week 7 discussion

Start-up businesses and venture capital

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Start-up businesses and venture capital: contents

• Financial strategy for a start-up business

• Stages in a start-up

• Two ways of accounting for the risk

• Real options

• Venture capital and business angels

• Example of corporate venturing

• Deal terms will include…

• Pre- and post-money

• Pre- and post-money example

• Anti-dilution clauses, used in a ‘down’ round

• Liquidation preference reduces risk and boosts return

Financial strategy for a start-up business

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Business risk Very high

Financial risk Very low

Source of outside funding Venture capital

Dividend policy Nil pay-out ratio

Future growth prospects Very high

Price/earnings multiple Very high

Current profitability (eps) Nominal or negative

Share price Rapidly growing but highly volatile

Stages in a start-up

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Business making R&D

spend

Prototype and market testing

Production & commercialization

Chance to become valuable

The length of each stage depends on the industry and business model

The number of successful entities decreases at each stage

Time

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Two ways of accounting for the risk Probability-adjust cash flows

• Probability-adjust the cash flows to allow for the changes in probability of success as each stage is reached

• This is more complex mathematically, but has the advantage that certain cash outflows are not discounted at a high rate

• It is theoretically more appropriate

Use a higher discount rate

• A high discount rate is applied to the whole project to allow for the overall risk taken on

• This is more commonly used, because it is simpler, but can be misleading

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Real options • Multi-stage projects

• Timing flexibility

• Alternative uses

• Growth potential

• Exit options

Real options take account of the

value inherent in flexibility

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Venture capital investors and business angels

Venture Capital

• Professional investment firms, generally investing funds they have raised as intermediaries rather than their own money

• Have a portfolio of high-risk investments, often specializing in a particular sector or a specific technology

Business Angels

• Individuals, often investing their own money

• Often more informal than professional firms

• Investment criteria include: favourable impression of the management team, familiarity with the sector, geographical proximity, synergy with own skills

Both venture capital firms and business angels are investing with the aim of a high financial return

Pre- and post-money

Pre-money value

+ Investment = Post- money value

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Pre- and post-money example • Entrepreneur seeks $100,000 in exchange for 10% of the

business. • This implies that the business as it stands is worth $900,000 (pre-

money) • And after the investment, it will be worth $1,000,000 (post-money)

$100,000 = 10% (Pre-money value + $ 100,000)

$ 100,000 = (10% x Pre-money value) + $ 10,000

10% x Pre-money value = $ 90,000

Pre-money value = $ 900,000

Post-money value = $ 900,000 + $ 100,000 = $ 1,000,000

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Anti-dilution clauses, used in a ‘down’ round

If someone else buys more cheaply, you get a refund.

Example

▪ Original VC investors bought ‘A’ shares at $100 per share. The ‘A’ shares will convert into ordinary shares on a disposal, on a 1:1 basis

▪ Next stage investors will buy ‘B’ shares at $ 50 each

▪ Because the ‘A‘ shares are being diluted, the holders of the ‘A’ shares are issued with new free(ish) shares, to bring their overall cost down to $ 50 per share. This dilutes the founder’s stake. Or, conversion terms may alter to achieve same effect.

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Liquidation preference reduces risk and boosts return

PE company makes sure that on a disposal it gets its money back, or a multiple of its money. Surplus proceeds are then split between parties

Example, where VC has put in $200,000 for 50% of the equity. Sales proceeds for equity of $100k, $300k and $1m.

$100,000

proceeds

$300,000

proceeds

$1 million

proceeds

No liquid’n pref $50,000 $150,000 $500,000

1x LP $100,000 $250,000 ($200k plus half of

$100k)

$600,000 ($200k plus half of

$800k)

2x LP $100,000 $300,000 $700,000 ($400k plus half of

$600k)

OR – the other shareholders may be credited with their own amounts paid for their shares, in a catch-up exercise before the net proceeds are divided

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Funding Process steps (1) • Complete Business Plan and form Founding Team1

• Undertake Investor Search2

• After finding interested investor, execute NDA (Non-disclosure Agreement)3

• Negotiate Valuation with Investor(s)4

• Negotiate Term Sheet with Investors5

• Negotiate & Sign Investment Agreement with Investors6

• Plan process again for next round of finance, according to business plan

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Funding Process steps (1) • 1 Complete Business Plan (your course capstone gives you this knowledge)

• 2 Undertake Investor Search (beyond the scope of this course and is an extensive exercise in itself)

• 3 After finding interested investor, execute NDA (there is an example in your course learning resources)

• 4 Negotiate Valuation with Investors (there is an example in your course learning resources)

• 5 Negotiate Term Sheet with Investors (there is an example in your course learning resources)

• 6 Sign Investment Agreement with Investors (beyond the scope of this course – these typically can run 50 pages and need to be prepared by an experienced attorney at startup contractual matters)

• Start process again for next round of finance