For A-Plus Writer Only

References

Hisrich, R.D., Peters, M.P. , & Shepherd, D.A. (2013). Entrepreneurship (Laureate Custom

Education). New York: McGraw-Hill Irwin.

Custom Create Edition ~ I LAUREATE EDUCATION INC

344 I '"'"P""'""h;p ··-· --·---~------- -----·-

INFORMAL RISK CAP.ITAL, VENTURE CAPITAL, AND GOING PUBLIC

1 To explain the basic stages of venture funding.

2 To discuss the informal risk-capital market.

3 To discuss the nature of the venture-capital industry

and the venture-capital decision process.

4 To explain all aspects of valuing a company.

5 To identify several valuation approaches.

6 To explain the process of going public.

'""''""'""h;p, E;ghth Ed•;oo I 345 ---------------------------------' - --- ------+-----

OPENING PROFILE

MARK ZUCKERBERG

According to Portfolio Research, it took 89 years for the telephone to reach 150 million

users and 38 years for television to do the same. Facebook, however, became 150 mil-

lion users strong after a mere five years.

It all started with Harvard student Mark Zuckerberg, who had a passion for program-

ming. He began building programs in middle school,

and by high school he had developed an application

aimed at helping the employees in his father's office

communicate. A few years later, he created an online

version of the game Risk (a game of world domination), followed by a program called

Synapse (a music player). Driven by his passion, he learned his coding knowledge

through C++ for Dummies and discussions with friends, and in 2001 he went on to

study computer science at Harvard. By 2006, he was a Harvard dropout.

Zuckerberg's first online program attempt at Harvard, Facemash, got him into seri-

ous trouble with school administrators. Facemash allowed users to rank photos of their

classmates according to their attractiveness. Even though the site had over 450 users

who voted more than 22,000 times within just a few days, Zuckerberg was accused of

violating individual privacy, violating copyright laws, and breaching security and was

obliged to take down the site. His second programming attempt, however, made him

the youngest self-made billionaire in history.

Entering Harvard, Zuckerberg was looking for a way to meet and get to know his

classmates. So in February 2004, with Harvard roommates Dustin Moskovitz, Eduardo

Saverin, and Chris Hughes, Zuckerberg developed a program that allowed his class-

mates to share as much or as little information about themselves as they wanted and

originally named it "TheFacebook.com." Users could share information about them-

selves such as their favorite bands, their relationship status, and class notes and could

change any of their content at any time they wanted. Zuckerberg's main concern with

creating the site was not to make millions or to reach unprecedented fame, but to al -

low the free sharing and transfer of information among members. He also wanted the

site to be a replica of human life: joining clubs, creating albums, finding out what

other people are doing with their lives. Zuckerberg knew that as long as he made it

easy to use, peer pressure and the network effect would ensure its growth.

333

346 I Entrepreneurship

334 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

Zuckerberg originally targeted the site to 18- to 24-year-olds, and it was at

limited to Harvard students. In March of that year, TheFacebook.com expande

other Ivy League schools, and by May 2005 was serving 800 colleges across the cot.-

try. At that time, the site operated upon exclusivity; a corresponding college e-rr:

address was required to sign up to become a member. In August 2005, the com pa:

name was officially changed to "Facebook," and later that year it was opened up:=

high school networks and a few companies, including Apple and Microsoft. By 7.:'":

end of 2005, the site had grown to 5.5 million active users compared to 1 mill"

exactly a year before.

In September 2006, Zuckerberg removed all registration restrictions on Facebook a--

opened up the site to the general public. Having anticipated a negative reaction tr~~

the college students who made the site so popular, he, along with the other fou nde, ~

had proactively taken action to prepare and inform existing members of new priva

features. For example, users could not only block other Facebook members from viewi:"·~

their profiles, but they could also avoid even being found on the site when their nar'""::

was searched. Opening Facebook to the public helped to more than double the sr.c ~

membership within one year; by December 2006 Facebook had 12 million active users..

In anticipation of growing the site to 200 million users, Zuckerberg began looki:-~

outside the confines of the United States, and in March 2007 two million Cana dia-

and one million British joined Facebook. In early 2008, Facebook was launched -

French, Spanish, and German, and by April 2008 it was translated and launched i

additional languages. August 2008 saw a Facebook membership of 100 million acti._

users; five months later, in January 2009, this number reached 150 million, and Febru--

2009's count revealed 175 million active users. By early 2009, five million new peo~ _

were joining Mark Zuckerberg's social network site every week, with the most com

new members being women over the age of 55.

As the site grew in membership, its platform blossomed as well. In September 2

the Groups application and Wall features were added, followed by the Photos applic::-

tion in October 2005. The Photo feature allowed users to tag everyone appeari ng -

the picture so the picture shows up on the corresponding members' profiles as we

This helped the application quickly gain popularity; in February 2008, 250 million p

tos were uploaded every month, and a year later, February 2009, the number had rise-

to 850 million monthly uploads. In April 2006, Facebook added the Mobile feature, a

lowing users to upload Facebook onto their mobile phones and access the site a

where, anytime. September 2006 saw the addition of the News and Mini-Feeds, w h·

created some backlash from members. The News feed informed users of all rec e...--

activity taken on the profiles of all their friends, including potentially embarrassi.""';:

changes such as breakups or professional demotions. Though such information \\'C.:.

already accessible (since the member chose to change it on his or her profile), use_

felt Facebook was spreading the news and informing those who would otherwise nc:

\\a\le noticed. {:>.. fac.eboo\<. groU? entit\ed "Students Against Facebook News Fe eci

was created and within 24 hours, 290,000 members had joined. Zuckerberg hea:=

I Entrepreneurship, Eighth Edition I 347

--------------------------------r--------"-·--·-

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 335

and listened to the outcry and reacted by creating and promoting additional privacy

settings enabling users to decide what profile changes could and could not be included

on the feed.

In 2007, another backlash occurred when Facebook launched a feature called

Beacon, informing users which Web sites their friends had visited, including informa-

tion on products they were purchasing. The user protest was overwhelming and even

included a filed lawsuit. This resulted in the allowance for users to disable Beacon on

their profile, and an apology from Zuckerberg, admitting, "We simply did a bad job

with this release, and I apologize for it."

In April 2008, a Chat feature was added, furthering the communication capabilities

of the users among each other, and by 2009, Facebook had grown to become more

than just a communication tool among friends. It has become the hub for users to

store their pictures, organize parties, chat, play games, and find jobs. From a profes-

sional standpoint, companies such as Ernst & Young and Dell use the site to recruit new

hires, and governmental parties, such as the Democratic Party in Maine, use it to

organize meetings.

In 2008, Mark Zuckerberg was named one of "The World's Most Influential People

of 2008" by Time magazine, and Forbes calls him the youngest self-made billionaire.

Many investors had recognized Facebook's value and potential early on; in 2005 Face-

book received $12.7 million in venture-capital money from Accel Partners and $27.5 mil-

lion from Greytock Partners in 2006. Also in 2006, Facebook and Microsoft formed a

strategic relationship, and by October 2007, Microsoft took a $240 million equity stake

in Facebook.

However, Facebook is not lacking challenges. Although the site is worth $3.7 billion

(in 2008), it has a unique financial predicament; its revenues reached a mere $280 mil-

lion in 2008, which did not even reach the break-even point. To bring the company to

a position where it financially makes the most of its soaring attractiveness to mar-

keters, Zuckerberg brought Sheryl Sandberg (who built Google's AdWords program)

on board as the chief operating officer. Because each user on the site has his or her

own unique story, the wealth of personal information allows advertisers to effectively

promote themselves to their target markets, based on each individual's profile. It also

gives marketers a better sense of new trends and popular activities. For example, if a

particular Face book group has hundreds of thousands of members, it is vital for adver-

tisers to join the group and stay aligned with current and upcoming trends and societal

interests.

Facebook also faces the challenge of "staying on top." The world has seen compa-

nies such as AOL and Yahoo!, who were each well positioned to become the ultimate

leader in communication platforms, fail. Zuckerberg and Facebook are working on

coming up with ways to continue growing and expanding to remain the leading social

network while making sure not to alienate its early adopters. Luckily, Zuckerberg's

vision for the future is well aligned with the needs for Facebook; he wants his site to

reach every person and every computer in the world .1

348 I Eotrepre"'""h ;p --~---+ -- -- ----------

336 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

early-stage .financillg

One of the first financings

obtained by a company

Unlike Mark Zuckerberg, many entrepreneurs find it difficult both to manage and ex the ventures they have created. To successfully start and especially grow a venture. entrepreneur must understand venture financing and obtain the necessary funding fr or::: variety of sources.

FINANCING THE BUSINESS In evaluating the appropriateness of financing alternatives, particularly angel ve venture-capital financing, an entrepreneur must determine the amount and the timing -- the funds required, as well as the projected company sales and growth. Conventional srnz businesses and privately held middle-market companies tend to have a difficult tim! obtaining external equity capital, especially from the venture-capital industry. Most ver:- ture capitalists like to invest in software, biotechnology, or high-potential ventures l.ik= Mark Zuckerberg's Facebook. The three types of funding as the business develops ~ indicated in Table 12.1. The funding problems, as well as the cost of the funds , differ ft each type. Early-stage financing is usually the most difficult and costly to obtain. T types of financing are available during this stage: seed capital and start-up capital. Seee capital, the most difficult financing to obtain through outside funds, is usually a relative . small amount of funds needed to prove concepts and fmance feasibility studies. Sin

TABLE 12.1 Stages of Business Development Funding

Early-Stage Financing

• Seed capital

• Start-up

Expansion or Development Financing

• Second stage

• Th ird stage

• Fourth stage

Relatively small amounts to prove concepts and finance feasibility studies

Product development and initial marketing, but with no commercial sales yet; funding to actually get com- pany operations started

Working capital for initial growth phase, but no clear profitability or cash flow yet

Major expansion for company with rapid sales growth; company is at breakeven or positive profit levels but is still private

Bridge financing to prepare company for public offering

Acquisition and Leveraged Buyout Financing

• Traditional acquisitions

• Leveraged buyouts (LBOs)

• Going private

Assuming ownership and control of another company

Management of a company acquiring company con- trol by buying out the present owners

Some of the owners/managers of a company buying all the outstanding stock, making the company privately held again

Entrepreneurship, Eighth Edition l 349 ------~----·----- ------------ -----------·--·-·· ----------- ------- - --~- ---------·------------------- --~--........... ~------ -"

development financing

Financing to rapidly

expand the business

acquisition financing

Financing to buy another

company

risk-capital markets

:\furkets providing debt

and equity to nonsecure

fin ancing situations

mformal risk-capital

'llllrket Area of risk-

capital markets consisting

mainly of individuals

enture-capital market

One of the risk-capital

markets consisting of

formal firms

public-equity market

One of the risk -capital

markets consisting of

publicly owned stocks of

companies

!Jusiness angels

A name for individuals in

the informal risk-capital

market

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 337

venture capitalists usually have a minimum funding level of above $500,000, they are rarely involved in this type of funding, except in the case of high-technology ventures of entrepreneurs who have a successful track record and need a significant amount of capi- tal. The second type of funding is start-up financing. As the name implies, start-up financ- ing is involved in developing and selling some initial products to determine if commercial sales are feasible. These funds are also difficult to obtain. Angel investors are active in these two types of financing.

Expansion or development financing (the second basic financing type) is easier to obtain than early-stage financing. Venture capitalists play an active role in providing funds here. As the firm develops in each stage, the funds for expansion are less costly. Generally, funds in the second stage are used as working capital to support initial growth. In the third stage, the company is at breakeven or a positive profit level and uses the funds for major sales ex- pansion. Funds in the fourth stage are usually used as bridge financing in the interim period as the company prepares to go public.

Acquisition financing or leveraged buyout financing (the third type) is more specific in nature. It is issued for such activities as traditional acquisitions, leveraged buyouts (man- agement buying out the present owners), and going private (a publicly held firm buying out existing stockholders, thereby becoming a private company).

There are three risk-capital markets that can be involved in financing a firm's growth: the informal risk-capital market, the venture-capital market, and the public-equity market. Although all three risk-capital markets can be a source of funds for stage-one financing, the public-equity market is available only for high-potential ventures, particularly when high technology is involved. Recently, some biotechnology companies raised their first-stage financing through the public-equity market since investors were excited about the potential prospects and returns in this high-interest area. This also occurred in the areas of oceanog- raphy and fuel alternatives when there was a high level of interest. Although venture- capital firms also provide some first-stage funding, the venture must require the minimum level of capital ($500,000). A venture-capital company establishes this minimum level of investment due to the high costs in evaluating and monitoring a deal. By far the best source of funds for first-stage financing is the informal risk-capital market-the third type of risk -capital market.

INFORMAL RISK-CAPITAL MARKET The informal risk-capital market is the most misunderstood type of risk capital. It consists of a virtually invisible group of wealthy investors, often called business angels, who are looking for equity-type investment opportunities in a wide variety of entrepreneurial ven- tures. Typically investing anywhere from $10,000 to $500,000, these angels provide the funds needed in all stages of financing, but particularly in start-up (first-stage) financing. Firms funded from the informal risk-capital market frequently raise second-and third- round financing from professional venture-capital firms or the public-equity market.

Despite being misunderstood by, and virtually inaccessible to, many entrepreneurs, the informal investment market contains the largest pool of risk capital in the United States. Although there is no verification of the size of this pool or the total amount of financing provided by these business angels, related statistics provide some indication. A 1980 sur- vey of a sample of issuers of private placements by corporations, reported to the Securities and Exchange Commission under Rule 146, found that 87 percent of those buying these is- sues were individual investors or personal trusts, investing an average of $74,000.2 Private placements filed under Rule 145 average over $1 billion per year. Another indication becomes apparent on examination of the filings under Regulation D-the regulation

l 350 I Entrepreneurship t--- ~---------- ---- -·-··------------

AS SEEN IN BUSINESSWEEK

OLD BANKS, NEW LENDING TRICKS

That didn't take long. The economy hasn't yet recov- ered from the implosion of risky investments that led to the worst recession in decades-and already some of the world's biggest banks are peddling a new gen- eration of dicey products to corporations, consumers, and investors.

