Assignment 7

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Chapter16-FundingStartupandGrowth.pptx

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CHAPTER 16 Funding Startup and Growth

CHAPTER OBJECTIVES

Understand the importance of a financial plan.

Explain methods of funding with equity or debt.

Explore non-dilutive funding sources.

Describe the valuation process for pre-revenue companies.

Understand the I P O process.

FUNDING A STARTUP (slide 1 of 2)

“How can I fund my new business?”

Probably no question is more on the minds of first-time entrepreneurs with new venture ideas.

Budding entrepreneurs suppose that if they have enough money they can make any business concept a success.

Unfortunately, that reasoning is faulty.

Inexperienced entrepreneurs also typically identify venture capital as their first and primary source of funding in the earliest stages of startup.

This mistake springs from a misconception about the needs of startup ventures, the requirements of venture capitalists (V Cs), and the nature of financial markets.

Research has found that of the top funding sources that entrepreneurs tap, the primary ones are personal savings, credit, and friends and family money.

FIGURE 16.1 Funding Sources for Entrepreneurs

FUNDING A STARTUP (slide 2 of 2)

Before beginning a hunt for capital, ask yourself the following questions:

Can you take time away from the business to spend on fund raising?

Is your business on a firm footing through its own resources?

What have you accomplished on your own? What have you invested in the business in terms of money, time, and resources?

Do you have a validated business model—one that you have tested in the market with real customers?

Do you have a financial plan for growth? Do you understand the milestones you will need to hit and how much funding will be required to get you there?

Have you put together a compelling story that investors will buy?

Securing funding for a new venture is a time-consuming and difficult process made more challenging by information asymmetry; that is, entrepreneurs have more information about themselves and their ventures than do the people from whom they seek resources.

16.1 THE FINANCIAL PLAN

Knowing whom to tap for startup capital is only half the battle.

The other half is having a strategic plan for funding the startup and growth of your company with the right kind of money from the right sources at the right milestones.

Planning carefully will avoid the need to seek financing too often, which can be costly both in time and money.

16.1a The Cost and Process of Raising Capital

Raising capital of any type is a time-consuming and costly process.

Raising capital will take at least twice as long as expected before the money is actually in your company’s bank account.

The search for capital will take you away from the activities of your business just when you’re needed most.

Therefore, it is helpful to use financial advisors who have experience in raising money, and it is vital to have a good management team in place to ensure the business continues to operate smoothly.

Your chosen funding source may not materialize, even after months of courting and negotiations.

It’s essential, therefore, to continue to look for additional investors in case the original investor backs out.

16.1b It Takes Money to Make Money

You need to be prepared to pay any costs incurred before you receive investor or bank money.

Investor money can rarely be applied to debts already incurred as investors like to see their money go forward to fund growth.

Keep your business plan and financial statements up to date.

You will need to prepare a prospectus, which is an offering document that describes the investment and its risks.

You will have the expenses of marketing the offering.

In addition to the upfront costs of seeking growth capital, you will incur costs after you acquire the capital, including:

Investment banking fees.

Legal fees.

Marketing costs.

Brokerage fees.

Various other fees charged by state and federal authorities.

16.1c Growth Stage Identification (slide 1 of 3)

Before you begin to plan for funding, it’s important to identify the stages of growth that your business will experience.

Every business is different, but in general, each will reach certain milestones that suggest the time has come to grow to the next level, and that will require an infusion of capital.

There are different types of money for the different stages of your venture.

In general, each milestone your business achieves creates more value for the company and enables you to seek greater amounts of capital in the form of equity and debt.

FIGURE 16.2 Funding Stages and Risk

16.1c Growth Stage Identification (slide 2 of 3)

Stage One: Business Model Development and Testing.

Here you will likely require seed funding, an initial investment typically by the founders and other sources of “friendly money.”

Stage Two: Transition.

Because your business may not have the internal cash flows required to fund the growth that customer demand requires, you may require outside capital from a private investor, early-stage venture capitalist (V C), or debt source.

