Early Stage Sources of Capital

Early Stage Sources of Capital

Stages of Entrepreneurial Development

Seed $5,000 to $100,000 Startup $20,000 to $400,000 Growth $500,000 to $3,000,000 Late Growth $1,000,000 to $5,000,000 Harvest $2,000,000 to 20,000,000

Early Stage Sources of Capital

Capital Source by Stage

Development Entrepreneur Friends, Family Angels Strategic Partners Venture Capital Asset Lenders SBA Loan EDC Startup Growth Late Growth Harvest

SBIC
Commercial Lenders Suppliers & Customers Private Placement Investment Bankers Private Equity Fund Institutional Investors IPO M&A Public Debt Early Stage Sources of Capital 3

Sources of Seed Capital

Entrepreneur Friends and family Angels Strategic partners

Early Stage Sources of Capital

Sources of Startup Capital

Venture investment clubs Economic development agencies Asset-based lenders SBA loans

Early Stage Sources of Capital

Sources of Growth Capital

Commercial lenders Suppliers & Customers Private placements Venture capitalists Small business investment companies

Early Stage Sources of Capital

Sources of Late Growth Capital

Investment bankers Private equity funds Institutional investors

Early Stage Sources of Capital

Sources of Harvest Capital

Initial public offerings Mergers and acquisitions Public debt

Early Stage Sources of Capital

Entrepreneur

Personal savings Credit cards Home equity Retirement accounts Life insurance

Early Stage Sources of Capital

Angels
Checkbook angels
$5,000 to $25,000 Capital A angels $25,000 to $250,000 Superangels $250,000 to $2,000,000

Early Stage Sources of Capital

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Angel Organizations
Managed Angel Networks Pledged Funds Angel Clubs CEO Angels Funded Active Investors
11

Early Stage Sources of Capital

Incubators
Advantages
Increased survival rate Non-monetary
resources

Disadvantages
Lengthened startup
time Low number of growth firms

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Economic Development Agencies and Community Development Corporations

Arkansas Certified Development
Corporation Arkansas Development Finance Authority Southern Development Bancorporation Economic Development Corporation
Early Stage Sources of Capital 13

Ten Tips for Bootstrapping

1) Accelerate Startup Plan as if time is money Imitate competitors
2) Focus on Cash Flow Focus on income generation Track weekly cash flow Manage payables and receivables
Early Stage Sources of Capital 14

Ten Tips for Bootstrapping

3) Be Frugal Control growth to control cash needs Avoid low value-added expenses
4) Rent versus buy Use licensing versus development Use franchise versus marketing Use leases versus purchasing
Early Stage Sources of Capital 15

Ten Tips for Bootstrapping

5) Pay with Equity Professional services Warrants
6) Use Underused Assets of Others Use equipment during off-peak hours Use meeting space of professionals Use unused space of other businesses
Early Stage Sources of Capital 16

Ten Tips for Bootstrapping

7) Find Non-cash Solutions Give managers compensation time Pay with in-kind services Pay with unused assets
8) Use Professionalism Sparingly Maintain an Internet web site Use business centers
Early Stage Sources of Capital 17

Ten Tips for Bootstrapping

9) Share Resources Strategic partnerships Complimentary cooperation
10) Lead by Example Sacrifice personal assets Suggest ways to avoid cash outlays
Early Stage Sources of Capital 18

UALR Entrepreneurial Financing

February 9, 2004

Early Stage Sources of Capital

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Demand for Funds - Classifications of firms