In recent months such big banks as Bank of America, Citigroup, and JPMorgan Chase have rolled out new- fangled corporate credit lines tied to complicated and volatile derivatives. Others, including Wells Fargo and Fifth Third, are offering payday-loan programs aimed at cash-strapped consumers. Still others are marketing new, potentially risky "structured notes" to small investors.

There's no indication that the loans and instru- ments are doomed to fail. If the economy keeps mov- ing toward recovery, as many measures suggest, then the new products might well work out for buyers and sellers alike.

But it's another scenario that worries regulators, lawmakers, and consumer advocates: that banks once again are making dangerous loans to borrowers who can't repay them and selling toxic investments to investors who don't understand the risks-all of which could cause blowups in the banking sector and weigh on the economy.

Some of Wall Street's latest innovations give rea- son for pause. Consider a trend in business loans. Lenders typically tie corporate credit lines to short- term interest rates. But now Citi, JPMorgan Chase, and BofA, among others, are linking credit lines both to short-term rates and credit default swaps (CDSs), the volatile and complicated derivatives that are sup- posed to act as "insurance" by paying off the owners if a company defaults on its debt. JPMorgan, BofA, and Citi declined to comment.

In these new arrangements, when the price of the CDS rises-generally a sign the market thinks the com- pany's health is deteriorating-the cost of the loan increases, too. The result: The weaker the company, the higher the interest rates it must pay, which hurts the company further.

The lenders stress that the new products give them extra protection against default. But for companies, the opposite may be true. Managers now must deal with two layers of volatility-both short-term interest

338

rates and credit default swaps, whose prices can spi ke for reasons outside their control.

At the other end of the borrower spectrum, big banks are entering another controversial arena: pay- day loans, whose interest rates can run as high as 400%. Historically the market has been dominated by small nonbank lenders, which mainly operate in poor urban centers and offer customers an advance o their paychecks. But big lenders Fifth Third and U.S. Bancorp started offering the loans, while Wells Farg continues to boost its payday-loan program, which · began in 1994.

More big banks are getting into the market just as a recent flurry of usury laws has crippled smaller play- ers. In the past two years lawmakers in 15 states have capped interest rates on short-term loans or kicked out payday lenders altogether. The state of Ohio, fo example, has imposed a 28% interest rate limit. B - thanks to interstate commerce rules, nationally cha. - tered banks don't have to follow local rules. Afte Ohio limited rates, Cincinnati-based Fifth Third, wh ic:t has 400 branches in the state but also operates i 11 others, introduced its Early Access Loan, with a._ annual interest rate of 120%. "These banks are skirting state laws," says Kathleen Day of advocacy grou Center for Responsible Lending. Says a spokeswoma for Fifth Third: "Our Early Access product fully co plies with federal regulations and applicable stat e regulations."

Lenders argue they offer a valuable service fo. those who need emergency cash. Wells Fargo says · warns customers using its Direct Deposit Advance t ha: the loan is expensive and tries to offer alternatives. "We have policies in place to prevent long-term usage of the services," says a spokeswoman. U.S. Banco didn't return calls.

National regulators are taking notice, however. The Office of Thrift Supervision says it is "looking into• two institutions that are offering the high-intere>.: loans. "We need to make sure there's no predato lending and also ensure that there are no risks to th e institutions," says an OTS spokesman.

Source: Reprinted from August 17, 2009 issue of Business Week by special permission, copyright© 2009 by The McGraw-Hill Companies, Inc., "Old Banks, New Lending Tricks," by Jessica Silver-Greenberg, Theo Francis, and Ben Levisohn, pp. 20-23.

Entrepreneurship, Eighth Edition

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 339

exempting certain private and limited offerings from the registration requirements of the Securities Act of 1933, discussed in Chapter 11. In its first year, over 7,200 filings, worth $15.5 billion, were made under Regulation D. Corporations accounted for 43 percent of the value ($6.7 billion), or 32 percent of the total number of offerings (2,304). Corporations fil- ing limited offerings (under $500,000) raised $220 million, an average of $200,000 per fmn. The typical corporate issuers tended to be small, with fewer than 10 stockholders, revenues and assets less than $500,000, stockholders' equity of $50,000 or less, and five or fewer employees.3

Similar results were found in an examination of the funds raised by small technology- based firms prior to their initial public offerings. The study revealed that unaffiliated indi- viduals (the informal investment market) accounted for 15 percent of these funds, while venture capitalists accounted for only 12 to 15 percent. During the start-up year, unaffili- ated individuals provided 17 percent of the external capital. 4

A study of angels in New England again yielded similar results. The 133 individual in- vestors studied reported risk-capital investments totaling over $16 million in 320 ventures between 1976 and 1980. These investors averaged one deal every two years, with an aver- age size of $50,000. Although 36 percent of these investments averaged less than $10,000, 24 percent averaged over $50,000. While 40 percent of these investments were start-ups, 80 percent involved ventures less than five years old. 5

The size and number of these investors have increased dramatically, due in part to the rapid accumulation of wealth in various sectors of the economy. One study of consumer finances found that the net worth of 1.3 million U.S. families was over $1 million. 6 These families, representing about 2 percent of the population, accumulated most of their wealth from earnings, not inheritance, and invested over $151 billion in nonpublic businesses in which they have no management interest. Each year, over 100,000 individual investors finance between 30,000 and 50,000 firms, with a total dollar investment of between $7 bil- lion and $10 billion. Given their investment capability, it is important to know the charac- teristics of these angels.

One article determined that the angel money available for investment each year was about $20 billion.7 This amount was confmned by another study indicating that there are about 250,000 angel investors who invest an amount of $10 billion to $20 billion annually in about 30,000 firms. 8 A recent study found that only about 20 percent of the angel in- vestors surveyed tended to specialize in a particular industry, with the typical investment in the first round being between $29,000 to over $100,000.9

The characteristics of these informal investors, or angels, are indicated in Table 12.2. They tend to be well educated; many have graduate degrees. Although they will finance fmns anywhere in the United States (and a few in other parts of the world), most of the firms that receive funding are within one day's travel. Business angels will make one to two deals each year, with individual firm investments ranging from $100,000 to $500,000 and the average being $340,000. If the opportunity is right, angels might invest from $500,000 to $1 million. In some cases, angels will join with other angels, usually from a common circle of friends, to finance larger deals.

Is there a preference for the type of ventures in which they invest? While angels in- vest in every type of investment opportunity, from small retail stores to large oil explo- ration operations, some prefer manufacturing of both industrial and consumer products, energy, service, and the retail/wholesale trade. The returns expected decrease as the number of years the firm has been in business increases, from a median five-year capi- tal gain of 10 times for start-ups to 3 times for established firms over five years old. These investing angels are more patient in their investment horizons and do not have a problem waiting for a period of 7 to 10 years before cashing out. This is in contrast to

352 I '"'"'""'""";' -~--- -------·------~---~---------------- ·---------·--------------------------·-----

340 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

TABLE 12.2 Characteristics of Informal Investors

Demographic Patterns and Relationships

• Well educated, with many having graduate degrees.

• Will finance firms anywhere, particularly in the United States.

• Most firms financed within one day's travel.

• Majority expect to play an active role in ventures financed .

• Many belong to angel clubs.

Investment Record

• Range of investment: $100,00()--$500,000

• Average investment: $340,000

• One to two deals each year

Venture Preference

• Most financings in start-ups or ventures less than 5 years old

• Most interest in financing:

• Manufacturing- industrial/commercial products

• Manufacturing-consumer products

• Energy/ natural resources

• Services

• Software

Risk/Reward Expectations

• Median 5-year capital gain of 10 times for start-ups

• Median 5-year capital gain of 6 times for firms under 1 year old

• Median 5-year capital gain of 5 times for firms 1-5 years old

• Median 5-year capital gain of 3 times for established f irms over 5 years old

Reasons for Rejecting Proposals

• Risk/return ratio not adequate

• Inadequate management team

• Not interested in proposed business area

• Unable to agree on price

• Principals not sufficiently committed

• Unfamiliar with area of business

the more predominant five -year time horizon in the formal venture-capital industry. Investment opportunities are rejected when there is an inadequate risk/return ratio, a subpar management team, a lack of interest in the business area, or insufficient commit- ment to the venture from the principals.

The angel investor market averages about $20 billion each year, which is about the same level of yearly investment of the venture-capital industry. The angel investment is in about eight times the number of companies. In normal economic conditions, the number of active

refe"al sources Ways individual investors find

out about potential deals

ity pool Money :::rised by venture

italists to invest

· · participatio11 ~g an ownership

on

I Entrepreneurship, Eighth Edition --~- 353

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 341

investors is around 250,000 individuals in the United States, with five or six investors typ- ically being involved in an investment

Where do these angel investors generally find their deals? Deals are found through re- ferrals by business associates, friends, active personal research, investment bankers, and business brokers. However, even though these referral sources provide some deals, most angel investors are not satisfied with the number and type of investment referrals. Fifty-one percent of the investors surveyed were either partially or totally dissatisfied with their re- ferral systems and indicated that at least moderate improvement is needed.

A phenomenon that is spreading throughout the United States is "brands" of angels or organized angel investor groups. Each angel group or club usually has a meeting for about two to three hours about 8 to 10 times each year. Some groups are now starting to co-invest with other groups. The group as a whole does not have any money but serves as a conven- ing and screening device for the presentations. The individual members of the group make the investment either individually or with others interested if any investment is made.

The typical club process is that you send the required form to the designated club mem- ber. Following initial screening, if the entrepreneur is chosen, then follow-up meetings with several club members occur. If the entrepreneur is selected to present at a future meeting, then the entrepreneur is provided guidance in terms of business plan refinement and the presentation. Usually 30 minutes is allocated for a presentation and questions, and then any interested club members meet with the entrepreneur to discuss further steps in the invest- ment decision process. The approximately 200 organized angel investor groups are identi- fied by the Kauffman Foundation (www.kauffman.org).

In several cases, these organized clubs have spawned an angel fund, which is a pool of money dedicated to a specific region and several industries. The fund size is between $5 and $10 million. The few angel funds in existence operate very much like university- sponsored venture-capital funds, which will be discussed later in this chapter.

VENTURE CAPITAL The important and little understood area of venture capital will be discussed in terms of its nature, the venture-capital industry in the United States, and the venture-capital process.

Nature of Venture Capital Venture capital is one of the least understood areas in entrepreneurship. Some think that venture capitalists do the early-stage financing of relatively small, rapidly growing technol- ogy companies. It is more accurate to view venture capital broadly as a professionally man- aged pool of equity capitaL Frequently, the equity pool is formed from the resources of wealthy limited partners. Other principal investors in venture-capital limited partnerships are pension funds, endowment funds, and other institutions, including foreign investors. The pool is managed by a general partner-that is, the venture-capital fum-in exchange for a percentage of the gain realized on the investment and a fee. The investments are in early-stage deals as well as second- and third-stage deals and leveraged buyouts . In fact, venture capital can best be characterized as a long-term investment discipline, usually oc- curring over a five-year period, that is found in the creation of early-stage companies, the expansion and revitalization of existing businesses, and the financing of leveraged buyouts of existing divisions of major corporations or privately owned businesses. In each invest- ment, the venture capitalist takes an equity participation through stock, warrants, and/or convertible securities and has an active involvement in the monitoring of each portfolio company, bringing investment, financing planning, and business skills to the firm.

I 354 I Entrepreneurship -·-r· ------·-· ----------~----------------- --------- --- - - -- ------------------ --- --

AS SEEN IN BUSINESSWEEK

SHE'S AN ANGEL

Barbara Boxer, a practicing attorney in Milwaukee, knows just how difficult it can be for women entre- preneurs to raise money. She ran her own mail-order medical supply company for 20 years before selling it in 1990, and now many of her clients are women who own businesses. After participating in a conference for women trying to raise funding, the 56-year-old decided to take matters into her own hands. Last sum- mer, Boxer started Women Angels, a group of women investors that focuses on women-owned businesses in the Midwest. Now the group's 22 members are get- ting ready to make their first investments. They will put $150,000 to $500,000 in each of two companies, one in biotech and one in transportation.

Boxer is part of a small but growing legion of women angel investors, who are using their own money to back young companies. Often, those are companies led by women. "We're seeing more women entrepreneurs who are cashing out of their busi- nesses," says Jeffrey Soh I, a professor of entrepreneur- ship at the University of New Hampshire. "The more women who are successful in business, particularly in entrepreneurship, the more women angels we're likely to see." That's because the prime candidates to be angel investors are former entrepreneurs. There are at least six women-focused angel groups in the U.S., with an additional dozen or so just getting started, accord- ing to a recent report from the Kauffman Foundation.

Angels are a rich source of capital for entrepre- neurs. Last year, 225,000 angels invested $23.1 billion in roughly 49,500 deals, according to the Center for Venture Research. Women represented 9% of that group, up from 5% in 2004. Part of that increase is coming from new women-led investment groups, but

there's still plenty of room for growth. Womer not only control 50% of the country's wealth, b they also represent an increasing percentage of e" - trepreneurs. About half of private companies are majority-owned by women, according to the Cente ' for Women's Business Research.

Why aren't there more women angel groups- There are plenty of reasons. For one, only abo 15%-20% of angels are organized into groups at al with the rest investing on their own. Angel investors tend to be serial entrepreneurs, and serial entrepre- neurs tend to be men. Social networks also play a rol since angel groups usually form around investo social circles. "Men tend to socialize and affiliate w itt- people they do business with," says Maggie Kenefa ke, manager of growth entrepreneurship for the Kauffma Foundation. "If you look at women, their networks are more social, philanthropic, or family-based."

Just because many women are newer to the investment game doesn't mean they're any less dis- cerning than men. Although women angels active seek out, and tend to attract, more women entrepre- neurs, the groups conduct the same amount of due diligence and ultimately fund companies at the sa me rate as men do, roughly 10% of the proposals the see. And while many of these new groups have every intention of helping other women entrepreneu rs, being an angel is, in the end, still an investment deci- sion. Says Boxer: "This isn't about altruism. It's aboU: making money."

Source: Reprinted from Summer 2006 Small Biz Supplement issue of Business Week by special permission, copyright © 2006 by The McGraw-Hill Companies, Inc., "She's an Angel," by Adrienne Carter, p. 34.