You must also plan for some type of liquidity event, such as an initial public offering (I P O) or acquisition, so that investors can cash out of the business and receive a return on their investment at some defined point in the future.

16.1c Growth Stage Identification (slide 3 of 3)

Stage Three: Rapid Growth.

This stage calls for larger sums of capital and perhaps a different type of money, termed mezzanine financing or bridge financing, if you decide to do an I P O.

For some businesses, such as lifestyle businesses, rapid growth may never be part of their evolution; instead, they may enjoy slow, steady, organic growth for many years.

Stage Four: Maturity.

If your business thrives over the long term, it will probably reach a relatively mature phase in which it ideally maintains a stable revenue stream with a loyal customer base.

In today’s dynamic environment, however, stability is rarely an enduring state.

To continue to be profitable, a mature business must disrupt its equilibrium with new products and services and new markets so that it can remain competitive.

16.1d The Unique Funding Issues of High-Tech Ventures (slide 1 of 2)

In technology ventures, early-stage money often comes from government grants or foundations.

It is a rare venture capital firm that will invest during the earliest product development phase of a high-tech venture because the risk is too high.

The time from idea generation through product development, market testing, and product launch is often referred to as the valley of death, because the failure rate is high due to the lack of identifiable markets, poor product design, and lack of funding.

The valley of death is similar to the “chasm” referred to by Geoffrey Moore where a new technology languishes because no practical or useful applications have been found.

16.1d The Unique Funding Issues of High-Tech Ventures (slide 2 of 2)

Once the technology approaches market readiness—in other words, it has successfully traversed the valley of death—it moves into a phase known as the “early adopter” stage where technically oriented users, who regularly purchase leading-edge technology, begin to use it.

At this point, the company will require marketing dollars to create awareness on the part of potential customers and enough demand to capture sufficient niches in the market to develop critical mass.

A critical mass of users in a variety of niches can shift the product into what Moore refers to as the “tornado,” a period of mass adoption that enables the technology to potentially become the standard in the industry.

16.1e The Unique Funding Issues for Social Ventures

Social ventures, those that are structured with a focus on providing a benefit to society, are rarely attractive to traditional types of investors because they don’t typically produce a significant return on investment.

Moreover, in most cases, they’re structured as nonprofits so legally they can’t offer the true ownership stakes that investors require.

As an increasing number of entrepreneurs choose to start social ventures, more creative ways to fund ventures are emerging to meet the need.

With impact investing, major insurance companies and pension funds make equity investments and cash deposits into community banks that then lend to social ventures to help them grow.

Social investment funds pool various sources of funding (donations, foundations, financial institutions, and corporations) and then lend to social ventures for lower-than-market rates of return but significant social impact.

16.2 FUNDING STARTUPS THROUGH BOOTSTRAPPING (slide 1 of 3)

The term bootstrapping refers to techniques for getting by on as few resources as possible and using other people’s resources whenever feasible.

More often than not, bootstrapping is a model for starting a business without money—or at least any money beyond that provided by the entrepreneur’s personal resources.

Some of the most common tried-and-true methods of bootstrapping include:

Getting traction as quickly as possible.

Hiring as few employees as possible.

Leasing or sharing everything.

Using other people’s money.

16.2 FUNDING STARTUPS THROUGH BOOTSTRAPPING (slide 2 of 3)

Get Traction as Quickly as Possible

Getting traction means launching the business in the quickest manner possible to start receiving real feedback from customers and to test the business model.

Potential investors will be much more likely to consider an investment if they can see your business in operation and attracting customers.

Hire as Few Employees as Possible

Typically, the greatest single expense a business has its payroll (including taxes and benefits).

Subcontracting work to other firms domestically or offshore, using temporary help, and hiring independent contractors can keep the number of employees and their associated costs down.

