Introduction to Entrepreneurship, 8e
Donald F. Kuratko
Chapter 8
The Search for Entrepreneurial
Ventures
Chapter Objectives
1.
2.
3.
4.
5.
6.
To differentiate between debt and equity as
methods of financing
To examine commercial loans and public stock
offerings as sources of capital
To discuss private placements as an
opportunity for equity capital
To study the market for venture capital and to
review venture capitalists evaluation criteria
for new ventures
To discuss the importance of evaluating
venture capitalists for a proper selection
To examine the existing informal risk-capital
market (angel capital)
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Figure
Who Is Funding Entrepreneurial Start-Up
Companies?
8.1
Source: Successful Angel Investing, Indiana Venture Center, March 2008.
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Debt Versus Equity
Debt Financing
Secured financing of a new venture that involves a
payback of the funds plus a fee (interest for the use of
the money).
Equity Financing
Involves the sale (exchange) of some of the
ownership interest in the venture in return for an
unsecured investment in the firm.
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Debt Financing
Commercial Banks
Make 1-5 year intermediate-term loans secured by
collateral (receivables, inventories, or other assets).
Questions in securing a loan:
What do you plan to do with the money?
How much do you need?
When do you need it?
How long will you need it?
How will you repay the loan?
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Debt Financing (contd)
Advantages
No relinquishment of
ownership is required.
Disadvantages
More borrowing allows
for potentially greater
return on equity.
Regular (monthly)
interest payments are
required.
During periods of low
interest rates, the
opportunity cost is
justified since the cost
of borrowing is low.
Continual cash-flow
problems can be
intensified because of
payback responsibility.
Heavy use of debt can
inhibit growth and
development.
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Table
Common Debt Sources
8.1
Business Type Financed
Debt
Source
Financing Term
Start-Up
Firm
Existing
Firm
Short
Term
Intermediate
Term
Long
Term
Trade credit
Yes
Yes
Yes
No
No
Commercial
banks
Sometimes, but
only if strong
capital or
collateral exists
Yes
Frequently
Sometimes
Seldom
Finance
companies
Seldom
Yes
Most frequent
Yes
Seldom
Factors
Seldom
Yes
Most frequent
Seldom
No
Leasing
companies
Seldom
Yes
No
Most frequent
Occasionally
Mutual savings
banks and
savings-and-loan
associations
Seldom
Real estate
ventures only
No
No
Real estate
ventures only
Insurance
companies
Rarely
Yes
No
No
Yes
Source: PricewaterhouseCoopers/National Venture Capital Association, MoneyTree Report, 2007.
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Other Debt Financing Sources
Trade Credit
Credit given by suppliers who sell goods on account.
Accounts Receivable Financing
Short-term financing that involves either the pledge of
receivables as collateral for a loan or the sale of
receivables at a discounted value (factoring).
Finance Companies
Asset-based lenders that lend money against assets
such as receivables, inventory, and equipment.
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Other Debt Financing Sources (contd)
Equity Instruments
Give investors a share of the ownership.
Loan with warrants provide the investor with the right to buy
stock at a fixed price at some future date.
Convertible debentures are unsecured loans that can be
converted into stock.
Preferred stock is equity that gives investors a preferred
place among the creditors in the event the venture is
dissolved.
Common stock is the most basic form of ownership and is
often are sold through public or private offerings.
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Equity Financing
Equity Financing
Money invested in the venture with no legal obligation
for entrepreneurs to repay the principal amount or pay
interest on it.
Funding sources: public offering and private
placement
Public Offering
Going public refers to a corporations raising capital
through the sale of securities on the stock markets.
Initial Public Offerings (IPOs): new issues of common stock
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Public Offerings
Advantages
Size of capital amount
Liquidity
Value
Image
Disadvantages
Costs
Disclosure
Requirements
Shareholder pressure
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Private Placements
Regulation D
Securities and Exchange Commission (SEC)
regulations for reports and statements required when
selling stock to private partiesfriends, employees,
customers, relatives, and professionals.
Defines four separate exemptions, which are based
on the amount of money being raised:
Rule 504a: placements of less than $500,000
Rule 504: placements up to $1,000,000
Rule 505: placements of up to $5 million
Rule 506: placements in excess of $5 million
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Private Placements (contd)
Accredited Purchaser
Regulation D uses the term accredited purchaser.
