How will you repay the loan?
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Debt Financing (contd)
Advantages
No relinquishment of ownership is required.
Disadvantages
More borrowing allows
for potentially greater return on equity.
Regular (monthly) interest payments are required.
During periods of low
interest rates, the opportunity cost is justified since the cost of borrowing is low.
Continual cash-flow problems can be intensified because of payback responsibility.
Heavy use of debt can
inhibit growth and development.
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Table
Common Debt Sources
8.1
Business Type Financed
Debt Source
Financing Term
Start-Up Firm
Existing Firm
Short Term
Intermediate Term
Long Term
Trade credit
Yes
Yes
Yes
No
No
Commercial banks
Sometimes, but only if strong capital or collateral exists
Yes
Frequently
Sometimes
Seldom
Finance companies
Seldom
Yes
Most frequent
Yes
Seldom
Factors
Seldom
Yes
Most frequent
Seldom
No
Leasing companies
Seldom
Yes
No
Most frequent
Occasionally
Mutual savings banks and savings-and-loan associations
Seldom
Real estate ventures only
No
No
Real estate ventures only
Insurance companies
Rarely
Yes
No
No
Yes
Source: PricewaterhouseCoopers/National Venture Capital Association, MoneyTree Report, 2007.
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Other Debt Financing Sources
Trade Credit Credit given by suppliers who sell goods on account. Accounts Receivable Financing Short-term financing that involves either the pledge of receivables as collateral for a loan or the sale of receivables at a discounted value (factoring). Finance Companies
Asset-based lenders that lend money against assets
such as receivables, inventory, and equipment.
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Other Debt Financing Sources (contd)
Equity Instruments
Give investors a share of the ownership.
Loan with warrants provide the investor with the right to buy stock at a fixed price at some future date. Convertible debentures are unsecured loans that can be converted into stock. Preferred stock is equity that gives investors a preferred place among the creditors in the event the venture is dissolved. Common stock is the most basic form of ownership and is often are sold through public or private offerings.
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Equity Financing Equity Financing Money invested in the venture with no legal obligation for entrepreneurs to repay the principal amount or pay interest on it. Funding sources: public offering and private placement Public Offering Going public refers to a corporations raising capital through the sale of securities on the stock markets. Initial Public Offerings (IPOs): new issues of common stock
regulations for reports and statements required when selling stock to private partiesfriends, employees, customers, relatives, and professionals.
Defines four separate exemptions, which are based
on the amount of money being raised: Rule 504a: placements of less than $500,000 Rule 504: placements up to $1,000,000 Rule 505: placements of up to $5 million Rule 506: placements in excess of $5 million
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Private Placements (contd)
Accredited Purchaser
Regulation D uses the term accredited purchaser.
Included in this category are the following: Institutional investors such as banks, insurance companies, venture capital firms. Any person who buys at least $150,000 of the offered security and whose net worth, including that of his or her spouse, is at least 5 times the purchase price. Any person who, together with his or her spouse, has a net worth in excess of $1 million at the time of purchase.
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Investors Sophisticated Investors Wealthy individuals who invest regularly in new and early- and late-stage ventures and are knowledgeable about the technical and commercial opportunities and risks of the business in which they invest.
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The Venture Capital Market
Venture Capitalists Are valuable and powerful source of equity funding for new ventures that provide:
Capital for start-ups and expansion
Market research and strategy Management-consulting, audits and evaluation Contactscustomers, suppliers, and businesspeople Assistance in negotiating technical agreements Help in establishing management and accounting controls Help in employee recruitment and employee agreements Help in risk management and with insurance programs Counseling and guidance in complying with government regulations
Decrease DecreaseininSmall Small Start-up Start-up Investments Investments
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Emergence Emergenceofof Feeder FeederFunds Funds
More MoreSophisticated Sophisticated Legal LegalEnvironment Environment
817
Investment Agreement Provisions
Choice of securities Preferred stock, common stock, convertible debt, and so forth Control issues Who maintains voting power Evaluation issues and financial covenants Ability to proceed with mergers and acquisitions Remedies for breach of contract Rescission of the contract or monetary damages
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Dispelling Venture Capital Myths
Myth 1:
your
Venture capital firms want to own control of
company and tell you how to run the business.
Myth 2:
Venture capitalists are satisfied with a
reasonable return on investment.
Myth 3:
Venture capitalists are quick to invest.
Myth 4:
Venture capitalists are interested in backing
new
ideas or high-technology inventions
management is a secondary consideration.
Myth 5:
Venture capitalists need only basic summary
information before they make an investment.