16.2 FUNDING STARTUPS THROUGH BOOTSTRAPPING (slide 3 of 3)

Lease or Share Everything

By leasing rather than purchasing major equipment and facilities, you can avoid typing up precious capital.

With a lease, there usually is no down payment, and the payments are spread over time.

Sharing space with established companies not only saves money on overhead but also gives a fledgling venture the aura of a successful, established company.

Use Other People’s Money

Establishing a good relationship with major suppliers can result in more favorable terms.

Where possible, it’s preferable to sell wholesale rather than retail.

Wholesalers have already set up the consumer and industrial channels to expand a company’s markets.

TABLE 16.1 Some Great Bootstrapping Techniques

Use student interns, who will often work for free just to get the experience.

Barter for media time.

Seek ways to motivate employees without money.

Manage receivables weekly.

Leverage purchasing discounts.

Put resources into things that make money rather than use money.

Work from home as long as possible.

Seek referrals from loyal customers.

Use independent contractors whenever possible.

Seek vendor credit.

Get customers involved in the business.

Keep operating expenses as low as possible.

Use email, Twitter, and social networks; they’re essentially free.

Network to find complementary resources that can be shared or leveraged.

16.3 FUNDING WITH EQUITY

When someone invests money in a venture, it is normally done to gain an ownership share in the business and to see that share appreciate.

This ownership share is term equity.

It is distinguished from debt in that equity investors put their capital at risk.

Typically, there is no guaranteed return and no absolute protection against loss.

Sources of equity financing include:

Informal capital.

Examples: Personal resources and “angels” or private investors.

Formal sources.

Example: Venture capital.

16.3a Friends and Family

Friendly money is often the only money available at startup.

It is important to treat the deal as a business deal and put everything in writing so there is no question about who gets what and what happens if there’s a disagreement or the business fails.

Many investors suggest structuring a convertible debt deal for friends and family because this tactic avoids having to place a valuation on the company that is likely to be wrong.

If you overvalue the company, friends and family will see their shares diluted in the next round of financing.

16.3b Private Investors—Angels (slide 1 of 3)

The most popular follow-up source of capital for new ventures is private investors, typically people you know or have met through business acquaintances.

These investors, who are called angels, are part of the informal risk-capital market, the largest pool of risk capital in the United States.

They can’t be found in a phone book, and they don’t advertise.

Angels have several definable characteristics:

Angels normally invest between $25,000 and $100,000 individually, or join forces to collectively invest between $250,000 and $1 million for about 20 to 40 percent of the equity.

16.3b Private Investors—Angels (slide 2 of 3)

Angels seek a return of approximately 20 to 30 times the original amount of the investment over a period of about five years.

Angels usually focus on first-stage financing—that is, startup funding or funding of firms younger than five years.

Angels are generally well educated, are often entrepreneurs themselves, and tend to invest within a relatively short distance from home because they like to be actively involved in their investments.

Angels tend to prefer technology ventures, manufacturing, energy and resources, and service businesses.

Retail ventures are less desirable because of their inordinately high rate of failure.

Angels typically look to reap the rewards of their investment within three to seven years.

16.3b Private Investors—Angels (slide 3 of 3)

Angels find their deals principally through referrals from business associates and tend to make investment decisions more quickly than other sources of capital.

Angels’ requirements in terms of documentation, business plan, and due diligence may be lower than venture capitalists, but they are still onerous.

In general, angels are an excellent source of seed or startup capital.

The secret to finding these elusive investors is networking—getting involved in the business community and speaking with those who regularly come into contact with sources of private capital: lawyers, bankers, accountants, and other businesspeople.

16.3c Venture Capital (slide 1 of 7)

Private venture capital companies have been the bedrock of many high-growth ventures, particularly in technology industries.

Venture capital is, quite simply, a pool of money managed by professionals.

These professionals usually assume the role of general partner and are paid a management fee plus a percentage of the gain from any investments.

The venture capital (V C) firm takes an equity position through ownership of stock in the company, normally requires a seat on the board of directors, and often brings their professional management skills to the new venture in an advisory capacity.