Lifestyle Firms provide a reasonable living for their founders, account for more than 90 percent of all start-ups it is unlikely that these firms will attract equity funding from external parties. These business ventures typically have five year revenue projections under $ 10 million. Middle Market Firms Have growth prospects of more than 20 percent annually and five year revenue projections between $10 and $ 50 million. These firms are attractive to business angel investors, but they also depend heavily on bootstrapping to fund initial growth. These firms typically make up less than 10 percent of all start ups. High Potential Firms Typically plan to grow into a substantial firm with fifty or more employees within five to ten years, have five-year revenue projections in excess of $ 50 million and anticipate annual growth rates in excess of 50 percent. Typically financed by business angels and later by venture capitalists. These firms typically make up less than 1 percent of all start-ups. On market projections, need to verify with top down and bottom up calculations. Can not say market is $x and all we need is x%. Investors want to see large growth opportunities that scale quickly. Key Point - not every firm is suitable for outside equity investment based on the financial economics of the investment.
Typically, the Middle Market or High Potential firm definition would be the target market
for outside equity capital. These firms account for less than 10% of the aggregate firms. At any point in time approximately 700,000 companies are actively trying to raise capital. Arthur Andersens 1995 national study 36 % of small, fast growing companies reported an inability to meet their capital needs. Early Stage Sources of Capital 20

Main Sources of Capital for Entrepreneurial Firms:

Source First Round Founder 74 % Family & friends 5% Business angels 7% Venture capitalists 5% Banks 6% Nonfinancial institutions 0 % IPOs and equity markets 3 % Second Round 7% 4% 34 % 13 % 15 % 15 % 10 % Third Round 13 % 0% 29 % 6% 16 % 10 % 26 %

Early Stage Sources of Capital

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Business Plan
Business plan should be clear, professional, realistic and to the point. Refine your sales pitch Prepare a 15-20 minute presentation in addition to the

plan. Really hone the presentation it is as important as the plan. Entrepreneur develops the plan and should use plain English avoid technical jargon. Investors want a plan for profit not an invention. Recurring revenue model and scalability are important factors Business plans get your company in the door but it does not sell the deal Business plans do not get funded people get funded. Borrow added creditability Board of Directors and Press Releases are examples Set up formal communication channels and define the roles for investors Memo vs. book Poorly developed assumptions are a main reason proposals are rejected. Other trouble spots include large salaries, back salaries, old loan obligations or buy out of prior investors. Also investors want to see some investment by the founders, percentages are important (% of net worth) Sweat Equity may be an issue. The investor wants to know what can you do to create value from this point on and how far along your are in the process Early Stage Sources of Capital 22 helps determine valuation (risk/reward)

Executive Summary Outline

1. 2. 3. 4.
5.

6. 7. 8. 9. 10.

Our Business Market Opportunity Value Proposition Proprietary or Distinguishable Position in the Marketplace Competition & Market Positioning Summary Our Customers Funds Requested and Why Use of Funds with Expected milestones Exit Strategy for Providers of Capital Conclusion

January 29, 2003

Bootstrapping
Bootstrapping is the most likely source of initial equity for 94 percent of new
technology based firms. It was initially used by more than 80 percent of the five hundred fastest growing privately held entrepreneurial firms in the United States. Examples: Obtain Research Grants (SBIR etc.) or have customer funded R&D Commercialize University Technology Reduce/Delay Compensation Work from home Buy used equipment instead of new Borrow or lease equipment instead of buying Hire personnel for short periods instead of permanently Coordinate purchases with other firms Speed up invoicing Cease doing business with slow payers Bartering for unused equipment/people Paying people with stock or with phantom stock
Early Stage Sources of Capital 24

Bootstrapping
Strategies Get operational quickly copycat idea in small target market to get off the
ground fast. Look for quick, break even, cash generating products Offer high value products or services that sustain direct personal selling Forget about the crack employee team Keep growth in check Focus on cash (not profits, market share or anything else) Cultivate banks before the business becomes creditworthy

Try to finance and bootstrap as long as possible until the need for external
growth finance becomes evident and unavoidable

Bootstrapping does not work for companies that are growing fast. Also

bootstrapping is like zero inventory or JIT it reveals hidden problems and forces the company to solve them.
Early Stage Sources of Capital 25

Success Rates for Obtaining Investment

Venture Capital 77% of proposals rejected at the initial screening stage 20% rejected during the due diligence stage 1-3 % funded Angels: Typically receive 36 investment proposals per year Interested in 8 Offers made to invest in 2, Typically find that 5% of deal flow result in a
deal.