Overview of the Venture-Capital Industry

342

Although the role of venture capital was instrumental throughout the industrialization of the United States, it did not become institutionalized until after World War IT. Before World War II, venture-capital investment activity was a monopoly led by wealthy individuals. investment banking syndicates, and a few family organizations with a professional manageL The first step toward institutionalizing the venture-capital industry took place in 1946 with the formation of the American Research and Development Corporation (ARD) in Boston. The ARD was a small pool of capital from individuals and institutions put together by Gen- eral Georges Doriot to make active investments in selected emerging businesses.

The next major development, the Small Business Investment Act of 1958, married pri- vate capital with government funds to be used by professionally managed small-business

SB/Cfirms Small

companies with some

government money that

invest in other companies

private venture-capital

firms A type of venture-

capital finn having general and limited partners

state-sponsored

~·enture-capital fund

A fund containing state

government money that

invests primarily in

companies in the state

Entrepreneurship, Eighth Edition 355 -~----

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 343

investment companies (SBIC firms) to infuse capital into start-ups and growing small busi- nesses. With their tax advantages, government funds for leverage, and status as a private- capital company, SBICs were the start of the now formal venture-capital industry. The 1960s saw a significant expansion of SBICs with the approval of approximately 585 SBIC licenses that involved more than $205 million in private capital. Many of these early SBICs failed due to inexperienced portfolio managers, unreasonable expectations, a focus on short-term profitability, and an excess of government regulations. These early failures caused the SBIC program to be restructured, which in tum eliminated some of the unnec- essary government regulations and increased the amount of capitalization needed. There are approximately 360 SBICs operating today, of which 130 are minority small-business investment companies (MESBICs) funding minority enterprises.

During the late 1960s, small private venture-capital firms emerged. 10 These were usually formed as limited partnerships, with the venture-capital company acting as the general part- ner that received a management fee and a percentage of the profits earned on a deal. The limited partners, who supplied the funding, were frequently institutional investors such as insurance companies, endowment funds, bank trust departments, pension funds, and wealthy individuals and families . There are over 900 of this type of venture-capital estab- lishment in the United States.

Another type of venture-capital firm was also developed during this time: the venture- capital division of major corporations. These firms, of which there are approximately 100, are usually associated with banks and insurance companies, although companies such as 3M, Monsanto, Xerox, Intel, and Unilever house such firms as well. Corporate venture- capital firms are more prone to invest in windows on technology or new market acquisi- tions than are private venture-capital firms or SBICs. Some of these corporate venture- capital firms have not had strong results .

In response to the need for economic development, a fourth type of venture-capital firm has emerged in the form of the state -sponsored venture-capital fund . These state- sponsored funds have a variety of formats. While the size and investment focus and industry orientation vary from state to state, each fund typically is required to invest a certain per- centage of its capital in the particular state. Generally, the funds that are professionally managed by the private sector, outside the state's bureaucracy and political processes, have performed better.

An overview of the types of venture-capital firms is indicated in Figure 12.1. Besides the four types previously discussed, there are now emerging university-sponsored venture-capital

FIGURE 12.1 Types of Venture-Capital Firms

I Types of venture-capital firms

I I I I Industry

Private venture- Small-business

sponsored: capital firms • Banks and State/

(general partners investment other financial government University

and limited company institutions sponsored sponsored

partners) (SBIC) • Nonfinancial

companies

356 l 1 Entrepreneurship

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344 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

TABLE 12.3 Total Venture Dollars Invested and Number of Deals

Year Total #of Deals --

1995 $ 7,879,331,900 1,773

1996 11,014,332,900 2,47 1

1997 14,612,026,900 3,084

1998 20,810,583,100 3,553

1999 53,475,711,500 5,396

2000 104,700,717,300 7,809

2001 40,703,455,300 4,456

2002 21,697,809,100 3,057

2003 19,585,475,700 2,865

2004 21,635,323,900 2,966

2005 23,173,465,300 3,155

2006 26,740,603,400 3,675

2007 30,885,861' 100 3,952

2008 28,298,040,600 3,808

Source: PricewaterhouseCoopersfThomson Venture Economics/National Venture Capital Association Money TreeTM Survey.

funds . These funds, usually managed as separate entities, invest in the technology of the par- ticular university. At such schools as Stanford, Columbia, and 'MIT, students assist professors and other students in creating business plans for funding as well as assisting the fund manager in his or her due diligence, thereby learning more about the venture-funding process.

The venture-capital industry has not returned to the highest level of dollars investei in 1999, 2000, and 2001. While the total amount of venture-capital dollars invested in- creased steadily from $7 .8 billion in 1995 to a high of $104.7 billion in 200C (see Table 12.3), 11 the total dollars invested declined to $40.7 billion in 2001, $21.7 bil- lion in 2002, and $19.6 billion in 2003. There was a slight increase to $21.6 billion i1: 2004 and $21 .7 billion in 2005. The total amount invested increased again in 2006 ($26.7 billion) and 2007 ($30.9 billion) before declining with the economic downturn to $28 .3 billion in 2008 .

The total amount of venture-capital dollars invested, disseminated across the number o'" deals, is indicated in column 3 of Table 12.3. The number of venture-capital deals went from 1,773 in 1995 to a high of 7,809 in 2000. In 2003, 2004, and 2005, the number of deals stayed fairly steady, at 2,865, 2,966, and 2,939, respectively. The number of deals increased in 2006 (3,675) and again in 2007 (3,952) before declining in 2008 to 3,808 deals.

These deals concentrated in three primary areas in 2008: software- $4,919 million (17 percent), industrial/energy- $4,651 million (16 percent), and biotechnology-$4,500 mil- lion (16 percent). This investment has significantly impacted the growth and developmen: of these three industry sectors. As indicated in Figure 12.2, other industry areas receiving venture-capital investment include the following: medical devices and equipment- $3,460 million (12 percent), media and entertainment- $2,039 million (7 percent), IT services-$1,832 million (6 percent), telecommunications- $1,688 million (6 percent). and semiconductors- $1,651 million (6 percent).

At what stage of the business development is this money invested? The percentage o venture-capital money raised by stage of the venture in 2008 is indicated in Figure 12. 3.

Entrepreneurship, Eighth Edition

FIGURE 12.2 Percentage of Venture Dollars Invested in 2008 by Industry Sector

Industrial/energy, 16.44%

Software, 17.38%

Health care services, 0.69%

Retailing/distribution, 0.95%

Computers and peripherals, 1 .45%

Consumer products and services, 1.54% Business products and

services, 1.70%

Biotechnology, 15.90%

Medical device and equ ipment, 12.23%

Media and entertainment, 7.21%

IT services, 6.47%

Telecommunications, 5.97%

Semiconductors, 5.83%

Networking and equipment, 2.28%

Electronics/instrumentation, 2.02%

Financial services, 1.89%

Numbers rounded to the nearest whole percent.

Source: PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association Money TreeTM Survey.

FIGURE 12.3 Percentage of Venture Dollars Raised by Stage in 2008

Later stage 38%

Start -up/seed 5%

Expansion 38%

Source: PricewaterhouseCoopers!Ibomson Venture Economics/National Venture Capital Association Money TreeTM Survey.

357 -- --·~

358 L Eotrepre"'""h;p ____ .............. '-"··----·~1 ----·--·------- ------- ·- ---------- --- - ----- -·-- --- -------- --- - ---- --------- ------ -- ------ - 346 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

I TABLE 12.4 Venture Investment Stages Stage

Year Start-Up/Seed Early Stage Expansion Later Stage Total

1995 $ 1,704,471,700 $ 2,541,970,600 $ 1,712,698,300 $ 2,036,641,700 $ 7 ,995, 782,300 21 .32% 31.79% 21.42% 25.47% 100.00%

1996 $ 2,412,661,100 $ 3,106,571,800 $ 2,555, 789,700 $ 3,190,091,200 $ 11,265,113,800 21.42% 27 .58% 22.69% 28.32% 100.00%

1997 $ 3,047,368,500 $ 3,674,240,600 $ 3,669,504, 700 $ 4,479,777,100 $ 14,870,890,900 20.49% 24.71% 24.68% 30.12% 100.00%

1998 $ 4,113,597,500 $ 5,652,693,500 $ 5,321,257,600 $ 5,991,717,200 $ 21,079,265,800 19.51% 26.82% 25.24% 28.42% 100.00%

1999 $ 6,605,334,400 $ 10,993,285,200 $ 13,130,681,200 $23,318,742,800 $ 54,048,043,600 12.22% 20.34% 24.29% 43.14% 100.00%

2000 $ 3,223,304,800 $ 25,406,580,700 $59,710,151,000 $ 16,427,731,000 $ 104,767,767,500 3.08% 24.25% 56.99% 15.68% 100.00%

2001 $ 778,015,300 $ 8,602,168,900 $ 23,008,875,900 $ 8,188,266,600 $ 40,577,326,700 1.92% 21.20% 56.70% 20.18% 100.00%

2002 $ 335,810,200 $ 3,835,17 5,200 $ 12,434,571,800 $ 5,404,111,000 $ 22,009,668,200 1.53% 17.42% 56.50% 24.55% 100.00%

2003 $ 347,769,000 $ 3, 559,772,100 $ 10,1 00,836,400 $ 5,768,505,400 $ 19,776,882,900 1.76% 18.00% 51.07% 29.17% 100.00%

2004 $ 470,124,200 $ 4,011,236,300 $ 9,165,044,300 $ 8,821,753,200 $ 22,468,158,000 2.09% 17.85% 40.79% 39.26% 100.00%

2005 $ 897,707,300 $ 3,819,745,600 $ 8,663,870,300 $ 9,792, 142,100 $ 23,173,465,300 3.87% 16.48% 37.39% 42.26% 100.00%

2006 $1,177,319,200 $ 4,172,001,400 $ 11,521,031,400 $ 9,870,251,400 $ 26,740,603,400 4.40% 15.60% 43.08% 36.91% 100.00%

2007 $ 1,267,968,200 $ 5,486, 760,800 $11,677,215,200 $ 12,453,916,900 $ 30,885,861 '1 00 4.11% 17.76% 37.81% 40.32% 100.00%

2008 $ 1,509,963,800 $ 5,339,272,800 $ 10,604,468,700 $ 10,844,335,300 $ 28,298,040,600 5.34% 18.87% 37.47% 38.32% 100.00%

Source: PricewaterbouseCoopers!Thomson Venture Economics/National Venture Capital Association Money TreeTM Survey.

The largest amount of money raised was for later-stage and expansion-stage investments (38 percent), followed by early-stage (19 percent), and start-up/seed stage (5 percent). Tra- ditionally the largest amount of money raised is for. expansion-stage investment. In 2002, for example, 57 percent of the venture money raised was for expansion, followed by early stage (23 percent), later stage (18 percent), and start-up (2 percent).

The money invested by stage and year from 1995 to 2008 is broken down in Table 12.4. Venture-capital money invested at the start-up/seed stage (for seed capital) went from $1,704 million in 1995 to a high of $6,605 million in 1999, before declining to a low of $335 million in 2002. The amount invested in this early-stage area increased to $1,268 million in 2007 and again to $1,510 million in 2008. Venture capitalists in 2008 showed a significant interest in funding start-up/seed capital deals, despite the economic downturn.

Where do these deals take place? Table 12.5 shows the amount of money invested in 2008 ($28 .2 billion) by region of the country. It should come as no surprise that the areas receiving the largest amount of venture capital were the Silicon Valley-$1 11 . 7 billion in

nture-capital process

-:be decision procedure of _ venture-capital firm

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 347

TABLE 12.5 Venture-Capital Investments by Region (2008)

Region # of Companies % S Invested (in millions) %

Silicon Valley 1,170 30.72% $10,980 38.80%

New England 460 12.08 $ 3,260 11.52

LA/Orange County 237 6.22 $ 1,994 7.05

NY Metro 308 8.09 $ 1,879 6.64

Midwest 267 7.01 $ 1,348 4.76

Texas 146 3.83 $ 1,283 4.53

Southeast 207 5.44 $ 1,240 4.38

San Diego 126 3.31 $ 1,217 4.30

Northwest 208 5.46 $ 1,160 4.10

DC/Metroplex 190 4 .99 $ 1,015 3.59

Colorado 100 2.63 $ 813 2.87

Philadelphia Metro 140 3.68 $ 750 2.65

North Central 77 2.02 $ 623 2.20

Southwest 78 2.05 $ 484 1.71

Upstate NY 29 0.76 $ 88 0.31

Sacramento/N.Cal 19 0 .50 $ 73 0.26

South Central 38 1.00 $ 71 0.25

AK/HI/PR 8 0.21 $ 21 0.07 --- Grand Total 3,808 100.0 % $28,299 100.0 %

Source: PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association Money TreeTM Survey.

1,170 companies (31 percent), and New England-$3.3 billion in 460 companies (12 per- cent). Other areas receiving funding were metro New York- $1.9 billion in 308 companies (8 percent), Los Angeles/ Orange County-$1.9 billion in 237 companies (6 percent), and the Midwest- $1.3 billion in 267 companies (7 percent).

Venture-Capital Process

To be in a position to secure the funds needed, an entrepreneur must understand the philos- ophy and objectives of a venture-capital firm, as well as the venture -capital process. The objective of a venture-capital firm is to generate long-term capital appreciation through debt and equity investments. To achieve this objective, the venture capitalist is willing to make any changes or modifications necessary in the business investment. Since the objec- tive of the entrepreneur is the survival of the business, the objectives of the two are fre- quently at odds, particularly when problems occur.

A typical portfolio objective of venture-capital firms in terms of return criteria and risk involved is shown in Figure 12.4. Since there is more risk involved in financing a business earlier in its development, more return is expected from early-stage financing (50 percent ROI) than from acquisitions or leveraged buyouts (30 percent ROI), which are later stages of development. The significant risk involved and the pressure that venture-capital firms feel from their investors (limited partners) to make safer investments with higher rates of return have caused these firms to invest even greater amounts of their funds in later stages

360 I '"'""""'"""" ---------·--· -t---------- ----·--- ----~--- ---------------------------·--

348 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

FIGURE 12.4 Venture-Capital Financing: Risk and Return Criteria

Highest risk Lowest risk

Highest return expected

Development Acquisitions and Early stage financing leveraged buyouts

50% ROI

40% ROI

30% ROI

Lowest return expected

Source: © 1992, American Economic Development Council (AEDC). All rights reserved. Reprinted from the Economic Development Review, vol. 10, no. 2, Spring 1992, p. 44, with the permission of AEDC.

of financing. In these late-stage investments, there are lower risks, faster returns, less man- agerial assistance needed, and fewer deals to be evaluated.