The ability to secure classic venture capital funding depends not only on what you bring to the table but also on the climate in the venture capital industry—in particular, the availability of liquidity events where investors can reap big returns on their investments.

16.3c Venture Capital (slide 2 of 7)

The Sequence of Events in Securing Venture Capital

The first priority of V Cs is to quickly eliminate any business plan that doesn’t meet their most important criteria.

They do this by looking for flaws in the business plan that would suggest that the venture is not a good investment opportunity.

V Cs are fundamentally risk averse, so it is your job to reduce risk in the three key areas where V Cs typically find it:

Management risk.

Technology risk.

Business model risk.

16.3c Venture Capital (slide 3 of 7)

The Sequence of Events in Securing Venture Capital (continued)

Three stages during which entrepreneurs receive funding:

1. Identification and validation of the first customer and the business model.

V Cs rarely invest at this stage even though the returns generally will be higher because the probability of not achieving those returns is also at its highest.

2. Early growth.

V Cs will enter at this stage if the potential to move into rapid growth is imminent.

3. Rapid growth.

This is where most V Cs invest because this stage is more likely to bring them to the liquidity event they need in three to five years to make the investment worthwhile.

16.3c Venture Capital (slide 4 of 7)

The Sequence of Events in Securing Venture Capital (continued)

The process of venture funding can vary from firm to firm, but, in general, it proceeds as follows:

The V C may ask for a copy of the executive summary for your business plan or a pitch deck.

If it can’t be immediately determined that your team’s qualifications are outstanding, the product concept innovative, and the projections for growth realistic, the V Cs will not bother to read a business plan or talk with you.

If they like what they see in the executive summary or deck, they will probably request a meeting to determine whether your management team can deliver what they project and whether the team seems to be coachable.

16.3c Venture Capital (slide 5 of 7)

The Sequence of Events in Securing Venture Capital (continued)

During the first meeting, the initial terms of an agreement may be discussed in a general sense, but it will probably take several meetings before an actual term sheet is spelled out and delivered.

The term sheet is essentially a letter of intent and it spells out the terms that the V C is prepared to accept.

If the meeting goes well, the next step is due diligence—that is, the V C firm will have its own team of experts check out your team and the business thoroughly.

If after exhaustive due diligence, the V Cs are still sold on the business, they will draw up the term sheet, which signals the start of a negotiation.

16.3c Venture Capital (slide 6 of 7)

The Sequence of Events in Securing Venture Capital (continued)

You should not expect to receive funding quickly, however.

The money is typically released in stages linked to agreed-upon milestones.

Also, the venture capital firm will continue to monitor the progress of your venture and probably will want a seat or several seats on the board of directors, depending on its equity stake in the company, to ensure that it has a say in the direction you take.

Capital Structure

Any investment deal consists of four components:

The amount of money to be invested.

The timing and use of the investment moneys.

The return on investment to investors.

The level of risk involved.

16.3c Venture Capital (slide 7 of 7)

Capital Structure (continued)

V Cs often want both equity and debt—equity because it gives them an ownership interest in the business, and debt because they will be repaid more quickly.

There are several provisions that venture capitalists often request to protect their investment, but two are particularly onerous.

The anti dilution provision.

This ensures that subsequent issues of stock at a lower price will not decrease the economic value of the V C’s investment.

The forfeiture provision.

This means that if your company does not achieve its projected performance goals, the founders may be required to give up some of their stock to the V C as a penalty.

16.4 FINANCING WITH DEBT

When entrepreneurs choose a debt instrument to finance a portion of startup expenses, they typically provide a business or personal asset as collateral in exchange for a loan bearing a market rate of interest.

The asset could be equipment, inventory, real estate, or the entrepreneur’s house or car.

Although it is best to avoid pledging personal assets as collateral for a loan, it’s sometimes unavoidable, because banks generally require first-time entrepreneurs to guarantee loans personally.

