11-1

Chapter 11: Human and Financial Capital

Questions answered in this chapter:

What is a startup? What are the different sources of human capital that can play a role in a startup business? What are the typical sources of funding for an early-stage startup business? What elements are needed for a successful pitch to investors? How is the value of a startup determined? What are the factors involved in negotiating with investors? What is an initial public offering? What process must an entrepreneur undertake to successfully complete and IPO?

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Exhibit 11-1: Venture Capital Market Size, 1995-2001

120 Amount invested 100 Number of deals 7000 9000 8000

80

6000

5000 60 4000

40

3000

2000 20 1000

0 1995 1996 1997 1998 1999 2000 2001

Source: Data from PricewaterhouseCoopers, MoneyTree Survey: Full Year & Q4 2001 Results: US Report.

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Defining a Startup

A startup is a business that is in the process of developing the underlying infrastructure needed to support future growth A startup is a business engaging in the the following three basic processes:

Developing and refining the offering and strategy to go to market Obtaining initial funding to begin operations Building a capable management team to handle operations

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Exhibit 11-2: Startup Business Investment Stages

Early Stage
Financing Stages

Expansion Stage
First-Stage SecondStage

Later Stage
Mezzanine Bridge

Seed Stage
Validate the business concept (e.g. build prototype, develop business plan, conduct market research)

Startup

Investment Purpose

Build management team and complete product development

Expand production, marketing, or sales capabilities

Provide working capital once shipping products or providing services

Fuel substantial growth (typically provided to business that are at least break even)

Prepare for initial public offering, usually planned in the next 6 months to a year

Type of Investors

Angel investors Traditional VC Consulting firms Online VC firms Incubators

Angel investors Traditional VC Consulting firms Incubators

Traditional VC Corporations

Traditional VC Corporations

Traditional VC Corporations Buyout firms Investment banks

Traditional VC Corporations Buyout firms Investment banks

Source:

Gold Book of Venture Capital Firms, Bob Zider, How Venture Capital Works, Harvard Business Review

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Relationship between Human and Financial Capital

Human and financial capital resources can influence the business planning process and, in turn, be influenced by the business plan

Human capital resources may include entrepreneurs, management team, strategic advisors and partners, and logistical advisors and partners Sources for financial capital include debt financing and equity financing

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Exhibit 11-3: The Relationship Between Financial Capital Human Human Capital and Financial Capital
Entrepreneur Equity Bootstrapping

Management Team

Angels

Venture Capital

Business Planning Process

Strategic Advisors & Partners

Corporate Ventures

Holding Company

Debt Trade Credit Commercial Bank Loans

Logistical Advisors & Partners

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Elements of a Solid Business Planning Process

The major elements of a business planning process include the following:

Defining the value proposition Framing the market opportunity Detailing how to reach customers Developing an implementation plan Evaluating potential external influences Articulating the revenue model Identifying needed people Calculating preliminary financial projections Establishing critical milestones Summarizing the advantage

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Human Capital

The role of human capital in a startup business is especially critical because, for a time, it is the only resource available When investors consider funding an early-stage company, they assess its human capital

Who is the entrepreneur? Does she have the drive to see this business through? Who is on the management team? Will they be able to execute?

The human capital attracts the financial capital

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Characteristics of Successful Entrepreneurs

Key characteristics common to successful entrepreneurs include the following:

Keenly Observant. Entrepreneurs are those who are able to make observations about the needs of industries, markets, and everyday life and find the best way to meet these needs Willingness to take risks. Entrepreneurs are willing to leave stable jobs and guaranteed salaries for their enterprises Drive. The entrepreneurs personal drive is especially important in the early stages, when his enthusiasm spurs the drive of other employees Flexibility. The ability to adapt and react quickly are especially important in the fast-changing Internet environment Vision. The most successful entrepreneurs are not driven by money, but by a vision or a passion consistently pursued

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The Trials and Tribulations of the Entrepreneur

From the outset, the entrepreneur is faced with reconciling several difficult paradoxes:

Being visionary vs. being realistic. The entrepreneur is faced with the challenge of coming up with unique ideas that are grounded in reality Generating quick returns vs. investing in the future. The entrepreneur is challenged with staying the course to build the organization while meeting the demands of the investors who are needed to build the organization in the first place Optimism vs. pragmatism. While optimism is an essential motivating force, it must be balanced with the pragmatism to evaluate potential weaknesses of the business