The venture capitalist does not necessarily seek control of a company, but would rathe:- have the finn and the entrepreneur at the most risk. The venture capitalist will want at lea54 one seat on the board of directors. Once the decision to invest is made, the venture capital- ist will do anything necessary to support the management team so that the busilless and the illvestment prosper. Whereas the venture capitalist expects to provide guidance as a mem- ber of the board of directors, the management team is expected to direct and run the dail. operations of the company. A venture capitalist will support the management team with ill- vestment dollars, financial skills, plannillg, and expertise ill any area needed.

Sillce the venture capitalist provides long-term investment (typically five years or more . it is important that there be mutual trust and understanding between the entrepreneur an1 the venture capitalist. There should be no surprises in the firm's performance. Both gooC. and bad news should be shared, with the objective of taking the necessary action to allo the company to grow and develop ill the long run. The venture capitalist should be available to the entrepreneur to discuss problems and develop strategic plans.

The venture capitalist expects a company to satisfy three general criteria before he o: she will commit to the venture. First, the company must have a strong management tean: that consists of individuals with solid experience and backgrounds, a strong commitmem to the company, capabilities in their specific areas of expertise, the ability to meet chal- lenges , and the flexibility to scramble wherever necessary. A venture capitalist woul rather invest in a first-rate management team and a second-rate product than the reverse. The management team's commitment should be reflected in dollars invested in the com- pany. Although the amount of the illvestment is important, more telling is the size of this investment relative to the management team's ability to invest. The commitment of the management team should be backed by the support of the family, particularly the spouse. of each key team player. A positive family environment and spousal support allow tean: members to spend the 60 to 70 hours per week necessary to start and grow the company.

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CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 349

One successful venture capitalist makes it a point to have dinner with the entrepreneur and spouse, and even to visit the entrepreneur's home, before making an investment decision. According to the venture capitalist, "I find it difficult to believe an entrepreneur can suc- cessfully run and manage a business and put in the necessary time when the home envi- ronment is out of control."

The second criterion is that the product and/or market opportunity must be unique, hav- ing a differential advantage in a growing market. Securing a unique market niche is essen- tial since the product or service must be able to compete and grow during the investment period. This uniqueness needs to be carefully spelled out in the marketing portion of the business plan and is even better when it is protected by a patent or a trade secret.

The final criterion for investment is that the business opportunity must have significant capital appreciation. The exact amount of capital appreciation varies, depending on such factors as the size of the deal, the stage of development of the company, the upside poten- tial, the downside risks, and the available exits. The venture capitalist typically expects a 40 to 60 percent return on investment in most investment situations.

The venture-capital process that implements these criteria is both an art and a science. 12

The element of art is illustrated in the venture capitalist's intuition, gut feeling, and creative thinking that guide the process. The process is scientific due to the systematic approach and data-gathering techniques involved in the assessment.

The process starts with the venture-capital firm establishing its philosophy and invest- ment objectives . The firm must decide on the following: the composition of its portfolio mix, including the number of start-ups, expansion companies, and management buyouts; the types of industries; the geographic region for investment; and any product or industry specializations.

The venture-capital process can be broken down into four primary stages: preliminary -;ary screening screening, agreement on principal terms, due diligence, and final approval. The preliminary ~uation of a deal screening begins with the receipt of the business plan. A good business plan is essential in

the venture-capital process. Most venture capitalists will not even talk to an entrepreneur who doesn't have one. As the starting point, the business plan must have a clear-cut mission and clearly stated objectives that are supported by an in-depth industry and market analy- sis and pro forma income statements. The executive summary is an important part of this business plan, as it is used for initial screening in this preliminary evaluation. Many business plans are never evaluated beyond the executive summary. When evaluating the business, the venture capitalist first determines if the deal or similar deals have been seen previously. The investor then determines if the proposal fits his or her long-term policy and short-term needs in developing a portfolio balance. In this preliminary screening, the ven- ture capitalist investigates the economy of the industry and evaluates whether he or she has the appropriate knowledge and ability to invest in that industry. The investor reviews the numbers presented to determine whether the business can reasonably deliver the ROI re- quired. In addition, the credentials and capability of the management team are evaluated to determine if they can carry out the plan presented.

The second stage is the agreement on principal terms between the entrepreneur and the venture capitalist. The venture capitalist wants a basic understanding of the principal terms of the deal at this stage of the process before making the major commitment of time and ef- fort involved in the formal due diligence process.

e The The third stage, detailed review and due diligence, is the longest stage, involving any- -= deal evaluation where from one to three months. There is a detailed review of the company's history, the

business plan, the resumes of the individuals, their financial history, and target market cus- tomers. The upside potential and downside risks are assessed, and there is a thorough eval- uation of the markets, industry, finances, suppliers, customers, and management.

362 I Entrepreneurship

350 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

final approval A

document showing the

final terms of the deal

In the last stage, final approval, a comprehensive, internal investment memoran prepared. This document reviews the venture capitalist's findings and details the invest:n::.:::..: terms and conditions of the investment transaction. This information is used to prepare - formal legal documents that both the entrepreneur and venture capitalist will sign to ize the deal. 13

Locating Venture Capitalists One of the most important decisions for the entrepreneur lies in selecting which ven capital firm to approach. Since venture capitalists tend to specialize either geographi by industry (manufacturing industrial products or consumer products, high technol..,.~ or service) or by size and type of investment, the entrepreneur should approach , those that may have an interest in the investment opportunity. Where do you find -- venture capitalist?

Although venture capitalists are located throughout the United States, the traditiona: "--- eas of concentration are found in Los Angeles, New York, Chicago, Boston, and Francisco . Most venture capital firms belong to the National Venture Capital Associ: and are listed on its Web site (www.nvca.org). An entrepreneur should carefully res the names and addresses of prospective venture-capital firms that might have an intere& the particular investment opportunity. There are also regional and national venture-c · associations. For a nominal fee or none at all, these associations will frequently send - entrepreneur a directory that lists their members, the types of businesses their meml invest in, and any investment restrictions. Whenever possible, the entrepreneur shoul introduced to the venture capitalist. Bankers, accountants, lawyers, and professors are"' sources for introductions.

Approaching a Venture Capitalist The entrepreneur should approach a venture capitalist in a professional business mann.~ Since venture capitalists receive hundreds of inquiries and are frequently out of the o working with portfolio companies or investigating potential investment opportunities, · important to begin the relationship positively. The entrepreneur should call any poteru venture capitalist to ensure that the business is in an area of investment interest. Then -"- business plan should be sent, accompanied by a short professional letter.

Since venture capitalists receive many more plans than they are capable of fund.iL_ many plans are screened out as soon as possible. Venture capitalists tend to focus and more time and effort on those plans that are referred. In fact, one venture-capital group that 80 percent of its investments over the last five years were in referred companies. Co=: sequently, it is well worth the entrepreneur's time to seek out an introduction to the venn::::' capitalist. Typically this can be obtained from an executive of a portfolio company, an countant, a lawyer, a banker, or a business school professor.

The entrepreneur should be aware of some basic rules of thumb before implementi:..~ the actual approach and should follow the detailed guidelines presented in Table 12.6. Fi great care should be taken in selecting the right venture capitalist to approach. Venture ~­ italists tend to specialize in certain industries and will rarely invest in a business outsi~ those areas, regardless of the merits of the business proposal and plan. Second, recogn.i=;: that venture capitalists know each other, particularly in a specific region of the coun _ When a large amount of money is involved, they will invest in the deal together, with o- venture-capital firm taking the lead. Since this degree of familiarity is present, a ventu..--=- capital firm will probably find out if others have seen your business plan. Do not s

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CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 351

TABLE 12.6 Guidelines for Dealing with Venture Capitalists

• Carefully determine the venture capitalist to approach for funding the particular type of deal. Screen and target the approach. Venture capitalists do not like deals that have been excessively "shopped."

• Once a discussion is started with a venture capitalist, do not discuss the deal with other venture capitalists. Working several deals in parallel can create problems unless the venture capitalists are working together. Time and resource limitations may require a cautious simultaneous approach to several funding sources.

• It is better to approach a venture capitalist through an intermediary who is respected and has a preexisting relationship with the venture capitalist. Limit and carefully define the role and compensation of the intermediary.

• The entrepreneur or manager, not an intermediary, should lead the discussions with the venture capitalist. Do not bring a lawyer, accountant, or other advisors to the first meeting. Since there are no negotiations during this first meeting, it is a chance for the venture capitalist to get to know the entrepreneur without interference from others.

• Be very careful about what is projected or promised. The entrepreneur will probably be held accountable for these projections in the pricing, deal structure, or compensation.

• Disclose any significant problems or negative situations in this initial meeting. Trust is a fundamental part of the long-term relationship with the venture capitalist; subsequent discovery by the venture capitalist of an undisclosed problem will cause a loss of confidence and probably prevent a deal.

• Reach a flexible, reasonable understanding with the venture capitalist regarding the timing of a response to the proposal and the accomplishment of the various steps in the financing transaction. Patience is needed, as the process is complex and time consuming. Too much pressure for a rapid decision can cause problems w ith the venture capitalist.

• Do not sell the project on the basis that other venture capitalists have committed them- selves. Most venture capitalists are independent and take pride in their own decision making.

• Be careful about glib statements such as, "There is no competition for this product" or "There is nothing like this technology available today." These statements can reveal a failure to do one's homework or can indicate that a perfect product has been designed for a nonexistent market.

• Do not indicate an inordinate concern for salary, benefits, or other forms of current compensation. Dollars are precious in a new venture. The venture capitalist wants the entrepreneur committed to an equity appreciation similar to that of the venture capitalist.

• Eliminate to the extent possible any use of new dollars to take care of past problems, such as payment of past debts or deferred salaries of management. New dollars of the venture capitalist are for growth, to move the business forward.

I

among venture capitalists, as even a good business plan can quickly become "shopworn." Thlrd, when meeting the venture capitalist, particularly for the first time, bring only one or two key members of the management team. A venture capitalist is investing in you and your management team and its track record, not in outside consultants and experts. Any experts can be called in as needed.

Finally, be sure to develop a succinct, well-thought-out oral presentation. This should cover the company's business, the uniqueness of the product or service, the prospects for growth, the major factors behind achieving the sales and profits indicated, the backgrounds and track records of the key managers, the amount of financing required, and the returns anticipated. This first presentation is critical, as is indicated in the comment of one venture capitalist: "I need to sense a competency, a capability, a chemistry within the first half hour

__ 1 6'!. -1 Entrepreneurship

352 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

factors in valuation

Nonmonetary aspects that

affect the fund valuation

of a company

of our initial meeting. The entrepreneur needs to look me in the eye and present his story clearly and logically. If a chemistry does not start to develop, I start looking for reasons not to do the deal."

Following a favorable initial meeting, the venture capitalist will do some preliminary in- vestigation of the plan. If favorable, another meeting between the management team and the venture capitalist will be scheduled so that both parties can assess the other and deter- mine if a good working relationship can be established and if a feeling of trust and confi- dence is evolving. During this mutual evaluation, the entrepreneur should be careful not to be too inflexible about the amount of company equity he or she is willing to share. If the entrepreneur is too inflexible, the venture capitalist might end negotiations. During this meeting, initial agreement of terms is established. If you are turned down by one venture capitalist, do not become discouraged. Instead, select several other nonrelated venture- capitalist candidates and repeat the procedure. A significant number of companies denied funding by one venture capitalist are able to obtain funds from other outside sources, including other venture capitalists.

VALUING YOUR COMPANY A problem confronting the entrepreneur in obtaining outside equity funds, whether from the informal investor market (the angels) or from the formal venture-capital industry, is de- termining the value of the company. This valuation is at the core of determining how much ownership an investor is entitled to for funding the venture. This is determined by consid- ering the factors in valuation. This, as well as other aspects of securing funding, has a po- tential for ethical conflict that must be carefully handled.

Factors in Valuation There are eight factors that, although they vary by situation, the entrepreneur should con- sider when valuing the venture. The first factor, and the starting point in any valuation, is the nature and history of the business. The characteristics of the venture and the industry in which it operates are fundamental to every evaluation process. The history of the company from its inception provides information on the strength and diversity of the company's op- erations, the risks involved, and the company's ability to withstand any adverse conditions.

The valuation process must also consider the outlook of the economy in general as well as the outlook for the particular industry. This, the second factor, involves an examination of the financial data of the venture compared with those of other companies in the industry. Management's capability now and in the future is assessed, as well as the future market for the company's products. Will these markets grow, decline, or stabilize, and in what eco- nomic conditions?

The third factor is the book value (net value) of the stock of the company and the over- all financial condition of the business . The book value (often called owner's equity) is the acquisition cost (less accumulated depreciation) minus liabilities. Frequently, the book value is not a good indication of fair market value, as balance sheet items are almost always carried at cost, not market value. The value of plant and equipment, for example, carried on the books at cost less depreciation may be low due to the use of an accelerated depreciation method or other market factors, making the assets more valuable than indicated in the book value figures. Land, particularly, is usually reflected lower than fair market value. For val- uation, the balance sheet must be adjusted to reflect the higher values of the assets, partic- ularly land, so that a more realistic company worth is determined. A good valuation should also value operating and nonoperating assets separately and then combine the two into the

'"'""""'"""'•· Eigh<h Editioo I 365 ---~----~~ ·-· -------- -------------------------------------------- --- ------------------ ---- ------· --- -·- -- -- - --~--------

financial ratios

Control mechanisms to

test the financial strength

of the new venture

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 353

total fair market value. A thorough valuation involves comparing balance sheets and profit and loss statements for the past three years when available.

While book value develops the benchmark, the future earning capacity of the company, the fourth factor, is the most important factor in valuation. Previous years' earnings are gen- erally not simply averaged but weighted, with the most recent earnings receiving the high- est weighting. Income by product line should be analyzed to judge future profitability and value. Special attention should be paid to depreciation, nonrecurring expense, officers' salaries, rental expense, and historical trends.