16.4a Commercial Banks

Banks are not normally a readily available source of either working capital or seed capital to fund a startup venture.

Because they are highly regulated, their loan portfolios are scrutinized carefully, so they generally do not make loans that have any significant degree of risk.

Generally, banks make loans on the basis of what are termed the five Cs:

Character.

Capacity.

Capital.

Collateral.

Condition.

In the case of entrepreneurs, character and capacity become the leading consideration, because the new business’s performance estimates are based purely on forecasts.

16.4b Commercial Finance Companies

Often called “hard asset” lenders, commercial finance companies:

Are not as heavily regulated as banks.

Base their decisions on the quality of the assets of the business.

Charge more than banks—as much as 5 percent or more over prime.

Factoring is a particular type of receivable financing wherein the lender, called the factor, takes ownership of a receivable at a discount and then collects against it.

Factoring has become a popular form of cash management in smaller companies that sell to big companies.

16.4c Small Business Administration Loan

With an Small Business Administration (S B A)-guaranteed loan, you can apply for a loan of up to $5.5 million from your bank, and the S B A guarantees that it will repay up to 90 percent of the loan to the commercial lender should the business default.

This guarantee increases the borrower’s chances of getting a loan.

To qualify:

Your business must be officially registered.

You must do business in the United States.

You must have equity in the business.

You need to exhaust all other lending sources before applying to the S B A.

16.5 OTHER NON-DILUTIVE FUNDING SOURCES

Entrepreneurs who need funding but don’t want to dilute their ownership in their company choose debt if it’s available and other sources where the return is not based on ownership.

Some examples are:

Crowdfunding.

Strategic alliances.

Grants.

State-funded incentives.

16.5a Crowdfunding (slide 1 of 2)

Crowdfunding is defined as “a collective effort by consumers who network and pool their money together, usually via the Internet, in order to invest in and support efforts initiated by other people or organizations.”

Budding entrepreneurs and inventors use sites such as Kick starter and Indie go go to pitch a project to the general public, seeking “donations” to reach a targeted level of funding.

In return, the “backers” receive discounts, free services, an early version of the product once the goal has been met, and the finished product when it is ready to ship.

In this way, the process not only raises money for product development, but it’s a way to validate whether the problem you are solving is real enough that customers will pay for a solution.

16.5a Crowdfunding (slide 2 of 2)

There are limitations to the use of crowdfunding—principally, the cap on the amount of money you can raise.

In the United States, the maximum amount is $1 million as specified by the JOBS Act of 2012.

Some of the important things to remember when you consider doing a crowdfunding campaign are the following:

Set a realistic goal for the amount of money you need.

Have a plan in place for manufacturing before you start the campaign.

Keep the timeframe for the campaign short to avoid attracting more backers than you can serve.

Have a real business in place before you market your product.

16.5b Strategic Alliances

A partnership with another business—whether formal or informal—is a strategic alliance.

Through strategic alliances, you can structure deals with suppliers, manufacturers, distributors, or customers that will help reduce expenditures for marketing, raw materials, production, or research and development (R & D).

16.5c Grants (slide 1 of 2)

The Small Business Innovation Development Act of 19 82 requires that all federal agencies with research and development budgets in excess of $100 million give a portion of their budgets to technology-based small businesses in the form of Small Business Innovative Research (S B I R) grants.

Grants have three phases.

1. Phase 1.

Provides up to $150,000 for six months for an initial feasibility study to determine the scientific and technical merit of your proposed idea.

2. Phase 2.

Provides up to an additional $1 million for two years for the firm to develop a well-defined product or process.

16.5c Grants (slide 2 of 2)

3. Phase 3.

Requires you to access private sector funds to commercialize the new technology but may also include government contracts for products, processes, or services that might be used by the U.S. government.

To qualify for an S B I R grant, your company must:

Employ fewer than 500 people.

Be at least 51 percent independently owned by a U.S. citizen.