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The Entrepreneur and the Idea

Some of the most common types of business ideas include the following:

Introduce a new product (new softwareMP3) Introduce a new service (overnight delivery FedEx) Improve an existing model of business (selling books on the InternetAmazon.com)

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The Management Team

The core team consists of individuals essential to the early formative days of the startup who will fill the following three roles:

Technology specialist: is the person who understands the specific mechanics of how the product works, how it is manufactured, and how it can be utilized Sales and marketing specialist: is the person with an indepth understanding of the startups customer Execution specialist: is the person who keeps everything in perspective in the startups development making the vision for the business a reality

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The Management Team (contd)

Extended management team can be created on an as-needed basis, depending on how quickly the startup is growing

Chief operating officer Chief financial officer VP of marketing VP of sales VP of business development Chief people officer

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Strategic Advisors and Partners

Strategic advisors and partners provide the startup with strategic direction, advice, and in many instances credibility for the organization as a whole

Advisory board members serve as an outsourced resource to fill a particular need and may receive stock options in exchange for their expertise The board of directors consists of individuals who will be responsible for the well-being of the company, as well as holding the management team accountable for its actions when the business formalizes operations A strategic association is the agreement of two entities to work together and exchange expertise in areas where they lack core competencies A strategic alliance is a legally binding contractual agreement to share resources on a project for a particular timeframe

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Logistical Advisors and Partners

Logistical advisors and partners differ from the strategic advisors and partners in that they are more involved in the day-to-day operations of the business

Necessary logistical advisors and partners include certified public accountants (CPA) and legal counsel Supporting logistical advisors and partners serve as outsourced, human-capital leverage for the startup and may include intermediaries, consultants, and incubators

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Financial Capital

Sources of debt financing (commercial banks, trade credit) Sources of equity financing (bootstrapping, venture-capital) Strategic investors are concerned how a certain business compliments their current activities (exposure to cutting-edge technology or business model, collaboration in research and development for a product, etc.) Financial investors are concerned with return on investment (ROI), internal rate of return, cost of capital, and return on equity

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Debt Financing

Trade credit is credit extended to a business by its suppliers. It is an interest-free loan covering the time period from when supplies are delivered to when the invoice is due

Suppliers typically offer trade credit to buyers with an established track record of making prompt payments Hidden interest rate cost

Commercial bank loan is, typically, an installment loan in which the business borrows a certain amount of money for a specified period with either a fixed or variable interest rate

Commercial banks evaluate a business loan application by assessing the likelihood of loan repayment Bank loans can be relatively difficult to obtain, especially for early-stage businesses with little collateral and no positive cash flow

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Equity Financing: Bootstrapping

Bootstrapping is the art of using personal resources to finance the early stages of a startup

Bootstrapping may include taking a personal loan, mortgaging a home, using credit cards or savings accounts Bootstrapping provides the most viable option for the entrepreneur when the startup is in the earliest stages of business, especially during the stages that involve proving the business concept Bootstrapping allows the entrepreneur to control the company and refine his business strategy without pressure from outside investors The disadvantage of bootstrapping is that it is unlikely to provide sufficient cash for a good business concept to grow quickly beyond the earliest stages

11-19

Equity Financing: Venture Capital

Venture-capital firms are usually private partnerships or closely held corporations that raise money from a group of private investors

A venture-capital firm typically invests $250,000 to $10 million in a business in exchange for a 30 to 40 percent equity stake and a seat on the board of directors In addition to receiving cash, the entrepreneur receives guidance for building the startup Venture capitalists, typically, charge management fees on the order of 1 to 5 percent of the capital investment in a startup A venture-capital firm seeks opportunities that will return 10 times the original investment within five years, but realizes that each investment is a gamble and that only 10 percent are likely to succeed The biggest disadvantage of venture capital funding is the sources concern with the bottom line

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Exhibit 11-5: Venture Capital InvestmentsBreakdown by Stage

100 90 80 70 60 50 40 30 20 10 0 Startup Early-stage Expansion Later-stage
1999 2000 2001

Source:

$BB Data from PricewaterhouseCoopers, MoneyTree Survey: Full Year & Q4 2001 Results: US Report.