The fifth valuation factor is the dividend-paying capacity of the venture. Since the entre- preneur in a new venture typically pays little if any in dividends, it is the future capacity to pay dividends rather than actual dividend payments made that is important. The dividend- paying capacity should be capitalized.

An assessment of goodwill and other intangibles of the venture is the sixth valuation factor. These intangible assets usually cannot be valued without reference to the tangible assets of the venture.

The seventh factor in valuation involves assessing any previous sale of stock. Previous stock sales accurately represent future sales if the stock sales are recent. Motives regarding the new sale (if other than arriving at a fair price) and any change in economic or fmancial conditions during the intermittent period should be considered.

The final valuation factor is the market price of the stocks of companies engaged in the same or similar lines of business. This factor is used in the specific valuation method dis- cussed later in this section. The critical issue is the degree of similarity between the pub- licly traded company and the company being valued.

Ratio Analysis Calculations of .financial ratios can also be extremely valuable as an analytical and control mechanism to test the financial well-being of a new venture during its early stages. These ratios serve as a measure of the financial strengths and weaknesses of the venture, but should be used with caution since they are only one control measure for interpreting the fi- nancial success of the venture. There is no single set of ratios that must be used, nor are there standard definitions for all ratios. However, there are industry rules of thumb that the entrepreneur can use to interpret the financial data. Ratio analysis is typically used on actual financial results but can also provide the entrepreneur with some sense of where problems exist in the pro forma statements as well. Throughout this section we will use information taken from the financial statements ofMPP Plastics (Chapter 10) to illustrate.

Liquidity Ratios Current Ratio This ratio is commonly used to measure the short-term solvency of the venture or its ability to meet its short-term debts. The current liabilities must be covered from cash or its equivalent; otherwise the entrepreneur will need to borrow money to meet these obligations. The formula and calculation of this ratio when current assets are $108,050 and current liabilities are $40,500 is:

Current assets = 108,050 = 2

. 67

times Current liabilities 40,500

While a ratio of 2:1 is generally considered favorable, the entrepreneur should also com- pare this ratio with any industry standards. One interpretation of this result is that for every dollar of current debt, the company has $2.67 of current assets to cover it. This ratio

I 366 I Entrepreneurship

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354 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

indicates that MPP Plastics is liquid and can likely meet any of its obligations even if there were a sudden emergency that would drain existing cash.

Acid Test Ratio This is a more rigorous test of the short-term liquidity of the venture be- cause it eliminates inventory, which is the least liquid current asset. The formula given the same current assets and liabilities and inventory of $10,450 is:

Current assets - Inventory 108,050 - 10,450 ----------=-- = = 2.40 times

Current liabilities 40,500

The result from this ratio suggests that the venture is very liquid since it has assets con- vertible to cash of $2.40 for every dollar of short-term obligations. Usually a 1:1 ratio would be considered favorable in most industries.

Activity Ratios

Average Collection Period This ratio indicates the average number of days it takes to convert accounts receivable into cash. This ratio helps the entrepreneur to gauge the liquid- ity of accounts receivable or the ability of the venture to collect from its customers. Using the formula with accounts receivable of $46,400 and sales of $995,000 results in:

Accounts receivable

Average daily sales

46,000 995,000/360 = 17 days

This particular result needs to be compared with industry standards since collection will vary considerably. However, if the invoices indicate a 20-day payment required, then one could conclude that most customers pay on time.

Inventory Turnover This ratio measures the efficiency of the venture in managing and selling its inventory. A high turnover is a favorable sign indicating that the venture is able to sell its inventory quickly. There could be a danger with a very high turnover that the venture is understocked, which could result in lost orders . Managing inventory is very im- portant to the cash flow and profitability of a new venture. The calculation of this ratio when the cost of goods sold is $645,000 and the inventory is $10,450 is:

Cost of goods sold 645,000 - ----='----- = = 61.7 times

Inventory 10,450

This would appear to be an excellent turnover as long as the entrepreneur feels that he or she is not losing sales because of understacking inventory.

Leverage Ratios

Debt Ratio Many new ventures will incur debt as a means of financing the start-up. The debt ratio helps the entrepreneur to assess the firm's ability to meet all its obligations (short and long term) . It is also a measure of risk because debt also consists of a fixed commit- ment in the form of interest and principal repayments. With total liabilities of $249,700 and total assets of $308,450, the debt ratio is calculated as:

Totalliabilities 249,700 at ------ = = 81-;o Total assets 308,450

This result indicates that the venture has financed about 81 percent of its assets with debt. On paper this looks very reasonable, but it would also need to be compared with industry data.

roaches Methods

- determining the worth

a company

Ent repreneu rship, Eighth Edition 367

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 355

Debt to Equity This ratio assesses the firm's capital structure. It provides a measure of risk to creditors by considering the funds invested by creditors (debt) and investors (equity). The higher the percentage of debt, the greater the degree of risk to any of the creditors. The calculation of this ratio using the same total liabilities, with stockholder's equity being $58,750, is:

Total liabilities 249,700

58 , 750

= 4.25 times Stockholder's equity

This result indicates that this venture has been financed mostly from debt. The actual in- vestment of the entrepreneurs or the equity base is about one-fourth of what is owed. Thus, the equity portion represents a cushion to the creditors. For MPP Plastics this is not a seri- ous problem because of its short-term cash position.

Profitability Ratios Net Profit Margin This ratio represents the venture's ability to translate sales into prof- its. You can also use gross profit instead of net profit to provide another measure of prof- itability. In either case it is important to know what is reasonable in your industry as well as to measure these ratios over time. The ratio and calculation when net profit is $8,750 and net sales are $995,000 is:

Net profit 8,750 --=-- = = 0.88% Net sales 995,000

The net profit margin for MPP Plastics, although low for an established firm, would not be of great concern for a new venture. Many new ventures do not incur profits until the sec- ond or third year. In this case we have a favorable profit situation.

Return on Investment The return on investment measures the ability of the venture to manage its total investment in assets. You can also calculate a return on equity, which sub- stitutes stockholders' equity for total assets in the following formula and indicates the abil- ity of the venture in generating a return to the stockholders. The formula and calculation of the return on investment when total assets are $200,400 and net profit is $8,750 is:

Net profit 8,750 - '--= 4.4%

Total assets 200,400

The result of this calculation will also need to be compared with industry data. However, the positive conclusion is that the firm has earned a profit in its first year and has returned 4.4 percent on its asset investment.

There are many other ratios that could also be calculated. However, for a start-up these would probably suffice for an entrepreneur in assessing the venture's financial strengths and weaknesses. As the firm grows, it will be important to use these ratios in conjunction with all other financial statements to provide an understanding of how the firm is perform- ing financially.

General Valuation Approaches There are several general valuation approaches that can be used in valuing the venture. One of the most widely used approaches assesses comparable publicly held companies and the prices of these companies' securities. This search for a similar company is both an art and a science. First, the company must be classified in a certain industry, since

368 I '"'"'""'"""'' --....l..-.·--""---......__j_ -- ---·------· --- - -- ·-----···-~----·-·------·--·--·----• ------ ·-----·-·-R ____ _

356 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

present value of future

cash flow Valuing a

company based on its

future sales and profits

replacement valr1e The

cost of replacing all

assets of a company

book value The

indicated worth of the

assets of a company

earnings approach

Determining the worth of

a company by looking at

its present and future

earnings

factor approach Using

the major aspects of a

company to determine its

worth

companies in the same industry share similar markets, problems, economies, and pote::- tial of sales and earnings. The review of all publicly traded companies in this indust:r; classification should evaluate size, amount of diversity, dividends, leverage, and grov.-~ potential until the most similar company is identified. This method is inaccurate when _ truly comparable company is not found.

A second widely used valuation approach is the present value of future cash flow . This method adjusts the value of the cash flow of the business for the time value of money an1 the business and economic risks. Since only cash (or cash equivalents) can be used ;_ reinvestment, this valuation approach generally gives more accurate results than profi~. With this method, the sales and earnings are projected back to the time of the valuatio:r: decision when shares of the company are offered for sale. The period between the valu- ation and sale dates is determined, and the potential dividend payout and expecteC. price-earnings ratio or liquidation value at the end of the period are calculated. Finally, rate of return desired by investors is established, less a discount rate for failure to mee· those expectations.

Another valuation method, used only for insurance purposes or in very unique circum- stances, is known as replacement value. This method is used when, for example, there is a unique asset involved that the buyer really wants. The valuation of the venture is based o the amount of money it would take to replace (or reproduce) that asset or another importanl asset or system of the venture.

The book value approach uses the adjusted book value, or net tangible asset value, to de- termine the firm's worth. Adjusted book value is obtained by making the necessary adjust- ments to the stated book value by taking into account any depreciation (or appreciation) of plant and equipment and real estate, as well as necessary inventory adjustments that result from the accounting methods employed. The following basic procedure can be used:

Book value $ ___ _

Add (or subtract) any adjustments such as appreciation or depreciation to arrive at figure on next line-the fair market value $ ___ _

Fair market value (the sale value of the company's assets) $. ___ _

Subtract all intangibles that cannot be sold, such as goodwill $ ___ _

Adjusted book value $

Since the book valuation approach involves simple calculations, its use is particularly good in relatively new businesses, in businesses where the sole owner has died or is disabled, and in businesses with speculative or highly unstable earnings.

The earnings approach is the most widely used method of valuing a company since it provides the potential investor with the best estimate of the probable return on investment. The potential earnings are calculated by weighting the most recent operating year's earn- ings after they have been adjusted for any extraordinary expenses that would not have normally occurred in the operations of a publicly traded company. An appropriate price- earnings multiple is then selected based on norms of the industry and the investment risk. A higher multiple will be used for a high-risk business and a lower multiple for a low-risk business. For example, a low-risk business in an industry with a seven-times-earnings mul- tiple would be valued at $4.2 million if the weighted average earnings over the past three years were $0.6 million (7 X $0.6 million).

An extension of this method is the factor approach, wherein the following three major factors are used to determine value: earnings, dividend-paying capacity, and book value.

I Entrepreneurship, Eighth Edition I

~--- --···---·--· ·-·. --·--- -----·-· ·-t 369

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 357

Appropriate weights for the particular company being valued are developed and multi- plied by the capitalized value, resulting in an overall weighted valuation. An example is indicated here:

Approach (in OOOs)

Earnings: $40 x 10

Dividends: $15 X 20

Book value: $600 x 0.4

Average: $328

10% discount: $33

Per-share value: $295

Capitalized Value

$400

$300

$240

Weight Weighted Value

0.4 $160

0.4 $120

0.2 $ 48

/Ujuidatiou value Worth A final valuation approach that gives the lowest value of the business is liquidation value. of a company if Liquidation value is often difficult to obtain, particularly when costs and losses must be es- everything was sold today timated for selling the inventory, terminating employees, collecting accounts receivable,

selling assets, and performing other closing-down activities. Nevertheless, it is also good for an investor to obtain a downside risk value in appraising a company.

General Valuation Method One approach an entrepreneur can use to determine how much of the company a venture capitalist will want for a given amount of investment is indicated here:

Venture-capitalist _ VC $investment X VC investment multiple desired ownership (%) - Company's projected profits in year 5 X Price-earnings multiple

Consider the following example:

A company needs $500,000 of venture-capital money.

The company is anticipating profits of $650,000.

The venture capitalist wants an investment multiple of 5 times.

The price-earnings multiple of a similar company is 12.

of comparable company

According to the following calculations, the company would have to give up 32 percent ownership to obtain the needed funds:

$500,000 X 5 $650,000 X 12 = 32 %

A more accurate method for determining this percentage is given in Table 12.7. The step- by-step approach takes into account the time value of money in determining the appropri- ate investor's share. The following hypothetical example uses this step-by-step procedure. H&B Associates, a start-up manufacturing company, estimates it will earn $1 million after taxes on sales of $10 million. The company needs $800,000 now to reach that goal in five years. A similar company in the same industry is selling at 15 times earnings. A venture- capital firm, Davis Venture Partners, is interested in investing in the deal and requires a

370 I ''"'preoooohip -- --~ +--- -- --- . --· ···-

358 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

TABLE 12.7 Steps in Valuing Your Business and Determining Investors' Share

1. Estimate the earnings after taxes based on sales in the fifth year.

2. Determine an appropriate earnings multiple based on what simi lar companies are selling for in terms of their current earnings.

3. Determine the required rate of return.

4. Determine the funding needed.

5. Calculate, using the following formulas:

Present value = Future valuation (1 +it

where:

Future valuat ion = Total estimated value of company in 5 years

i = Required rate of return

n = Number of years

Initial funding Investors' share = p

1 resent va ue

50 percent compound rate of return on investment. What percentage of the company will have to be given up to obtain the needed capital?

$1,000,000 X 15 times earning multiple Present value = ) 5 (1 + 0 .50

= $1,975 ,000 $800,000 .

$ = 41% will have to be giVen up

1,975,000

Evaluation of an Internet Company The valuation process for early-stage Internet companies is quite different from the tradi- tional valuation process. Traditionally, private-equity companies would examine historical financials and operations as part of a very quantitative process using such things as dis- counted cash flow (DCF), comparables, and/or multiples of EBITDA (earnings before in- terest, taxes, depreciation, and amortization). Following this, the culture and management are examined in a more qualitative way. When institutional investors focus on earlier-stage companies-in particular Internet companies that have little or no history, no historical financials, and no comparables-a different approach has to be taken in the valuation process.

For these companies, the qualitative portion of due diligence carries much more weight than in other evaluations. The focus is more on the market itself. How big is it? How is it segmented? Who are the players? How will it evolve? Once these questions are resolved, the potential entrepreneurial company's financial projections are compared with the future market in terms of fit, realism, and opportunity. After getting comfortable with the market size and potential revenue of a company, the investor examines the man- agement team. Is this a management team that will take the company "all the way"? Who will they need to bring in? How much should be set aside for an employee stock ownership

deal structure The form

of the transaction when

;noney is obtained by a

company

g public Selling

e part of the company

• registering with the

-c

I Entrepreneurship, Eighth Edition I 3 71 ---· -------· ---- ----·- ---- -- -----r--~----

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 359

plan (ESOP)? The more complete the management team is, the higher the valuation. If the management team is still thin, then a substantial portion of the company's assets needs to be set aside to attract and retain good employees. Different industries require different valuations. For example, an infrastructure business is viewed differently from a business-to-business firm.