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Angel Investors
Angels are typically wealthy individuals/families willing to invest in high risk
deals offered by entrepreneurs whom they admire and with whom they wish to be associated.

Speak with securities attorney before approaching outside investors, there are
legal issues at stake. Investors may not know about the rules but they impact how the company raises capital over the subsequent 12 months. Typically equity sales to angel investors will fall under three rules of Reg D: Rule 504 for offerings of up to $ 1 million Rule 505 for offerings up to $ 5 million Rule 506 for offerings over $5 million

Angel capital is not only about the money, it has to do with the resources angels
bring to fledging companies. Over 80% of angels have started a company on their own so they understand the process.

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Angel Investors
Angels and Venture Capital are not interchangeable. Angels are part time investors VC are full time Angels invest on their own behalf - VC invest on behalf of others VC generally invest in higher amounts and have more money Angels make investments in virtually all industry sectors. Business angels fund thirty to forty times more ventures each year

than venture capitalists. The National Venture Capital Association has suggested that angels may actually invest around $ 100 billion annually. According to the Center for Venture Research there are 400,000 angels.

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Angel Investors
Angels tend to have less risk aversion and lower expectations of return than
other types of investors. Their cost of finance is often cheaper for the entrepreneur and their funding is received more quickly than from other finance sources. Angels are more flexible in their financial decisions than venture capitalists.

Downsides include that angels are not likely to do multiple rounds, they may
want a hands on role and be unqualified and they do not have the national reputation or prestige when trying to get Investment Banking assistance.

Angels are more geographically dispersed. Location is important, 65% of angels

invest in deals reasonable close to where they live, within 300 500 miles. Interesting point is that 35% do not have this need they will invest as long as a lead investor lives geographically close to the enterprise.

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Angel Investors
Angels tend to be men from 46-65 years of age. Age does seem to influence
investors to this activity. In the 56-65 year old bracket investors tend to trust their own judgment rather than that of brokers or intermediaries. These investors tend to have postgraduate degrees. They have a wealth of business experience.

Investment Size 20% indicate they invest $ 25,000 per deal 40 % indicate the invest $25,000 to $99,999 per deal 25% indicate the invest $ 100,000 $250,000 per deal 15% indicate they invest more than $250,000 per deal.
Active investors invest in 1-4 deals per year with a mean of 3 deals. Holding period ran from 5-10 years. 5-15% of their portfolio is for private equity deals. Angels can also offer loan guarantees

Angels provide 84 percent of rounds under $250,000 and 58 percent between

$250,000 and $500,000 while overall rounds of less than $500,000 business angels will offer, in dollar terms, Early four Stage times as much as venture capitalists. Sources of Capital 30

Investors Investment Criteria (Rough Order) for All Investors

Criteria

Angels
1 2 3 4 5 6 7 8 9 10 14 21 23 24 24 26 27

VC
3 1 5 2 9 6 10 4 13 8 26 11 27 17 12 25 20
31

Enthusiasm of Entrepreneur Trustworthiness of the Entrepreneur Sales potential of the product Expertise of the Entrepreneur Investor liked the Entrepreneur upon meeting Growth potential of the market Quality of product Perceived financial rewards Niche Market Track Record of Entrepreneur Investors strength filling gaps in business Overall competitive protection Local venture (geography) Investors understanding of the business/industry Potential exit routes (liquidity) Presence of (potential) co-investors Formal competitive protection of product (patents)
Early Stage Sources of Capital

Perfect Angel Investors

Investing expertise Industry Experience & Contacts Entrepreneurial Experience Risk tolerance Patient Money Additional Investment Deep but not to deep- pockets. Idea angel has personal net worth of $2 million to $50 million. If an angel has more than that your company may fall below their radar screen. If they have less you may be out of luck if you need follow on financing. Congruent Exit Strategy Active Participation Cheerleader Potential

Early Stage Sources of Capital

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Investment Criteria for Angel Investors

Important

Investors strengths in filling gaps Investors involvement possible Trustworthiness of entrepreneur Quality of product Low initial capital costs Investor liked entrepreneur upon meeting Niche market Low cost to market initially Track record of entrepreneur Sales potential of product