11-21

Exhibit 11-6: Top 10 Venture Capital Dealmakers in 2001

New Enterprise Associates Baltimore, Md. 82

Intel Capital
J.P. Morgan Partners

Chandler, Ariz.
New York, N.Y.

72
69

Bessemer Venture Partners

Austin Ventures U.S. Venture Partners Warburg Pincus St. Paul Venture Capital Technology Crossover Ventures (TCV) Mobius Venture Capital

Wellesley Hills, Mass.

Austin, Texas Menlo Park, Calif New York, N.Y. Eden Prairie, Minn. Palo Alto, Calif. Mountain View, Calif.

68
62 61 53 52 49 47

[i] Source: Data from PricewaterhouseCoopers, MoneyTree Survey: Full Year & Q4 2001 Results: US Report.

11-22

Equity Financing: Angels

Angels are wealthy individuals who invest personal capital in startups in exchange for equity or sometimes a seat on the board of directors

Its critical for the entrepreneur to develop a network of individuals within the industry to gain introductions to potential financiers because angels seldom look at unsolicited business plans Business plans are evaluated based on the quality of the management team, market potential for the business idea, and the track record of the entrepreneur Typically, angels are more flexible in accepting changes in the original business plan if it is necessary Angels tend to be more involved in the day-to-day operations of startups

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Equity Financing: Corporate Ventures

Large corporations sometimes set up venture funds as a subsidiary that can make investments on behalf of the parent company, referred to as either corporate venture or direct investors

Corporate-venture funds invest in complimentary business for primarily strategic reasons In exchange for cash, capital ventures seek an equity stake in the company and access to the companys technology or product Established corporations can offer the operational expertise as well as the credibility and visibility that come from associating with an established high-profile parent Because the investments are strategic rather than financial, the pricing of deals with corporations tends to favor the entrepreneur more than deals with venture-capital firms

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The Business Plan

A business plan should provide the following information to a potential investor

Description of the product or service that will be offered and the value proposition for the customer Summary of the size and nature of the market opportunity Explanation of the revenue model Profiles of the management team, advisory board, and board of director members describing specific relevant skills and expertise Clear articulation of the startups core competencies and sustainable competitive advantage Summary of financials and financing needs

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Valuation

Valuation is the art/science of trying to determine the worth of a company Methods used in valuing a company

The Comparables Method

Determine the worth of a company by comparing it to other similar companies The companies should be similar with respect to industry focus, income statement ratios, location, relations with suppliers, customer base, potential growth, growth rate and capital structure This method assumes that similar companies exist and that the information for comparison is available

11-26

Valuation (Contd)

The Financial Performance Method

Uses a companys earnings (or potential earnings) to project future cash flows and applies a discount rate to determine the Present Value (PV) of those cash flows The Discounted Cash Flow (DCF) is determined from

Proforma Income Statements Projections about the companys future income statements are made based on growth assumptions for cost and revenues Free Cash Flow The amount of cash the company will have at its disposal is estimated based on the proforma income statement Terminal Value The expected value of the company at the end of the projected period is estimated. A discount rate is then applied to this value to estimate the present value of the company

11-27

Valuation (Contd)

The Venture Capital Method

VCs use a hybrid valuation method, looking at both comparables and free cash flows To compensate for their high risk investments, VCs apply a very large discount rate to estimate the companys present value To compensate for future dilution, VCs require a higher percentage ownership (for a given investment) based on an estimated retention ratio This valuation method is necessarily subjective

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Exhibit 11-7: Typical Discount Rates by Funding State

Startup
First Stage Second Stage Third Stage Fourth Stage

50% to 70%
40% to 60% 35% to 50% 30% to 50% 30% to 40%

IPO

25%-35%

Source: Data from James L. Plummer, QED Report on Venture Capital Financial Analysis (QED Research, Palo Alto, CA), 1987

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Negotiations

Principles for Entrepreneurs

Investors want to know two things: What is the opportunity and why is this management team the best to pull it off Guidelines for pitching an investment opportunity

Know the audience Keep the presentation concise Talk about the management team

Term Sheet

A Term Sheet is a non-binding description of the proposed deal between the financier and the entrepreneur The Term Sheet is analogous to a Letter of Intent (LOI) or Memorandum of Understanding (MOU)