Be technology-based.

Be organized for profit.

Not be dominant in its field.

If you receive a grant, you must perform two-thirds of the Phase 1 effort and one-half of the Phase 2 effort.

16.5 VALUING A PRE-REVENUE OR VERY EARLY-STAGE COMPANY (slide 1 of 4)

A company’s valuation is the means by which investors calculate the return on their investment.

You should not attempt to place a value on your company when pitching to investors for the following reasons:

You will always overvalue the business because you have an emotional attachment to it.

Your perspective on the business is likely very different from the investors who take into consideration a variety of factors that you probably do not.

16.5 VALUING A PRE-REVENUE OR VERY EARLY-STAGE COMPANY (slide 2 of 4)

Important terminology:

Post-money valuation.

The amount being invested divided by the investor’s ownership percentage.

Pre-money valuation.

The value of your company prior to the investment.

Fully diluted shares.

The total number of shares outstanding after accounting for all possible conversions that could be exercised in the future.

Investors’ initial percentage of ownership.

The percentage of fully diluted shares that investors own at the time of investment.

Liquidation preferences.

The distribution of preferred and common stock after company obligations have been satisfied.

FIGURE 16.3 Summary of Factors That Enter into the Valuation of Pre-Revenue Companies

16.5 VALUING A PRE-REVENUE OR VERY EARLY-STAGE COMPANY (slide 3 of 4)

Calculating value is fundamentally challenging because value is a subjective term with many meanings.

At least six different definitions of value are in common use:

1. Fair market value.

The place at which a willing seller would sell and a willing buyer would buy in an arm’s-length transaction.

2. Intrinsic value.

The perceived value arrived at by interpreting balance sheet and income statements through the use of ratios, discounting cash flow projections, and calculating liquidated asset value.

16.5 VALUING A PRE-REVENUE OR VERY EARLY-STAGE COMPANY (slide 4 of 4)

3. Investment value.

The worth of the business to an investor based on his or her individual requirements in terms of risk, return, tax benefits, and so forth.

4. Going-concern value.

The current financial status of the business as measured by financial statements, debt load, and economic environmental factors that may affect its long-term continuation.

5. Liquidation value.

The amount that could be recovered by selling off all the company’s assets.

6. Book value.

An accounting measure of value that reflects the difference between total assets and total liabilities.

16.6a Two Venture Capital Methods (slide 1 of 2)

A simple version of the venture capital method involves estimating the terminal value (T V), the expected investor return in the harvest year, the post-money valuation, and the pre-money valuation.

The formulas used in this method are:

EXAMPLE #1

Suppose the T V is estimated to be $50 million and the investors expect a 30 x R O I in the harvest or exit year on their $500,000 investment.

What is the post-money valuation?

What is the pre-money valuation?

16.6a Two Venture Capital Methods (slide 2 of 2)

Another method, employed in the private equity arena to value investments with negative cash flows and earnings but with future promise, involves the V C firm determining what R O I is required during the time the firm is invested.

It then applies a price/earnings (P / E) ratio or multiple of earnings to the estimated future value of the venture at the end of the period, which is equivalent to its T V.

The T V is then discounted based on the targeted rate of return the investor is seeking.

Percentage ownership is then calculated using the following formula:

EXAMPLE #2

Suppose a company required an investment of $5 million over three years. The V C wants a 50 percent return on the initial investment and forecasts that the company’s after-tax earnings in the third year will be $10 million. The investor sets the P / E ratio at 8 on the basis of comparables in the public market and experience with similar ventures.

What is the discounted terminal value?

What is the required percentage of ownership?

16.6b Divergence and Dilution

As the value of a venture increases, the value of its shares does not always achieve a corresponding increase.

This discrepancy is referred to as valuation divergence.

Divergence is related to dilution, which is the decline in the percentage ownership of the company as new rounds of funding are secured.

