Chapter 2

An Overview of New Venture Financing

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Learning Objectives
Learn new venture financing terminology. Understand the value of tying financing to performance milestones Recognize the distinguishing characteristics of the various stages of new venture development Identify the financing sources available to a new venture and the factors favoring one over another Learn the basic structures and availability of various financing sources Identify the key elements of deal structure and the functions they serve

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Some Milestones for New Venture Planning

Completion of concept and product testing Completion of prototype First financing Completion of initial plant tests Market testing Production start-up First competitive action First redesign or redirection First significant price change
Block and Macmillan (1992)

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Stages of New Venture Development

Development stage Start-up Early growth Rapid growth Exit

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Stages of New Venture Development

Figure 2-2

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Sequence of New Venture Financing

Bootstrapping Seed financing R&D financing Start-up financing First-stage financing Second-stage financing Third-stage financing Mezzanine financing Bridge financing LBO, MBO, IPO

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Sources of New Venture Financing

Self, friends, and family Business angels Venture capital investors Small business investment companies (SBICs) Trade credit and factoring Asset-based lending Mezzanine capital Private placements of equity (relational investors) IPOs Public debt

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Sources of New Venture Financing

Figure 2-3

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International Venture Capital and Business Angel Investment

2000-2001 Averages
$18,000 $16,000 $14,000

Venture Capital

Informal Investment

Figure 2-3

Millions of US Dollars

$12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0

Netherlands New Zealand South Africa South Korea Denmark Finalnd France Germany Hungary India Portugal Singapore Argentina Norway Poland Australia Belgium Spain Sweden Brazil Canada Ireland Israel Japan Mexico Italy

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Venture Capital Commitments by Limited Partner Type

Figure 2-4

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Venture Capital Investments by Industry

Figure 2-5

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Venture Capital Investments by Region

Figure 2-6

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How Changes in the Stock Market Relate to New Equity Capital Raising
Figure 2-7

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Deal Structures
The deal Term sheet Pre-money valuation Post-money valuation Investment agreement Representations and warranties Covenants and undertakings Affirmative covenants Negative covenants Registration rights Preemptive rights Ratchets or anti-dilution provisions
Chapter 2

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End of Chapter Questions

Question 2-1
Use the Internet to locate some websites of venture capital firms and angel investors Based on your search, what are the characteristics of investments sought by these two types of investors? What are the main differences in investment characteristics between the two types of investors? What differences in investment objectives, if any, do you see within each type of investor?

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Question 2-2
In activities such as education and healthcare, profit and non-profit enterprises compete with each other What do you think it means for an enterprise to be organized as non-profit? Why do you think non-profit enterprises sometimes compete aggressively for business?

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Question 2-3
What is limited liability in terms of total risk and risk allocation? If equity investors have limited liability and the venture fails, how does it affect the equity investors, creditors, employees, suppliers and customers? Do you think it would matter to other stakeholders whether equity investors have limited liability? Why or why not?

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Question 2-4
The following table contains financial information from the business plan of a new venture, LaserGolf, Inc, that makes a portable device that uses Laser technology for measuring distances with great precision. (Amounts in thousands of dollars and in intervals of six months)

* Equals cash flow available to investors

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Question 2-4 (Contd)

How would you propose to identify the stages of new venture development? How much cash is the venture expected to need in total? Why? Would your proposal for staging be different if you were advising the entrepreneur as opposed to a prospective investor? What would you suggest as useful milestones for evaluating progress? What kinds of investors are best suited for investing at various stages of development? Suppose, after your group makes an initial investment in the venture prior to month 18, the venture fails to achieve the next milestone you had agreed for making the next cash infusion, what would you do? Why?

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Question 2-5
An existing biotechnology venture has a prototype of a device for using ultrasound to shatter kidney stones. The venture is seeking an infusion of $5 million to carry it to the next milestone. The $5 million is needed to complete the testing required for FDA approval. Three alternatives are under consideration: Scenario 1: An investor is proposing to provide the capital in exchange for $2 million shares of common stock Scenario 2: The investor will accept 1.8 million shares of preferred stock, convertible to common on a 1 for 1 basis Scenario 3: The investor will accept 1.5 million convertible preferred shares, along with warrants to acquire an additional 1.5 million shares for a nominal price. The warrants can be exercised only if the venture fails to achieve the revenue level projected by the entrepreneur in 2 years

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Question 2-5 (Contd)

Compute the pre- and post- money valuations for each scenario. If you were the entrepreneur, what factors would you consider in deciding which offer to accept? If you were the investor, how would you interpret the entrepreneurs choice? In any case, entrepreneur would own 2.5 million shares of common stock

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Question 2-6
In a previous round of financing for a resort spa, an investor contributed $2 million in exchange for 1 million shares of common stock with the entrepreneur retaining 2 million shares. Due to massive delays and cost overruns, the entrepreneur needs another $1 million with which he hopes to complete development. However the existing agreement includes a ratchet provision for the prior investor. Under the terms of the ratchet, the investor will receive enough new free shares so that his average cost per share is same as that of any new investor

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Question 2-6 (Contd)

a) Suppose that in the absence of the ratchet provision a new investor would be willing to accept 1.25 million shares in exchange for the $1 million of investment. Compute the postmoney valuation b) Now based on valuation in previous part, giving effect to the ratchet provision, what price per share would the new investor seek and how many shares would the existing investor receive? c) Suppose the ratchet agreement has a floor that limits the average cost of the existing investor to a minimum of $1 per share. How would the limitation affect the price per share for the new investor and the number of new shares to the new investor? d) What fraction of the equity would the entrepreneur end up retaining under each of three scenarios?

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Question 2-7
Define term sheet and investment agreement. What are the differences between the two?

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Question 2-8
Search the Internet or print media sources to find a prospective invention that may lead to a marketable product in the future (Popular Science is a good source, among others, www.popsci.com). a) Briefly describe the product. b) As a potential investor, identify four milestones that you might want to use as bases for staging investments and evaluating progress. c) Referring to Figure 2-2, identify the stage of development. d) Based on your reading of the chapter, what types of financing would you select for the product and for which development stage(s) would you employ each financing type? Explain.

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Question 2-9
Hacker Inc., a software developer, is considering a financing deal with an investor. They have agreed on a $2 million investment for 2 million shares. Hacker has developed promising gaming software to use with popular game consoles. But has been stymied by the closed architecture of the consoles. If the architecture opens up and interest in the software takes off, Hacker will need considerably more money to continue its line of software. a) Design a ratchet provision, to include in the investment agreement, which will protect the investor against dilution in subsequent funding rounds. b) Why would the entrepreneur agree to the provision? c) What are the costs, direct and indirect, of such an anti-dilution provision? Explain.

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Question 2-10
Why do you think convertible preferred stock is so common in investment deals between entrepreneurs and venture capital investors? Why not use common stock? Why not use convertible debt?

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Question 2-11
When would you organize as an S Corporation instead of a C Corporation?

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Question 2-12
As an entrepreneur, when would you seek business angel financing as opposed to venture capital financing?

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Question 2-13
Explain the advantages of basing financing on attainment of milestones. What problems might milestones create?

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