Lesser Importance
Growth potential of Market Venture is local Ability to break even without
further funding Formal competitive protection of products (patents) Overall competitive position of product

Early Stage Sources of Capital

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Catching an Angel Investor

Step 1 - Sourcing. Step 2 - Evaluating Step 3 - Valuation Step 4 - Structuring Step 5 - Negotiating Step 6 - Support Step 7 - Harvesting

Early Stage Sources of Capital

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Sourcing
Word of mouth. You want to come
recommended. network of friends, acquaintances and friend of friends. Determine the ideal investors for Recent US research confirms that your firm and follow a rifle angels are widespread, at least 2.8 approach. percent of US households have at Target lead investors least one angel in the family. Check out potential investors due More than 50% of private equity diligence is a two way street investors deal flow comes from family, friends, associates and Local Angel Group. Most will not colleagues. take cold calls so you will need a Snowballing. Find one business referral but once you are in angel angel can lead to them knowing groups offer an opportunity to others. One caveat it is quality not present you company to several quantity. For every venture no angels. matter how unusual there is an Professional Networks. Talk to angel out there willing to fund the professional service providers who idea. may know angels. Matchmakers. Be careful, ask for Investee firms. Firms that have references and will they take the received angel money in the past fees when you have the money. 35 introduce you to their angels Early Stage Sources of Capital

Personal Networks. Explore your

Evaluating - Four Main Areas

1.
People you, the management team, other investors, advisors and significant stakeholders, anybody that has a stake in your companies success. Unique Talent or Knowledge Contacts Willingness to Hire Professional Management Chemistry with Investors Professional Advisors: Attorneys, Financial Advisors and Accountants Context external factors that could impact your business including available technology, customer needs, the overall economy, regulations and competitors Deal the price of the deal you propose and its structure. Price starts with valuation. Structure refers to the terms of the investment and other factors board seats, salary limits, etc. Business Opportunity Your business model, market size, potential and actual customers and timing of your opportunity. Investors want to invest in a company not a single product remember the objective is to create wealth, not make a living
Early Stage Sources of Capital

2. 3. 4.

36

Evaluating - When making the pitch

Show Passion and Be Yourself Focus on your team its not about just you, you do not have enough time or the skills to do everything. Sell the Team as a Team Show you have sales or can get them. Make sure the deal you are proposing makes sense from the investors point of view. Tell the angels what is in it for them. Think through what the investors need to get out of the deal in terms of ownership and potential returns. Do not aim to squeeze every last nickel out of them. From the beginning, you want investors always to feel as if they're making money Discuss the exit strategy. Sell the company, go public et al and let them know the time frame for such an event. Have the necessary documents in hand, business plan, financials, corporate bios etc.

Respect the angels time. Be

punctual. Ask how much time they have for the meeting keep your answers short and to the point. If you do not know the answer don't fake it say you will find out and do it within a certain time frame. Magic Words: I Dont Know. Know What Can Bite You and Say So Address Tough Questions Before Asked/Answer the Questions When Asked Never Oversell or Shade the Facts Listen and Enjoy the Process

Early Stage Sources of Capital

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Search Tips

Weigh the pros and cons of angels before you being the search for and discussions with private investors. If angel investors are deemed appropriate form realistic expectations of roughly how much money you will need and how much equity you are willing to surrender Learn about angels before you go after them. Figure out the role you want them to play for example if you need accounting help find an angel that can bring money and accounting assistance Contrary to popular belief relatively few lawyers, doctors and other professionals are currently involved as angels. Create Excitement around the Investment - After a handful of angels have expressed any degree of interest, you, the entrepreneur, should move interest into action and investment. Set a realistic deadline for the investment, then tell investors that the supply of available equity is fast dwindling.