After going through the process of deriving a value, the investor looks at all the opportuni- ties available in the investor market. Generally, the value in early-stage technology companies is driven by a combination of market structure and management team maturity, modified by the supply and demand forces that exist in a market that is highly competitive for good, solid companies.

An entrepreneur seeking financing should keep in mind that markets are changing and traditional systems are being turned upside down. Investors and entrepreneurs who have a sense of how this is going to occur and can predict the impact new technologies will have on traditional and newly formed markets are the ones who will be more highly rewarded.

DEAL STRUCTURE In addition to valuing the company and determining the percentage of the company that may have to be given up to obtain funding , a critical concern for the entrepreneur is the deal structure, or the terms of the transaction between the entrepreneur and the funding source. To make the venture look as attractive as possible to potential sources of funds, the entre- preneur must understand the needs of the investors as well as his or her own needs. The needs of the funding sources include the rate of return required, the timing and form of re- turn, the amount of control desired, and the perception of the risks involved in the particu- lar funding opportunity. While some investors are willing to bear a significant amount of risk to obtain a significant rate of return, others want less risk and less return. Other in- vestors are more concerned about their amount of influence and control once the invest- ment has been made.

The entrepreneur's needs revolve around similar concerns, such as the degree and mech- anisms of control, the amount of financing needed, and the goals for the particular firm. Before negotiating the terms and the structure of the deal with the venture capitalist, the entrepreneur should assess the relative importance of these concerns to negotiate most strategically. Both the venture capitalist and the entrepreneur should feel comfortable with the final deal structure, and a good working relationship needs to be established to deal with any future problems that may arise.

GOING PUBLIC Going public occurs when the entrepreneur and other equity owners of the venture offer and sell some part of the company to the public through a registration statement filed with the securities commission of the country. In the United States, this is the Securities and Ex- change Commission (SEC) pursuant to the Securities Act of 1933 . The resulting capital in- fusion to the company from the increased number of stockholders and outstanding shares of stock provides the company with financial resources and generally with a relatively liq- uid investment vehicle. Consequently, the company will have greater access to capital mar- kets in the future and a more objective picture of the public's perception of the value of the business. However, given the reporting requirements, the increased number of stockholders (owners), and the costs involved, the entrepreneur must carefully evaluate the advantages and disadvantages of going public before initiating the process . A list of these advantages and disadvantages is given in Table 12.8.

_ _3~~ Entrepreneurship

$ ETHICS

FINANCIAL TRANSPARENCY A MUST

Money is like water: It's best when clear, and it needs to flow freely or it can stagnate. In order to flow, the money system must be trusted by everyone around the world. Today, that most vital trust is broken. A short while ago money flowed freely, and investors asked few questions other than what their returns would be. Now, it is exceptionally difficult for even rock-solid businesses to finance their daily opera- t ions. A lack of transparency led us into this situation, and only an abundance of transparency can deliver us to better times.

Many of the economic challenges we face are the function of a global crisis in confidence. Investors, employees, and analysts have good reason to pause and consider where their efforts and investments will be safe. This lack of confidence is preventing basic, sound business from thriving and is ultimately prolonging the downturn. The complex inventions of investment banks and hedge funds allowed clever financial engineers to hide bad business fundamen- tals and allowed risk to be spread and distanced from its original creators. A lack of transparency hid the true exposure of giants like AIG and to the detriment of international stakeholders and the American public.

Advantages

Nontransparent Financial Tools: Too many in the corporate community have lost their focus on transparency. Nearly every corporation that violated basic governance principles did so by creating a web of complex and confusing rules. Blinded by outsize returns, investors and employees opted for faith over verification. If nontransparent financial tools were the workhorses of the economic downturn, fraud- sters rode dressage horses that demonstrated how far blind trust can mislead. The leadership failure at Satyam (SAY) confirms that the problem is global and demonstrates another shortcoming in corporate governance. When auditors and boards fail to get to details of the financials, shareholders lose out.

Capitalism is not broken, but history shows that it cannot be run on autopilot either. The Great Depres- sion of the 1930s was triggered by corporate misman- agement that led the Supreme Court to condemn corporations as "Frankenstein monsters, capable of doing evil." In 1934, public outcry in the U.S. gave rise to the Securities & Exchange Commission, which for- mally defined corporate ownership and control. But regulators failed to clearly address responsibilities relating to "acceptable behavior" and levels of dis- closure for corporations.

The three primary advantages of going public are obtaining new equity capital, realizing an enhanced valuation due to the greater liquidity of an equity investment in the company, and enhancing the company's ability to obtain future funds. Whether it is first-stage, second-stage, or third-stage financing that is desired, a venture is in constant need of capital. The new

TABLE 12.8 Advantages and Disadvantages of Going Public

Advantages Disadvantages

• Ability to obtain equity capital • Increased risk of liability

• Enhanced ability to borrow • Expense

• Enhanced ability to raise equity • Regulation of corporate governance policies and

• Liquidity and valuation procedures

• Prestige • Disclosure of information

• Personal wealth • Pressures to maintain growth pattern

• Loss of control

360

These loopholes proved a fertile breeding ground for much corporate malfeasance. During the 1970s, SEC investigations revealed widespread illegal con- tracting practices, insider trading, deceptive advertis- ing, and savings-and-loan scandals. Over 500 public American companies-including 117 of the then For- tune 500 companies-were charged by the SEC or confessed to corporate misconduct. The governance failures sent regulators back to the drawing board and blue ribbon panels worked to create frame- works for enhancing corporate accountability. The result was a surfeit of good governance codes issued across the globe by securities exchange commissions, stock exchanges, and investor associations.

Sarbanes-Oxley Reforms: Unfortunately, these prescriptions were also'Short-lived and failed to curb f inancial mismanagement and corporate fraud around the turn of the millennium. Instead, creative accounting and significantly large CEO pay packages resulted. Lessons from Enron, Worldcom, and Tyco resulted in the passage of Sarbanes-Oxley reforms t hat significantly increased rules and regulations and enforcement.

One common theme throughout the evolution of corporate governance is increased transparency. But here is only so much regulators can do, and trying o regulate for every possibility surely will stifle

growth. Corporate leaders must seize this opportu- nity to prioritize openness in their organizations.

romoting transparency not only covers greater dis-

Entrepreneurship, Eighth Edition

closure to regulators or the investing public; it also means that risk should be in plain sight to the insti- tution's own management. If exposure to "hidden" risk must exist, there should be good, quantitative estimates of that risk and an acknowledgement of what is unknowable.

lnfosys (INFY) has staked its past and future success on being as transparent as possible, publish- ing metrics that go well beyond those required by law. One of our corporate policies is "when in doubt, disclose." In 1999 we became the first company on Nasdaq to produce its balance sheet and income statement according to the generally accepted accounting principles of eight countries. Reminding stakeholders of sound business fundamentals and providing as much information as possible are the best antidotes for fear and uncertainty in the mar- ket. Corporations that recognize and embrace the principles of transparency will benefit from a lower cost of capital, the ability to attract talent, and bet- ter client relationships. The financial waters are backed up now, but responsible corporate leaders and regulators that prioritize transparency will have the best chance of reassuring skeptical investors and returning prosperity.

Source: Reprinted from February 27, 2009 issue of Business Week by special permission, copyright© 2009 by The McGraw-Hill Companies, Inc., from "Infosys CEO: Financial Transparency a Must," by Kris Gopalakrishnan. Business Week magazine: www.businessweek.com/ globalbiz/content/feb2009/gb20090226_80374l.htm.

capital provides the needed working capital, plant and equipment, or inventories and sup- plies necessary for the venture's growth and survival. Going public is often the best way to obtain capital on the best possible terms.

Going public generally results in a public trading market and provides a mechanism for valuing the company and allowing this value to be easily transferred among parties. Many family-owned or other privately held companies may need to go public so that the value of the company can be disseminated among the second and third generations. Venture capital- ists view going public as one of the most beneficial ways to attain the liquidity necessary to exit a company with the best possible return on their investment. Other investors benefit as well due to easier liquidation of their investment when the company's stock takes on value and transferability. Because of this liquidity, the value of a publicly traded security is sometimes higher than shares of one that is not publicly traded. In addition, publicly traded companies often find it easier to acquire other companies by using their securities in the transactions.

As noted earlier, the third primary advantage is that publicly traded companies usually find it easier to raise additional capital, particularly debt. Money can often be borrowed more easily and on more favorable terms, the company's balance sheet is strengthened by the new equity capital, and the company has better prospects for raising future equity capital.

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362 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

initial public offering

(I PO) The first public

registration and sale of a

company's stock

Disadvantages Although the advantages of going public are significant for a new venture, they must be carefully weighed against the numerous disadvantages . Some entrepreneurs want to keep their companies private, even in times of a hot stock market. Why do entrepreneurs avoid an initial public offering (!PO)?

Two major reasons are the increased reporting and the potential loss of control that car: occur in a publicly traded company. Yet, to stay on the cutting edge of technology, compa- nies frequently need to sacrifice short-term profits for long-term innovation. This can require reinvesting in technology that in itself may not produce any bottom-line results. particularly in the short run. Making long-term decisions can be difficult in publicly traded companies where sales and profit results indicate the capability of management via stock values.

Some of the most troublesome aspects of being public are the resulting loss of autonomy as well as increased duties to public stockholders and administrative burdens. The company must make decisions with respect to the fiduciary duties owed to the public shareholder and it needs to disclose to the public all material information regarding the company, its op- erations, and its management. One publicly traded company had to retain a more expensive investment banker than would have been required by a privately held company to obtain an "appropriate" fairness opinion in a desired merger. The investment banker increased the ex- penses of the merger by $150,000, in addition to causing a three-month delay in the merger proceedings. Management of a publicly traded company also spends a significant amount of additional time and expense addressing queries from shareholders, press, and financial analysts and ensuring compliance with the complicated accessing, reporting, and securities trading regulations. CEOs of most publicly traded companies set aside one day per week for this.

Finally, when enough shares are sold to the public, the company can lose control of de- cision making, which can even result in the venture being acquired through an unfriendly tender offer.

With the enactment of the Sarbanes-Oxley Act in 2002, corporate governance and dis- closure requirements of public companies and the practices and conduct of accountants and lawyers engaged by public companies became subject to significantly greater regulation enforcement by the Securities and Exchange Commission and the stock exchanges. As are- sult, the expense and administrative responsibilities of being a public company, as well as the liability risks of officers and directors, are greater than ever. Among the other conse- quences of the new regulation, the recruitment of qualified independent directors has become a much more difficult challenge for most public companies.

If all these disadvantages themselves have not caused the entrepreneur to look for alter- native financing rather than an IPO, the expenses involved may. The major expenses of go- ing public include accounting fees, legal fees, underwriter's fees, registration and blue-sky filing fees, and printing costs. The accounting fees involved in going public vary greatly, depending in part on the size of the company, the availability of previously audited financial statements, and the complexity of the company's operations . Generally, the costs of going public average $700,000, although they can be much greater when significant complexities are involved. Additional reporting, accounting, legal, and printing expenses can run any- where from $50,000 to $250,000 per year, depending on the company's past practices in the areas of accounting and shareholder communications. In addition to the SEC reports that must be filed, a proxy statement and other materials must be submitted to the SEC for review before distribution to the stockholders. These materials contain certain disclosures concerning management, its compensation, and transactions with the company, as well as

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CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 363

the items to be voted on at the meeting. Public companies must also submit an annual re- port to the shareholders containing the audited financial information for the prior fiscal year and a discussion of any business developments. The preparation and distribution of the proxy materials and annual report are some of the more significant items of additional ex- pense incurred by a company after it is public.

Accounting fees for an initial public offering fluctuate widely but typically average $200,000. Fees are at the lower end of this range if the accounting firm has regularly au- dited the company over the past several years. They are at the higher end of the range if the company has no prior audits or if it engages a new accounting firm. The accounting fee covers the preparation of financial statements, the response to SEC queries, and the prepa- ration of "cold comfort" letters for the underwriters described later in this chapter. The fees can be affected by the quality and reputation of the accounting firm used in the last three years before going public. Sometimes it becomes necessary to redo these last three years at additional cost if an appropriate firm had not been used.

Legal fees will vary significantly, typically ranging from $150,000 to $350,000. These fees generally cover preparation of corporate documents, preparation and clearing of the registration statement, negotiation of the final underwriting agreement, and closing of the sale of the securities to these underwriters. Additional legal fees may also be assessed and can be extensive, particularly if a major organization is involved. A public company also pays legal fees for the work involved with the Financial Industry Regulatory Authority (FINRA) and state blue-sky filings. The legal fees for FINRA and state blue-sky filings range from $8,000 to $30,000, depending on the size of the offering and the number of states in which the securities will be offered.

In most of the more significant public offerings, the company technically sells the shares to the underwriters, who then resell the shares to the public investors . The difference in the per-share price at which the underwriters purchase the shares from the company and the price at which they sell them to the public is the underwriters ' discount, which usually ranges from 7 to 10 percent of the public offering price of the new issue. In some IPOs, the underwriters can also require additional compensation, such as warrants to purchase stock, reimbursement for expenses, and the right of first refusal on any future offerings. The FINRA regulates the maximum amount of the underwriters' compensation and reviews the actual amount for fairness before the offering can take place.

There are other expenses in the form of SEC, FINRA, and state blue-sky registration fees . Of these, the SEC registration fee is quite small: one-fiftieth of 1 percent of the max- imum aggregate public offering price of the security. For example, the SEC fee would be $4,000 on a $20 million offering. The minimum fee is $100. The SEC fee must be paid by certified or cashier's check. The FINRA filing fee is also small in relation to the size of the offering: $100 plus one-hundredth of 1 percent of the maximum public offering price. In the preceding example of a $20 million offering, this would be $2,100, with the FINRA fee being $5,100.

The final major expense, printing costs, typically ranges from $50,000 to $200,000. The registration statement and prospectus discussed later in this chapter account for the largest portion of these expenses. The exact amount of expenses varies, depending on the length of the prospectus, the use of color or black and white photographs, the number of proofs and corrections, and the number printed. It is important for the company to use a good printer because accuracy and speed are required in the printing of the prospectus and other offer- ing documents.