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Venture Capitalists and Business Plans
Proposal Proposal Size Size
Financial Financial Projections Projections
Competitive Competitive Advantage Advantage
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Investment Investment Recovery Recovery
Company Company Management Management
820
Factors in Successful Funding of Ventures
Characteristics Characteristicsof of the theEntrepreneurs Entrepreneurs
Characteristi Characteristi cs csof ofthe the Request Request
Characteristics Characteristicsof of the theEnterprise Enterprise 2009 South-Western, a part of
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Figure
8.2 Venture Capitalist System of Evaluating Product/Service and Management Level 4
Status of Product/Service
Fully developed product/service
Established market Satisfied users
4/1
4/2
4/3
4/4
3/1
3/2
3/3
3/4
2/1
2/2
2/3
2/4
1/1
1/2
1/3
1/4
Level 3 Fully developed product/service Few users as of yet Market assumed
Level 2 Riskiest
Operable pilot or prototype
Not yet developed for production Market assumed
Level 1 Product/service idea Not yet operable Market assumed
Level 1 Individual founder/ entrepreneur
Level 2
Level 3
Level 4
Two founders Other personnel not yet identified
Partial management teammembers identified to join company when funding received
Fully staffed, experienced management team
Riskiest
Status of Management Source: Stanley Rich and David Gumpert, Business Plans That Win $$$ (New York: Harper & Row, 1985), 169. Reprinted by permission of Sterling Lord Literistic, Inc. Copyright 1985 by Stanley Rich and David Gumpert.
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Table
Returns on Investment Typically Sought by
Venture Capitalists 8.3
Stage Of Business
Expected Annual Return
on Investment
Expected Increase on Initial Investment
Start-up business (idea stage)
60% +
1015 investment
First-stage financing (new business)
40%60%
612 investment
Second-stage financing (development stage)
30%50%
48 investment
Third-stage financing (expansion stage)
25%40%
36 investment
Turnaround situation
50% +
815 investment
Source: W. Keith Schilit, How to Obtain Venture Capital, Business
Horizons (May/June 1987): 78. Copyright 1987 by the Foundation for the School of Business at Indiana University. Reprinted by permission.
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Table
8.4
Factors in Venture Capitalists Evaluation Process
Attribute
Level
Definition
Timing of entry
Pioneer Late follower
Enters a new industry first
Enters an industry late in the industrys stage of development
Key success factor stability
High
Requirements necessary for success will not change radically during
industry development
Low
Requirements necessary for success will change radically during
industry development
High
Considerable resources and skills available to overcome market
ignorance through education
Low
Few resources or skills available to overcome market ignorance
through education
Long
An extended period of monopoly for the first entrant prior to
competitors entering the industry
Short
A minimal period of monopoly for the first entrant prior to competitors
entering this industry
Educational capability
Lead time
Source: Dean A. Shepherd, Venture Capitalists Introspection: A Comparison of In Use and Espoused Decision Policies, Journal of Small Business Management (April 1999): 7687; and Venture Capitalists Assessment of New Venture Survival, Management Science (May 1999): 621632. Reprinted by permission. Copyright 1999, the Institute for Operation Research and the Management Sciences (INFORMS), 7240 Parkway Drive, Suite 310, Hanover MD 21076 USA.
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Table
Factors in Venture Capitalists Evaluation Process
8.4
(contd) Attribute
Level
Definition
Competitive rivalry
High
Intense competition among industry members during industry
development
Low
Little competition among industry members during industry
development
High
Considerable imitation of the mechanisms used by other firms to
enter this, or any other, industryfor example, a franchisee
Low
Minimal imitation of the mechanisms used by other firms to enter
this, or any other, industryfor example, introducing a new product
Broad
A firm that spreads its resources across a wide spectrum of the
marketfor example, many segments of the market
Narrow
A firm that concentrates on intensively exploiting a small segment
of the marketfor example, targeting a niche
High
Venturer has considerable experience and knowledge with the
industry being entered or a related industry
Low
Venturer has minimal experience and knowledge with the industry
being entered or related industry
Entry wedge mimicry
Scope
Industry-related competence
Source: Dean A. Shepherd, Venture Capitalists Introspection: A Comparison of In Use and Espoused Decision Policies, Journal of Small Business Management (April 1999): 7687; and Venture Capitalists Assessment of New Venture Survival, Management Science (May 1999): 621632. Reprinted by permission. Copyright 1999, the Institute for Operation Research and the Management Sciences (INFORMS), 7240 Parkway Drive, Suite 310, Hanover MD 21076 USA.
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Criteria for Evaluating
New-Venture Proposals Major Categories of Venture Capitalist
Screening Criteria:
Entrepreneurs personality
Entrepreneurs experience
Product or service characteristics
Market characteristics
Financial considerations
Nature of the venture team
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Table
Ten Criteria Most Frequently Rated Essential in
New-Venture 8.5
Criterion
Percentage
Capable of sustained intense effort
64
Thoroughly familiar with market
62
At least ten times return in five to ten
years
50
Demonstrated leadership in past
50
Evaluates and reacts to risk well
48
Investment can be made liquid
44
Significant market growth
43
Track record relevant to venture
37
Articulates venture well
31
Proprietary protection
29
Source: Reprinted by permission of the publisher from Criteria Used by Venture Capitalists to Evaluate New Venture Proposals, by Ian C. MacMillan, Robin Siegel, and P. N. Subba Narasimha, Journal of Business Venturing (winter 1985): 123. Copyright 1985 by Elsevier Science Publishing Co., Inc.