Early Stage Sources of Capital

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Valuation

Angels price the company based on its potential capital return in the future but realize their are non financial returns that accrue to the angel. Excitement of a start up, sense of contributing, opportunity to give something back to the entrepreneurial world, new economic opportunities for a community. Angels value the deal less than the entrepreneurs will. Ideas are cheap its the execution that adds value. Potential investors do not have a clue at this point whether you and your team will be able to execute. Valuation methods include:

sales multiples, price-earnings ratio, free cash flow multiple, book value, liquidation value, replacement value, Comparables, discounted cash flow

Early Stage Sources of Capital

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Valuation Examples
Sales Forecast (Year 5) Risk Founder:
Inexperienced Experienced

Under $ 50,000,000 High Low

$300,000 $600,000 $500,000 $1,000,000

Over $ 50,000,000 High Low

$600,000 $1,000,000 $1,800,000 $3,000,000

Every deal is different but some ballpark pre money valuations are as follows: Sound idea $1 million max. Prototype $1 million max. Quality Management Team $ 1 -$ 2 million max. Quality Board $ 1 million max. Product Rollout or sales $ 1 million max. Total Potential Value $ 1 - $ 6 million max.

Early Stage Sources of Capital

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Actual Returns to Investors

IRR (%) Negative 0-24 25-49 50-99 100+ Angels (%) 39.8 23.8 12.7 13.3 10.2 VC (%) 64.2 7.1 7.1 9.5 12.0

Arkansas examples: An investor made a $20,000 investment into Wal-Mart now worth
+$91 million An investor made a $400,000 investment in 1968 into Systematics, now worth +$1 billion

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Target Multipliers
The targeted rates of return on individuals deals have to be higher so

that the portfolio can net acceptable returns. As a general rule investors target the following annual IRRs:

Years to Exit Development Stage 6 Seed 5 Start-up 4 First Stage 3 Second Stage 2 Mezzanine 1 Mezzanine Pre-exit

Rate of Return 66% 60% 53% 47% 41% 35%

Multiplier 21X 10.5X 5.5X 3.2X 2.0X 1.35X

Early Stage Sources of Capital

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Structuring

First on what terms are the angels investing? Debt/equity, what type of debt/equity, will investors get cash before entrepreneurs, will angels have right to invest in future rounds? Second what role will the angels play in your companies future? Will they be silent partners or active ones? Three fundamental ways angels invest in companies: Common Stock Easiest & Simplest Same risk as founders Little Structural Flexibility Valuation set for future Preferred Convertible Stock with various terms Most Common Investment Structural Flexibility Can Manipulate IRR Upside guarantees, downside protection Convertible note with various terms Protection of principal Interest as current return Warrants as sweetener Limited Upside
Early Stage Sources of Capital

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Structuring
Everything is negotiable, time to negotiate is before the term sheet gets signed.
Everybody needs to know how the relationship is going to work up front.

Downside Protective Strategies Liquidation Preference Straight Participating rare in early deals Antidilution Protection Weighted Average Full Ratchet - Draconian Dividends

Early Stage Sources of Capital

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Structuring

Management issues Affirmative Covenants Accounts and Reports Approval of Budgets Board of Directors Independent Public Accountants Financial Statements Class Voting Rights Investor Can block important corporate transactions Should disappear if preferred holds less than a certain percentage of company Investor/Founder Issues Sweat Equity vs. Financial Investor Vesting/Buy Back at Cost For Cause vs. No Fault Divorce Tag Along Rights Right of First Refusal/First Offer Baskets for Management Shares Non-competitive/Non Solicitation Agreements Employment/Service Agreements Early Stage Sources of Capital

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Structuring
Early In Issues Preemptive Rights All vs. Pro Rata Pay to Play Liquidity Opportunities IPOs Registration Rights Conversion Acquisition Liquidation Preference Conversion Redemption Lackluster Investments

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Negotiating
How much of the company are you going to give up? The trick is to align everyone's interest. The position you want to end

up with is its you and me against the world as opposed to its you against me. During negotiations angels will tend to focus on the numbers, specifically their initial ownership stake. They believe that will have the greatest impact on the future return on their investment so many will bargain hard over it. Angels have the advantage of time, you may need to move quickly they do not face the same time pressure. On the contrary many angels prefer to take their time during negotiations not least of all in the hope that you will eventually come around to their terms. Some angels will enlist a professional to negotiate others will simply reject the deal and move on. There is no reason you can not take the same position put your best deal forward and say politely this is a take it or leave it position. If you are asked why say you do not want to start your relationship off on adversarial footing.
Early Stage Sources of Capital 47

Support
An angels investment should be just the beginning of the interaction

not as an end point. Feel free to solicit the angels help any way you can, find customers, follow on investors, key staff, suppliers etc. Support should be a two way street. You should provide regular updates to all investors. You may also want to put in key prospects or other key events and one of the investors may have a contact.