Some help in stemming these rapidly increasing costs could come from more significant use of the Internet in the publication and distribution of prospectuses, as well as from other stockholder communications such as proxy statements and annual reports. However, use of

376 I Eo<repreo~"hip ----~----~-·-···------ ---····--.. ---·-- -

364 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

this medium is still somewhat in its infancy state. The SEC is continually refining its rules in this regard in an effort to allow companies to take advantage of this technology while maintaining the disclosure principles originally developed in the 1930s.

Not only can going public be a costly event, but also the process leading up to it can be exasperating. Just ask Bing Yeh, who went through some trying circumstances starting when he decided to go public in July 1995 and ending when his company, Silicon Storage Technology (SST), issued its IPO on November 22 of that same year. 14 While the exact process varies with each company, the goal is the same as it was for SST -make sure the company is well received by Wall Street. For some companies, getting ready to go public can involve eliminating members of the management team and board, dropping marginal products, eliminating treasured perks such as the corporate jet, hiring a new accounting firm, subduing some personality traits, dressing up the senior management, or hiring new members of the management team. For Bing Yeh and SST, the makeover centered around four primary tasks : (1) hiring a chief financial officer, (2) reorganizing the financials, (3) writing a company biography, and (4) preparing for the road show (this is the time when management will present the company to potential investors).

Regardless of how much reading is done, like Bing Yeh, almost every entrepreneur is unprepared and wants to halt the preparation process at some point. Yet for a successful IPO, each entrepreneur must follow Yeh' s example by listening to the advice being given and making any recommended changes.

TIMING OF GOING PUBLIC AND UNDERWRITER SELECTION Two of the most critical issues in a successful public offering are the timing of the offering and the underwriting team. An entrepreneur should seek advice from several financial ad- visors as well as other entrepreneurs who are familiar with the process in making decisions in these two areas.

Timing

The critical question each entrepreneur must ask is, "Is the company ready to go public?" Some criteria to help answer this question are indicated in the following section.

First, is the company large enough? While it is not possible to establish rigid minimum-size standards that must be met before an entrepreneur can go public, New York investment banking firms prefer at least a 100,000 share offering at a minimum of $20 per share. This means that the company would have to have a post offering value of at least $50 million to support this $20 million offering, given that the company is will- ing to sell shares representing not more than 40 percent of the total number of shares outstanding after the offering is completed. This size of offering will occur only with past significant sales and earnings performance or a solid prospect for future growth and earnings.

Second, what is the amount of the company's earnings, and how strong is its financial performance? Not only is this performance the basis of the company valuation, but it also determines if a company can successfully go public and the type of firm willing to under- write the offering. While the exact criteria vary from year to year, thereby reflecting mar- ket conditions, generally a company must have at least one year of good earnings and sales before its stock offering will be acceptable to the market. Larger underwriting firms have more stringent criteria, such as sales as high as $15 million to $20 million, a $1 million or more net income, and a 30 to 50 percent annual growth rate.

377 --- -··--··· ---· ·- ·--·-----· -------------- '""''""'""hip, Eighth Edi<ioo I - - -------------··-- --------~

managing underwriter

Lead financial firm in

selling stock to the public

underwriting syndicate

Group of firms involved

in selling stock to the

public

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 365

Thlrd, are the market conditions favorable for an initial public offering? Underlying the sales and earnings, as well as the size of the offering, is the prevailing general market con- dition. Market conditions affect both the initial price that the entrepreneur will receive for the stock and the aftermarket, or the price performance of the stock after its initial sale. Some market conditions are more favorable for IPOs than others. Unless the need for money is so urgent that delay is impossible, the entrepreneur should attempt to take his or her company public in the most favorable market conditions.

Fourth, how urgently is the money needed? The entrepreneur must carefully appraise both the urgency of the need for new money and the availability of outside capital from other sources. Since the sale of common stock decreases the ownership position of the en- trepreneur and other equity owners, the longer the time before going public, given that profits and sales growth occur, the less percentage of equity the entrepreneur will have to give up per dollar invested.

Finally, what are the needs and desires of the present owners? Sometimes the present owners lack confidence in the future viability and growth prospects of the business, or they have a need for liquidity. Going public is frequently the only method by which present stockholders may obtain the cash needed.

Underwriter Selection Once the entrepreneur has determined that the timing for going public is favorable, he or she must carefully select a managing underwriter that will then take the lead in forming the underwriting syndicate. The underwriter is of critical importance in establishing the initial price for the stock of the company, supporting the stock in the aftermarket, and creating a strong following among security analysts.

Although most public offerings are conducted by a syndicate of underwriters, the entrepreneur needs to select the lead or managing underwriter(s). The managing under- writer will then develop the syndicate of underwriters for the initial public offering. An entrepreneur should ideally develop a relationship with several potential managing underwriters (investment bankers) at least one year before going public. Frequently, this occurs during the first- or second-round financing, when the advice of an investment banker helps structure the initial financial arrangements to position the company to go public later.

Since selecting the investment banker is a major factor in the success of the public of- fering, the entrepreneur should approach one through a mutual contact. Commercial banks, attorneys specializing in securities work, major accounting firms, providers of the initial financing, or prominent members of the company's board of directors can usually provide the needed suggestions and introductions . Also, because the relationship will be ongoing and will not end with the completion of the offering, the entrepreneur should employ sev- eral criteria in the selection process, such as reputation, distribution capability, advisory services, experience, and cost.

Since an initial public offering rarely involves a well-known company, the managing un- derwriter needs a good reputation to develop a strong syndicate team and provide confi- dence to potential investors. This reputation helps sell the public offering and supports the stock in the aftermarket. The ethics of the potential underwriter is an aspect that must be carefully evaluated.

The success of the offering also depends on the underwriter's distribution capability. An entrepreneur wants the stock of his or her company distributed to as wide and varied a base as possible. Since each investment banking firm has a different client base, the entrepreneur should compare client bases of possible managing underwriters. Is the client base strongly

-- ~78 __ 1 Entrepreneursh ip 366 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

full and.fair disclosure

The nature of all material submitted to the SEC for

approval

institutional or is it composed of individual investors? Or is it balanced between the Is the base more internationally or domestically oriented? Are the investors long ten::::. speculators? What is the geographic distribution-local, regional, or nationwide? As managing underwriter and syndicate with a quality client base will help the stock sell perform well in the aftermarket.

Some underwriters are better able than others to provide financial advisory servi Although this factor is not as important as the previous two in selecting an underwri:: financial counsel is frequently needed before and after the IPO. An entrepreneur shO' pose such questions as the following: Can the underwriter provide sound financial ad'ri Has the underwriter given good financial counsel to previous clients? Can the underwri·- render assistance in obtaining future public or private financing? The answers to th• questions will indicate the degree of ability among prospective underwriters.

As reflected in the previous questions , the experience of the investment banking firm important. The finn should have experience in underwriting issues of companies in same or at least similar industries . This experience will give the managing underwri~ credibility, the capability to explain the company to the investing public, and the ability - price the IPO accurately.

The final factor to be considered in the choice of a managing underwriter is cost. Goi1:5 public is a very costly proposition, and costs can vary significantly among underwriters Costs associated with various possible managing underwriters must be carefully weigh-- against the other four factors. The key is to obtain the best possible underwriter and not' to cut comers, given the stakes involved in a successful initial public offering.

REGISTRATION STATEMENT AND TIMETABLE Once the managing underwriter has been selected, a planning meeting should be he.~ among those company officials responsible for preparing the registration statement, the company's independent accountants and lawyers, and the underwriters and their counse At this important meeting, frequently called the "all hands" meeting, a timetable is pre- pared that indicates dates for each step in the registration process. This timetable estab- lishes the effective date of the registration, which determines the date of the final financial statements to be included. The timetable should indicate the individual(s) responsible foc preparing the various parts of the registration and offering statement. Problems may arise in an initial public offering due to the timetable not being carefully developed and agreeC. to by all parties involved.

After the completion of the preliminary preparation, the first public offering normally requires six to eight weeks to prepare, print, and file the registration statement with the SEC. Once the registration statement has been filed, the SEC generally takes 6 to 12 weeks to declare the registration effective. Delays frequently occur in this process, especially (1) during heavy periods of market activity; (2) during peak seasons such as March. when the SEC is reviewing a large number of proxy statements; (3) when the company 's attorney is not familiar with federal or state regulations regarding the registration process: ( 4) when issues arise over requirements of the SEC resulting from its review of the filing: or (5) when the managing underwriter is inexperienced.

In reviewing the registration statement, the SEC attempts to ensure that the documen makes a full and fair disclosure of the material reported. The SEC has no authority to with- hold approval of or require any changes in the terms of an offering that it deems unfair or inequitable, as long as all material information concerning the company and the offering is fully disclosed. However, the Financial Industry Regulatory Authority (FINRA) will

prospect11s Document for distribution to

prospective buyers of a

public offering

registration statement Materials submitted to tbe

SEC for approval to sell

stock to tbe public

Fonn S-1 Form for

registration for most

initial public offerings of

stock

I

Entrepreneurship, Eighth Edition I 3 79 .. -·· ----- ---- - --·-- ---t- ------

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 367

review each offering, principally to determine the fairness of the underwriting compensa- tion and its compliance with FINRA bylaw requirements.

The registration statement itself consists primarily of two parts: the prospectus (a legal offering document normally prepared as a brochure or booklet for distribution to prospec- tive buyers) and the registration statement (supplemental information to the prospectus, which is available for public inspection at the office of the SEC and EDGAR). Both parts of the registration statement are governed principally by the Securities and Exchange Act of 1933 (the "1933 Act"), a federal statute requiring the registration of securities to be of- fered to the public. This act also requires that the prospectus be furnished to the purchaser at or before the making of any written offer or the actual confirmation of a sale. Specific SEC forms set forth the informational requirements for a registration. Most initial public offerings will use a Form S-1 registration statement. Smaller offerings may be able to use the shorter forms SB- 1 or SB-2.

The Prospectus The prospectus portion of the registration statement is almost always written in a highly stylized narrative form, since it is the selling document of the company. While the exact format is decided by the company, the information must be presented in an organized, log- ical sequence and in an easy-to-read, understandable manner to obtain SEC approval. Some of the most common sections of a prospectus include the cover page; prospectus summary; description of the company; risk factors; use of proceeds; dividend policy; capitalization; dilution; selected financial data; the business, management, and owners; type of stock; un- derwriter information; and the actual financial statements.

The cover page includes information such as company name, type and number of shares to be sold, a distribution table, date of prospectus, managing underwriter(s), and syndicate of underwriters involved. There is a preliminary prospectus and then a final prospectus once it has been approved by the SEC. The preliminary prospectus is used by the underwriters to solicit investor interest in the offering while the registration is pending. The final prospectus contains all the changes and additions required by the SEC and the information concerning the price at which the securities will be sold. The final prospectus must be delivered with or prior to the written confirmation of purchase orders from investors participating in the offering.

The prospectus starts with a table of contents and summary. The prospectus summary highlights the important features of the offering, similar to the executive summary of a business plan that was discussed previously in Chapter 7.

A brief introduction of the company follows, which describes the nature of the business, the company's history, major products, and location.

Then a discussion of the risk factors involved is presented. Such issues as a history of operating losses, a short track record, the importance of certain key individuals, depen- dence on certain customers, significant level of competition, or market uncertainty are the typical risk factors revealed to ensure that the purchaser is aware of the speculative nature of the offering and the degree of risk involved in purchasing.

The next section, use of proceeds, needs to be carefully prepared since the actual use of the proceeds must be reported to the SEC after the offering. This section is of great interest to potential purchasers as it indicates the reason(s) the company is going public and its future direction.

The dividend policy section details the company's dividend history and any restrictions on future dividends. Most entrepreneurial companies have not paid any dividends but have retained their earnings to finance future growth.

380 l +

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368 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

red herring Preliminary

prospectus of a potential

public offering

The capitalization section indicates the overall capital structure of the company -· before and after the public offering.

Whenever there is significant disparity between the offering price of the shares price paid for shares by officers, directors , or founding stockholders, a dilution sec · necessary in the prospectus. This section describes the dilution, or difference betw~ share price paid by the public investors and the weighted average price at which all • have been issued, including the pre-IPO shares sold to officers, directors, and fo stakeholders.

Form S-1 requires that the prospectus contain selected financial data for each of the five years of company operation to highlight significant trends in the company's fin~ condition. There must also be a discussion of management's analysis of the company·s .::_ nancial condition and results of operations. This analysis should cover at least the last years of operation.

The next section, the business, is the largest part of the prospectus. It provides inf, tion on the company, its industry, and its products, and includes the following: the · · cal development of the company; principal products, markets, and distribution meth new products being developed; sources and availability of raw materials; backlog o export sales; number of employees; and nature of any patents, trademarks , licenses, chises, and physical property owned; competition; and effects of governmental regulatio.:: -

Following the business section is a discussion of management and security holders . T.: section covers background information, ages, business experience, total remuneration, stock holdings of directors, nominated directors , and executive officers. Also, any ot:n=";; stockholder (not in the preceding categories) who beneficially owns more than 5 percen~ - the company must be indicated.

The description of the capital stock section, as the name implies, indicates the par stated value of the stock being offered, dividend rights, voting rights, liquidity, and t:ram- ferability if more than one class of stock exists.

Following this, the underwriter information section explains the plans for distributii:5 the securities, such as the amount of securities to be purchased by each underwriting p2:'- ticipant involved.

The prospectus part of the registration statement concludes with the actual finan~­ statements. Form S-1 normally requires audited balance sheets for the last two fiscal years. audited income statements and statements of retained earnings for the last three fis, years, and unaudited interim financial statements as of 135 days prior to the date when the registration statement becomes effective. It is this requirement that makes it so important pick a date for going public in light of year-end operations and to develop a good timetable This will help avoid the time and costs of preparing additional interim statements.

The Registration Statement This section of Form S-1 contains certain information regarding the offering, the past unreg- istered securities offering of the company, and any other undertakings by the company. The registration statement also includes exhibits such as the articles of incorporation, the under- writing agreement, company bylaws, stock option and pension plans, and initial contracts .