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Table
8.6
Venture Capitalists Screening Criteria
Venture Capital Firm Requirements
Financial Information on the Proposed Business
Must fit within lending guidelines of venture firm for
stage and size of investment
Financial projections should be realistic
Proposed business must be within geographic area
of interest
Must have full information
Proposal Characteristics
Prefer proposals recommended by someone known
to venture capitalist
Should be a reasonable length, be easy to scan,
have an executive summary, and be professionally presented
Proposed industry must be kind of industry invested
in by venture firm
Proposal must contain a balanced presentation
Nature of the Proposed Business
Use graphics and large print to emphasize key
points
Projected growth should be relatively large within
five years of investment
Entrepreneur/Team Characteristics
Economic Environment of Proposed Industry
Industry must be capable of long-term growth and profitability Economic environment should be favorable to a new entrant Proposed Business Strategy
Must have relevant experience
Should have a balanced management team in place Management must be willing to work with venture partners Entrepreneur who has successfully started previous business given special consideration
Selection of distribution channel(s) must be feasible
Product must demonstrate defendable competitive position
Source: John Hall and Charles W. Hofer, Venture Capitalists Decision Criteria in New Venture Evaluation, Journal of Business Venturing (January 1993): 37.
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Venture Capitalist Evaluation Process
Stage 1: Initial Screening
This is a quick review of the basic venture to see if it meets the
venture capitalists particular interests.
Stage 2: Evaluation of the Business Plan
This is where a detailed reading of the plan is done in order to
evaluate the factors mentioned earlier.
Stage 3: Oral Presentation
The entrepreneur verbally presents the plan to the venture
capitalist.
Stage 4: Final Evaluation
After analyzing the plan and visiting with suppliers, customers,
consultants, and others, the venture capitalist makes a final decision.
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8.7 Essential Elements for a Successful Presentation to a Venture Capitalist
TEAM MUST: Be able to adapt Know the competition Be able to manage rapid growth Be able to manage an industry leader Have relevant background and industry experience Show financial commitment to firm, not just sweat equity Be strong with a proven track record in the industry unless the company is a start-up or seed investment PRODUCT MUST: Be real and work Be unique Be proprietary Meet a well-defined need in the marketplace Demonstrate potential for product expansion, to avoid being a one-product company Emphasize usability Solve a problem or improve a process significantly Be for mass production with potential for cost reduction
MARKET MUST: Have current customers and the potential for many more Grow rapidly (25% to 45% per year) Have a potential market size in excess of $250 million Show where and how you are competing in the marketplace Have potential to become a market leader Outline any barriers to entry
BUSINESS PLAN MUST:
Tell the full story, not just one chapter Promote a company, not just a product Be compelling Show the potential for rapid growth and knowledge of your industry, especially competition and market vision Include milestones for measuring performance Show how you plan to beat or exceed those milestones Address all of the key areas Detail projections and assumptions; be realistic Serve as a sales document Include a strong and well-written executive summary Show excitement and color Show superior rate of return (a minimum of 30% to 40% per year) with a clear exit strategy
Source: Andrew J. Sherman, Raising Capital, 2nd ed. AMACOM Books, 2005; p.175.
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Informal Risk Capital
Business Angel Financing Wealthy individuals in the United States are looking for investment opportunities. They are referred to as business angels or informal risk capitalists.
Types of Angel Investors
Corporate angels Entrepreneurial angels Enthusiast angles Micromanagement angels Professional angels
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Table
Main Differences Between Business Angels and
Venture Capitalists 8.8
Main Differences
Business Angels
Venture Capitalists
Personal
Entrepreneurs
Investors
Firms funded
Small, early-stage
Large, mature
Due diligence done
Minimal
Extensive
Location of investment
Of concern
Not important
Contract used
Simple
Comprehensive
Monitoring after investment
Active, hands-on
Strategic
Exiting the firm
Of lesser concern
Highly important
Rate of return
Of lesser concern
Highly important
Source: Mark Van Osnabrugge and Robert J. Robinson, Angel Investing (San Francisco: Jossey-Bass, 2000), 111. This material is used by permission of John Wiley & Sons, Inc.
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Table
8.9
Angel Stats
Typical deal size
$250,000
Typical recipient
Start-up firms
Cash-out time frame
5 to 7 years
Expected return
35 to 50% a year
Ownership stake
Less than 50%
Source: William E. Wetzel, University of New Hampshires Center for Venture Research, and the Indiana Venture Center, 2008.
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Figure
8.3
The Pros and Cons of Business Angel Investments
Source: Mark Van Osnabrugge and Robert J. Robinson, Angel Investing (San Francisco: Jossey-Bass, 2000), 64. This material is used by permission of John Wiley & Sons, Inc.
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Key Terms and Concepts
accounts receivable
financing accredited purchaser angel capital business angel debt financing equity financing factoring finance companies