Early Stage Sources of Capital

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Harvesting
Getting the investors their money back plus a return. Typically in these forms: Walking harvest your company distributes cash directly to its investors on
a regular basis. Partial Sale your investor sell their stakes to your companys management another stakeholder or an outsider. Strategic Sale A competitor acquires your company for strategic reasons, your investors receive a negotiated share of the acquisition price. Financial Sale A buyer outside your industry acquires your company for its cash flow. Initial Public Offering your company sells stock in the public markets. Less experienced angels, overemphasize the IPO as a primary exit route. An IPO is the exception not the rule. Negative Harvest - bankruptcy

Early Stage Sources of Capital

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Venture Capital
Of the nearly one million firms that are started each year in the United
States only one to two thousand actually receive venture capital financing.

Venture Capitalists are rarely able to fund small start up firms seeking

less than $ 5 million, regardless of the quality of the venture because of their specific investment criteria and high costs of due diligence, negotiating and monitoring.

Key points are have an outstanding Business Model, get Personal

Introductions and have a great Executive Summary

Early Stage Sources of Capital

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Types of Venture Funds

Stage of Investment
Seed/Start-up Mid-Stage Late-Stage Mezzanine LBO

Location
Regional Nationwide Coastal

By Industry
Computer Science Medical Telecom Biotechnology

January 29, 2003

Venture Funds as Partnerships

Object is to create Large, Successful Companies, make Outstanding

Returns on the Funds Capital - 25%+ IRR for Limited Partners and to Permit the Venture Capitalist to Share in Profits over a typical 10-Year Term

Investors are Limited Partners Invest 99% of Capital No Liability Receive Capital Return First, Then 80% of Profit No Role in Decisions Venture Capitalists are General Partners Invest 1% of Capital Some Liability Receive 20% of Profits Make All Decisions
January 29, 2003

Initial Public Offerings

An IPO typically has to be in the $20 - $50 million range to create a market for a
firm.

At the IPO stage providing financing for the firms growth is usually not the

major motivation, rather procuring exit routes and share liquidity is primary.

The SBA estimates that fewer than one in a thousand new ventures actually
have an IPO.

In the United States, it is estimated that only 1 percent of corporations are

publicly traded and only .25 percent are listed on an organized exchange.

Around 26-33 percent of all IPOs in the United States are venture capital funded
firms.

Early Stage Sources of Capital

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Lessons
Never split equity 50/50, and dont give away equity Friends and family financing have interesting hidden costs SBIR funds are like a gift from a wealthy uncle. It gets you to the first prototype

but does not get you to the marketplace If you are going to get financing outside of friends and family get an external board. Investment due diligence is about intgretity. It is about can I trust you? Will you make the right decisions with my money? Big money brings big expectations. You may not be with the company to accomplish those expectations. Perception is reality everybody likes a winner and wants to avoid a losing image. The business model is more important than the technology Do not give your family and friends a price when they invest. Give them some predetermined premium to the valuation set by the first outside money to avoid down rounds. Get an external confidant to act as a sounding board, they will help you keep a level plane
Early Stage Sources of Capital 54

Sources
Inc Magazine October 16, 2001 National Association of Seed & Venture Funds handouts The Angel Investors Handbook - Gerald A. Benjamin & Joel Margulis Angel Investing: Matching Startup Funds with Startup Companies -- A
Guide for Entrepreneurs, Individual Investors, and Venture Capitalists - Robert J. Robinson & Mark Van Osnabrugge

Early Stage Sources of Capital

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