Procedure Once the preliminary prospectus is filed as a part of the registration statement, it can be dis- tributed to the underwriting group. This preliminary prospectus is called a red herring, be- cause a statement printed in red ink appears on the front cover. The registration statement

'""'P""'""h;p, E;ghth Ed;doo I 381 ------~----- ---·~ ·----------· --·---- -- --------------- ·-- ---·------------~-- ---- -

comment letter A letter from the SEC to a

company indicating

corrections that need to

be made in the submitted

prospectus

pricing amendment Additional information on

price and distribution

submitted to the SEC to

develop the final prospectus

I[Uiet period 90-day period in going public

when no new company

:nformation should be

released

ue-sky laws Laws of

~ h state regulating

lie sale of stock

· ons of underwriters

xlp support the price

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 369

is then reviewed by the SEC to determine the adequacy of the disclosure. Some deficien- cies are almost always found and are communicated to the company via either telephone or a comment letter. This preliminary prospectus contains all the information that will appear in the final prospectus except that which is not known until shortly before the effective date: offering price, underwriters' commission, and amount of proceeds . These items are filed through a pricing amendment and appear in the final prospectus. The time between the initial filing of the registration statement and its effective date, usually around 2 to 10 months, is called the waiting period. During this time the underwriting syndicate is formed and briefed. Any company publicity regarding the proposed offering cannot be released during this period.

LEGAL ISSUES AND BLUE-SKY QUALIFICATIONS Legal Issues In addition to all the legal issues surrounding the actual preparation and filing of the prospectus, there are several other important legal concerns. Perhaps the one that is of the most concern to the entrepreneur is the quiet period, the period of time from when the de- cision to go public is made to 90 days following the date the prospectus becomes effective. Care must be taken during this period regarding any new information about the company or key personnel. Any publicity effort creating a favorable attitude about the securities to be offered is illegal. The guidelines established by the SEC regarding the information that can and cannot be released should be understood not only by the entrepreneur but by every- one else in the company as well. All press releases and other printed material should be cleared with the attorneys involved as well as the underwriter. The entrepreneur and key personnel must curtail speaking engagements and television appearances to avoid any pos- sible problematic response to interviewer or audience questions. For example, one entre- preneur whose company was in the process of going public had to postpone a TV guest appearance on The Today Show with one of the authors of this textbook, where she was to discuss women entrepreneurs, not her company.

Blue-Sky Qualifications The securities of certain smaller companies going public must also be qualified under the blue-sky laws of each state in which the securities will be offered. This is true unless the state has an exemption from the qualification requirements. These blue-sky laws may cause additional delays and costs to the company going public . Offerings of securities that will be traded on the more prominent stock exchanges or listed on the NASDAQ Global Market have been preempted from most state registration requirements by the National Securities Markets Improvement Act of 1996. Many states allow their state securities ad- ministrators to prevent an offering from being sold in their state on such substantive grounds as past stock issuances, too much dilution, or too much compensation to the un- derwriter, even though all required disclosures have been met and clearance has been granted by the SEC.

AFTER GOING PUBLIC After the initial public offering has been sold, there are still some areas of concern to the entrepreneur. These include aftermarket support, relationship with the financial commu- nity, and reporting requirements .

382 ! Entrepreneurship -~··,:.-....;,;.. ___ . ~-- -··--···-•>··---·---·------~------- --

AS SEEN IN BUS/NESSWEEK

WHERE VENTURE CAPITAL NEVER VENTURED BEFORE

The fishermen from the Indian village of Chidambaram live a hard life. They sleep most of the day, then spend the night out on the water. For light during those dark hours, they have long depended on wob- bly kerosene lamps that were easily blown out or, worse, toppled by the wind, risking a deadly fire on their boats. But these days, the kerosene lamps have been replaced with MightyLights, $50 solar- powered fixtures. "I save 100 rupees [$2.50] a month on kerosene alone," says K Kanimuri, a fisherman's wife who also uses the MightyLight in her makeshift kitchen.

Kanimuri and her fellow villagers may not know it, but the change in their fortunes is rooted in global finance. MightyLights are the brainchild of New Delhi- based Cosmos Ignite Innovations, a startup that aims to provide simple products for the world's poorest people. And Cosmos got its start with backing from Vinod Khosla, a veteran Silicon Valley venture capital- ist. Now Cosmos is in talks with other groups includ- ing London-based 3i and eBay Inc. founder Pierre M. Omidyar for a second round of funding. "For us, it's not just the light, but using a sustainable model to effect social change," says Matthew Scott, chief exec- utive of Cosmos.

Just a few years ago, most venture capital funds focused on pure technology companies operating in industrialized countries. But now, VCs are starting to

Aftermarket Support

look for opportunities in the developing world. "The base of the pyramid is often ignored but offers a tremendous opportunity," says Katie Hill, the India representative of Acumen Fund, an $8 million fund backed by the Cisco Systems Foundation and the Rockefeller Foundation. Acumen has put $1.5 million into Ziqitza, a Mumbai-based ambulance company that offers deep discounts on its service for residents of the city's vast slums.

The trend is due in part to the amount of money chasing deals. VCs these days are forced to "invest in less fished areas," says Sumir Chadha, managing director of Sequoia Capital India, an arm of the Silicon Valley VC firm. But don't mistake such invest- ments as charity. Santa Monica {Calif.)-based Clear- stone Venture Partners has put $5 million into DigiBee Microsystems, which expects to pocket handsome profits by selling low-end mobile phones to poor Indians. And two California VC funds are considering a $5 million investment in Novatium, a Chennai com- pany that has developed a $100 PC and expects to sell 3 million of them by 2010. Says Novatium CEO Alok Singh: "We have always been market-driven and make money."

Source: Reprinted from July 9, 2007 issue of Business Week by spe- cial permission, copyright© 2007 by The McGraw-Hill Companies, Inc., "Where Venture Capital Never Ventured Before," by Nandini Lakshman, p. 97.

Once issued, the price of the stock is typically monitored, particularly in the initial weeks after its offering. Usually the managing underwriting firm will be the principal market maker in the company's stock and will be ready to purchase or sell stock in the interdealer market. To stabilize the market, and prevent the price from going below the initial public offering price, the underwriter will usually enter bids to buy the stock in the early stages af- ter the offers, thereby giving aftermarket support. This support is important in allowing the stock not to be adversely affected by an initial drop in price.

370

Relationship with the Financial Community

Once a company has gone public, the financial community usually takes a greater interest. An entrepreneur will need an increasing portion of time to develop a good relationship with this community. The relationship established has a significant effect on the market interest and the price of the company's stock. Since many investors rely on analysts and brokers for

IN REVIEW

SUMMARY

Entrepreneurship, Eighth Edition J 383

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 371

investment advice, the entrepreneur should attempt to meet as many of these individuals as possible. Regular appearances before societies of security analysts should be a part of establishing this relationship, as well as public disclosures through formal press releases. Frequently, it is best to designate one person in the company to be the information officer, ensuring that the press, public, and security analysts are dealt with in a friendly, efficient manner. There is nothing worse than a company not responding in a timely manner to information requests.

Reporting Requirements The company must file annual reports on Form 10-K, quarterly reports on Form 1 0-Q, and specific transaction or event reports on Form 8-K. The information in Form 10-K on the business, management, and company assets is similar to that in Form S-1 of the registration statement. Of course, audited financial statements are required.

The quarterly report on Form 10-Q primarily contains the unaudited financial informa- tion for the most recently completed fiscal quarter. No Form 10-Q is required for the fourth fiscal quarter.

A Form 8-K report must be filed within two to five days of such events as the acquisi- tion or disposition of significant assets by the company outside the ordinary course of the business, the resignation or dismissal of the company's independent public accountants, or a change in control of the company.

Under the Sarbanes-Oxley Act, the due dates for reports have been accelerated. In addi- tion, by adopting its Regulation FD, the Securities and Exchange Commission has tried to minimize selective disclosures of important corporate developments and information. Un- der this regulation, public companies are required to make immediate and broad public dis- closures of important information at the same time they release the information to anyone outside the company.

The company must follow the proxy solicitation requirements in connection with hold- ing a meeting or obtaining the written consent of security holders . The timing and type of materials involved are detailed in Regulation 14A under the Securities Exchange Act of 1934. These are but a few of the reporting requirements of public companies that must be carefully observed, since even inadvertent mistakes can have negative consequences for the company. The reports required must be filed on time.

In financing a business, the entrepreneur determines the amount and timing of funds needed. Seed or start-up capital is the most difficult to obtain, with the most likely source being the informal risk-capital market (angels). These investors, who are wealthy individuals, average one or two deals per year, ranging from $100,000 to $500,000, and generally find their deals through referrals.

Although venture capital may be used in the first stage, it is primarily used in the sec- ond or third stage to provide working capital for growth or expansion. Venture capital is broadly defined as a professionally managed pool of equity capital. Since 1958, small- business investment companies (SBICs) have combined private capital and government

384 +I '""''""'""h;p -·-··~-~--~-- -------------------- -- ·- --- ·--~------------------------------------------------

372 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

funds to finance the growth and start-up of small businesses. Private venture-capital firms have developed since the 1960s, with limited partners supplying the funding. At the same time, venture-capital divisions operating within major corporations began appearing. States also sponsor venture-capital funds to foster economic development.

To achieve the venture capitalist's primary goal of generating long-term capital appre- ciation through investments in business, three criteria are used: The company must have strong management; the product/market opportunity must be unique; and the capital appreciation must be significant, offering a 40 to 60 percent return on investment. The process of obtaining venture capital includes a preliminary screening, agreement on prin- cipal terms, due diligence, and final approval. Entrepreneurs need to approach a poten- tial venture capitalist with a professional business plan and a good oral presentation.

Valuing the company is of concern to the entrepreneur. Eight factors can be used as a basis for valuation: the nature and history of the business, the economic outlook, book value, future earnings, dividend-paying capacity, intangible assets, sales of stock, and the market price of stocks of similar companies. Numerous valuation approaches that can be used were discussed.

In the end, the entrepreneur and investor must agree on the terms of the transac- tion, known as the deal. When care is taken in structuring the deal, the entrepreneur and the investor will maintain a good relationship while achieving their goals through the growth and profitability of the business.

Going public-transforming a closely held corporation into one in which the gen- eral public has proprietary interest-is indeed arduous. An entrepreneur must carefully assess whether the company is ready to go public as well as whether the advantages outweigh the disadvantages of doing so.

Once the decision is made to proceed, a managing investment banking firm must be selected and the registration statement prepared. The expertise of the investment banker is a major factor in the success of the public offering . In selecting an investment banker, the entrepreneur should consider reputation, distribution capability, advisory services, experience, and cost. To prepare for the registration date, the entrepreneur must organize an "all hands" meeting of company officials, the company's independ- ent accountants and lawyers, and the underwriters and their counsel. A timetable must be established for the effective date of registration and for the preparation of neces- sary financial documents, including the preliminary and final prospectuses. Following the initial public offering, the entrepreneur should strive to maintain a good relation- ship with the financial community and adhere strictly to the reporting requirements of public companies.

RESEARCH TASKS

c 1. Go to a directory of venture capitalists and ascertain what percentage of funds for a typical venture-capital firm are invested in seed, start-up, expansion or development, and acquisitions or leveraged buyouts. What criteria do venture capitalists report using in their initial screening of business proposals?

2. Obtain an initial public offering prospectus for three companies. Use at least two different approaches for valuing each company.

3. Search the Internet for services that provide access to business angels or informal investors. How do these sites work? If you were an entrepreneur looking for funding, how much would it cost to use this service? How many business angels are registered on the typical database? How many entrepreneurs are registered on

Entrepreneurship, Eighth Edition ~ 385 ------~----------------- I ~-

CHAPTER 12 INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING PUBLIC 373

the typical database? How effective do you believe these services are? (Use data where possible to back up your answer.)

4. How many companies went public per year over the last 1 0-year period? How do you explain this variation in the "popularity" of going public?

5. Analyze the prospectuses of 10 companies that went public in 2005. In your opinion, which companies are likely to do well in the public offering, and which are less likely to do well? Conduct the following calculation to test your propositions: Stock price after 1 week - Offering price ..,.. Offering price. Compare this price with the originaiiPO price.

6. Analyze the prospectuses of five companies going public. What are the reasons they state for going public? How are they going to use the proceeds? What are the major risk factors presented?

CLASS DISCUSSION

1. An investor provides an entrepreneurial firm with the capital that it needs to grow. Over and above providing the capital, in what other ways can the investor add value to the firm? What are the possible downsides of having a venture capitalist as an investor in the business?

2. Assume that you have been very lucky and have been given a considerable fortune. You want to become a business angel (straight after graduation). How would you go about setting up and running your "business angel" business? Be specific about generating deal flow, selection criteria, the desired level of control and involvement in the investee, etc.

3. What drives the market for IPOs? Why is it so volatile?

4. If you were an entrepreneur in a "hot" market, would you invest the substantial amount of time, energy, and other resources necessary to try and go public before the bubble bursts? Or would you prefer to utilize those resources to build your business and create value for customers?

SELECTED READINGS

Betros, Chris. (September 2008). From Startup to IPO: New Zealand's Most Successful Entrepreneur. J@pan Inc., no. 80, pp. 37-39.

This article profiles an entrepreneur-Ted Williams-from New Zealand who has had great success launching an Internet business in Japan. During this interview, Mr. Williams recounts his first days in Japan from being a tourist to trading whisky for office furniture to reorganizing the management structure of his company in preparation for an I PO. Va/ueCommerce, Mr. Williams's company, is Japan's first in- teractive Internet marketing site.

Delaney, Laurel. (April 2007). Howdy, Partner. Entrepreneur, vol. 35, no. 4, p. 87. This very brief editorial column illustrates another tactic for boosting capital: forming strategic global alliances (SGAs). The author, Laurel Delaney, owns a consultancy advising entrepreneurs on international endeavors. In her column, Ms. Delaney asserts that strategic global alliances can offer successful avenues for defraying informal risk. The anecdote includes Ms. Delaney's experience exporting food to Japan. Ms. Delaney also highlights the three telltale qualities of a poten- tially auspicious SGA partner: good chemistry, internal trust, and charted perfor- mance results.