Included in this category are the following:
Institutional investors such as banks, insurance companies,
venture capital firms.
Any person who buys at least $150,000 of the offered security
and whose net worth, including that of his or her spouse, is at
least 5 times the purchase price.
Any person who, together with his or her spouse, has a net
worth in excess of $1 million at the time of purchase.
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Investors
Sophisticated Investors
Wealthy individuals who invest regularly in new and
early- and late-stage ventures and are knowledgeable
about the technical and commercial opportunities and
risks of the business in which they invest.
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The Venture Capital Market
Venture Capitalists
Are valuable and powerful source of equity funding for
new ventures that provide:
Capital for start-ups and expansion
Market research and strategy
Management-consulting, audits and evaluation
Contactscustomers, suppliers, and businesspeople
Assistance in negotiating technical agreements
Help in establishing management and accounting controls
Help in employee recruitment and employee agreements
Help in risk management and with insurance programs
Counseling and guidance in complying with government
regulations
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Table
Venture Capital Investments Comparison by
8.2
Stages
Stage
Amount
Deals
Expansion
$10.8 billion
1,235
Later Stage
$12.2 billion
1,168
Early Stage
$5.2 billion
995
Start up/ Seed
$1.2 billion
415
**data from 2007
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Recent Developments in Venture Capital
More-Experienced
More-Experienced
Venture
VentureInvestors
Investors
More-Specialized
More-Specialized
Venture
VentureFunds
Funds
Decrease
DecreaseininSmall
Small
Start-up
Start-up
Investments
Investments
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Emergence
Emergenceofof
Feeder
FeederFunds
Funds
More
MoreSophisticated
Sophisticated
Legal
LegalEnvironment
Environment
817
Investment Agreement Provisions
Choice of securities
Preferred stock, common stock, convertible debt, and
so forth
Control issues
Who maintains voting power
Evaluation issues and financial covenants
Ability to proceed with mergers and acquisitions
Remedies for breach of contract
Rescission of the contract or monetary damages
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Dispelling Venture Capital Myths
Myth 1:
your
Venture capital firms want to own control of
company and tell you how to run the business.
Myth 2:
Venture capitalists are satisfied with a
reasonable return on investment.
Myth 3:
Venture capitalists are quick to invest.
Myth 4:
Venture capitalists are interested in backing
new
ideas or high-technology inventions
management is a secondary consideration.
Myth 5:
Venture capitalists need only basic summary
information before they make an investment.
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Venture Capitalists and Business Plans
Proposal
Proposal
Size
Size
Financial
Financial
Projections
Projections
Competitive
Competitive
Advantage
Advantage
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Investment
Investment
Recovery
Recovery
Company
Company
Management
Management
820
Factors in Successful Funding of Ventures
Characteristics
Characteristicsof
of
the
theEntrepreneurs
Entrepreneurs
Characteristi
Characteristi
cs
csof
ofthe
the
Request
Request
Success
Successin
inSeeking
Seeking
Funding
Funding
(Demand
(DemandSide)
Side)
Sources
Sourcesof
of
Advice
Advice
Characteristics
Characteristicsof
of
the
theEnterprise
Enterprise
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Figure
8.2
Venture Capitalist System of Evaluating Product/Service
and Management
Level 4
Status of Product/Service
Fully developed product/service
Established market
Satisfied users
4/1
4/2
4/3
4/4
3/1
3/2
3/3
3/4
2/1
2/2
2/3
2/4
1/1
1/2
1/3
1/4
Level 3
Fully developed product/service
Few users as of yet
Market assumed
Level 2
Riskiest
Operable pilot or prototype
Not yet developed for production
Market assumed
Level 1
Product/service idea
Not yet operable
Market assumed
Level 1
Individual founder/
entrepreneur
Level 2
Level 3
Level 4
Two founders
Other personnel not
yet identified
Partial management
teammembers
identified to join
company when
funding received
Fully staffed,
experienced
management team
Riskiest
Status of Management
Source: Stanley Rich and David Gumpert, Business Plans That Win $$$ (New York: Harper & Row, 1985), 169.
Reprinted by permission of Sterling Lord Literistic, Inc. Copyright 1985 by Stanley Rich and David Gumpert.