TABLE 16.2 Valuation Divergence

16.6 ACCESSING THE PUBLIC MARKETS

Undertaking the initial public offering (I P O), or “going public,” is the goal of many companies because it is an exciting way to raise large amounts of money for growth that probably couldn’t be raised from other sources.

However, deciding whether to do a public offering is difficult at best.

Doing so sets in motion a series of events that will change the business and the relationship of the entrepreneur to that business forever.

Moreover, returning to private status once the company has been a public company is an almost insurmountable task.

An I P O is just a more complex version of a private offering, in which the founders and equity shareholders of the company agree to sell a portion of the company (via previously unissued stocks and bonds) to the public by filing with the Securities and Exchange Commission (S E C) and listing their stock on one of the stock exchanges.

16.7a Advantages and Disadvantages of Going Public (slide 1 of 2)

There are a number of important advantages to becoming a public company.

It provides the offering company with a tremendous source of interest-free capital for growth and expansion, paying off debt, or product development.

The company acquires the future option of additional offerings once it is well known and has a positive track record.

A public company has more prestige and clout in the marketplace, so it becomes easier to form alliances and negotiate deals with suppliers, customers, and creditors.

Restricted stock and stock options can be used to attract new employees and reward existing employees.

It is also easier for the founders to harvest the rewards of their efforts by selling off a portion of their stock or borrowing against it.

16.7a Advantages and Disadvantages of Going Public (slide 2 of 2)

There are also challenges to being a public company.

There is a risk of loss in shareholder value.

An I P O is a very expensive process.

Going public is enormously time-consuming.

Everything the company does or owns becomes public information subject to the scrutiny of anyone interested in the company.

A shift in company control makes the C E O of a public company responsible primarily to the shareholders and only secondarily to anyone else.

The entrepreneur / C E O may no longer have a controlling portion of the outstanding stock.

Macroeconomic conditions can adversely affect a company’s stock, regardless of what the company does.

Public companies are subject to the stringent disclosure rules under the Sarbanes-Oxley Act (SOX).

A public company faces intense pressure to perform in the short term.

16.7b The Public Offering Process (slide 1 of 2)

There are several steps in the I P O process.

The first step is to choose an underwriter, or investment banker, which is the firm that sells the securities and guides the corporation through the I P O process.

The investment bank should be able to support the I P O after the offering by giving financial advice, aid in buying and selling stock, and assistance in creating and maintaining interest in the stock over the long term.

Once chosen, the underwriter draws up a letter of intent, which outlines the terms and conditions of the agreement between the underwriter and the entrepreneur / selling stockholder and also specifies the price range for the stock.

16.7b The Public Offering Process (slide 2 of 2)

A registration statement must be filed with the S E C.

This document is known as a red herring, or prospectus, because it discusses all the potential risks of investing in the I P O.

The prospectus is given to those interested in investing in the I P O.

It is a given critical document because the S E C will render a decision on the I P O based on this statement.

After filing the registration statement, an advertisement called a tombstone announces the offering in the financial press.

The next decision is which stock exchange to list the offering.

The high point of the I P O process is the road show, generally a two-week whirlwind tour of all the major institutional investors by the entrepreneur and the I P O team to market the offering.

This is done so that once the registration statement has met all the S E C requirements and the stock has been priced, the offering can be sold before its value has a chance to fluctuate in the market.

FIGURE 16.4 The I P O Process Simplified

Terminal Value in the th Year

Post-Money Valuation

Anticipated ROI in the th Year

Pre-Money ValuationPost-Money ValuationI

nvestment

$50,000,000

Post-Money Valuation

Post-Money Valuation$1,600,000

Pre-Money Valuation$1,600,000$500,000

Pre-Money Valuation$1,100,000

# years

Discounted TV

(1Target Return)

Invested Amount

Required Ownership Percent

Discounted TV

($10,000,000 8)

Discounted TV

(10.50)

Discounted TV$23,700,000

$5,000,000

Required Ownership Percent

$23,700,000

Required Ownership Percent21%