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Negotiations (Contd)

Securities

Types of Securities: The type of securities chosen by

the company and the investor reflect the risk/reward appetite Zero Coupon Bonds - Upon maturity of this security, the
investor redeems the initial investment and interest at a predetermined rate. This type of security provides ultimate protection to the investor

Convertible Debentures These securities are loans that are

converted into common stock (equity). The investor is considered to be a creditor until the company is past its high-risk stage

Preferred Stock This is the most commonly used security with

VCs

Convertible Preferred Redeemable Preferred Participating Convertible Preferred

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Negotiations (Contd)

Rights and Privileges of Investors

Common rights that investors demand are

Right of First Refusal Investor has the right to meet any offer of
outside financing in future investment rounds Preemptive Right Investor has the right to maintain his percentage of ownership by investing additional funds in future investment rounds Redemption Rights Investor has the right to achieve liquidity if the company has not been sold or undergone IPO within a predetermined time period Registration Rights Investor has the right to demand that shares be registered, forcing the company into liquidity (public offering) Covenants Terms designed to ensure that the money provided by the investor is used in a manner that is consistent with the agreement between the entrepreneur and investor Antidilution Provisions Provisions that protect the investor from dilution in ownership that might occur in future round of financing

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Exhibit 11-8: Pre- and Post-Money Valuations Made Easy

Cumulative Round of Financing Amount invested this round % Received this round VCs Share Founders Share Implied Valuation (Post Money)

Seedstage Round First Round

$1,000,000

40%

40%

60%

$2,500,000

$4,000,000

20%

52%

48%

$20,000,000

Second Round

$15,000,000

20%

62%

38%

$75,000,000

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Exhibit 11-9: Venture-Backed IPOs, 1995-2001

248 216 200

Number of IPOs

143 121

68

21

Source: Data from VentureOne research.

1995

1996

1997

1998

1999

2000

2001

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Exit (The Path to Liquidity)

Initial Public Offering (IPO)

Determining the Right Time for an IPO

Asses if the company is ready for an IPO Asses if the market is ready to accept their offering
Selection of Underwriters The underwriters are the bankers that will arrange
for the purchase of stock for a commission

The IPO Process

the companys business and financial fundamentals Distribution of Preliminary Prospectus - or Red Herring

Preparation of Registration Statement for SEC Create prospectus outlining

Preparation for and Completion of the Road Show The companys offering
is presented directly to potential investors

The Incorporation of SEC comments into the Registration Segment Agreement on a final share price and number of shares to be offered Close of the offering and distribution of the final prospectus

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Exhibit 11-10: IPO Pros and Cons

Pro
Provides founders and shareholders with liquidity (although not immediate liquidity because of lock out periods, signals to the market, etc.)

Con
IPOs are expensive and time-consuming. An unfavorable market (something that the company can not control or predict) might necessitate pulling the IPO at the last second

Provides capital to fuel expansion and growth within the company Possibility of attracting and retaining employees at lower than market rates because of granting of stock options and promise of eventual liquidity The price of the companys shares should increase dramatically with an IPO, providing (at least paper) wealth to the founders and other shareholders

Strict SEC reporting requirements

Pressure to product quarterly numbers for analysts

Increased Officer and Director liability

As long as the company is performing well, it can return to the market to raise additional cash

Hostile takeover is possible

The ability to use stock as currency

Doesnt necessarily provide a liquid market for all shareholders because of restrictions on trading the stock

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Exit (Contd)

Mergers and Acquisitions (M&A)

M&A can often achieve the same goals as IPO (e.g. liquidity and increased valuation) with lower potential risk In a Merger, two companies combine to achieve a financial and/or strategic objective, usually through the exchange of shares In an Acquisition, one company buys another, usually with cash and/or stock

Analysts predict that M&A will become increasingly popular

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Exhibit 11-11: Internet Mergers and Acquisitions in 2001

400
Number of Deals Total Amount of Deals

16 14 12 Billions of 10

Number of Deals per Year

300

dollars

8 6 4 2

200 Q1
Source: Data from Webmergers.com database.

Year 2001

0 Q3 Q4

Q2

37