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Table
Returns on Investment Typically Sought by
Venture Capitalists
8.3
Stage Of
Business
Expected Annual Return
on Investment
Expected Increase
on Initial Investment
Start-up business
(idea stage)
60% +
1015 investment
First-stage financing
(new business)
40%60%
612 investment
Second-stage financing
(development stage)
30%50%
48 investment
Third-stage financing
(expansion stage)
25%40%
36 investment
Turnaround situation
50% +
815 investment
Source: W. Keith Schilit, How to Obtain Venture Capital, Business
Horizons (May/June 1987): 78. Copyright 1987 by the Foundation for
the School of Business at Indiana University. Reprinted by permission.
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Table
8.4
Factors in Venture Capitalists Evaluation Process
Attribute
Level
Definition
Timing of entry
Pioneer
Late
follower
Enters a new industry first
Enters an industry late in the industrys stage of development
Key success
factor stability
High
Requirements necessary for success will not change radically during
industry development
Low
Requirements necessary for success will change radically during
industry development
High
Considerable resources and skills available to overcome market
ignorance through education
Low
Few resources or skills available to overcome market ignorance
through education
Long
An extended period of monopoly for the first entrant prior to
competitors entering the industry
Short
A minimal period of monopoly for the first entrant prior to competitors
entering this industry
Educational
capability
Lead time
Source: Dean A. Shepherd, Venture Capitalists Introspection: A Comparison of In Use and Espoused Decision Policies, Journal of Small Business Management
(April 1999): 7687; and Venture Capitalists Assessment of New Venture Survival, Management Science (May 1999): 621632. Reprinted by permission. Copyright
1999, the Institute for Operation Research and the Management Sciences (INFORMS), 7240 Parkway Drive, Suite 310, Hanover MD 21076 USA.
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Table
Factors in Venture Capitalists Evaluation Process
8.4
(contd)
Attribute
Level
Definition
Competitive rivalry
High
Intense competition among industry members during industry
development
Low
Little competition among industry members during industry
development
High
Considerable imitation of the mechanisms used by other firms to
enter this, or any other, industryfor example, a franchisee
Low
Minimal imitation of the mechanisms used by other firms to enter
this, or any other, industryfor example, introducing a new product
Broad
A firm that spreads its resources across a wide spectrum of the
marketfor example, many segments of the market
Narrow
A firm that concentrates on intensively exploiting a small segment
of the marketfor example, targeting a niche
High
Venturer has considerable experience and knowledge with the
industry being entered or a related industry
Low
Venturer has minimal experience and knowledge with the industry
being entered or related industry
Entry wedge
mimicry
Scope
Industry-related
competence
Source: Dean A. Shepherd, Venture Capitalists Introspection: A Comparison of In Use and Espoused Decision Policies, Journal of Small Business Management
(April 1999): 7687; and Venture Capitalists Assessment of New Venture Survival, Management Science (May 1999): 621632. Reprinted by permission. Copyright
1999, the Institute for Operation Research and the Management Sciences (INFORMS), 7240 Parkway Drive, Suite 310, Hanover MD 21076 USA.
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Criteria for Evaluating
New-Venture Proposals
Major Categories of Venture Capitalist
Screening Criteria:
Entrepreneurs personality
Entrepreneurs experience
Product or service characteristics
Market characteristics
Financial considerations
Nature of the venture team
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Table
Ten Criteria Most Frequently Rated Essential in
New-Venture
8.5
Criterion
Percentage
Capable of sustained intense effort
64
Thoroughly familiar with market
62
At least ten times return in five to ten
years
50
Demonstrated leadership in past
50
Evaluates and reacts to risk well
48
Investment can be made liquid
44
Significant market growth
43
Track record relevant to venture
37
Articulates venture well
31
Proprietary protection
29
Source: Reprinted by permission of the publisher from Criteria Used by Venture Capitalists to Evaluate New Venture Proposals, by Ian C. MacMillan,
Robin Siegel, and P. N. Subba Narasimha, Journal of Business Venturing (winter 1985): 123. Copyright 1985 by Elsevier Science Publishing Co., Inc.
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Table
8.6
Venture Capitalists Screening Criteria
Venture Capital Firm Requirements
Financial Information on the Proposed Business
Must fit within lending guidelines of venture firm for
stage and size of investment
Financial projections should be realistic
Proposed business must be within geographic area
of interest
Must have full information
Proposal Characteristics
Prefer proposals recommended by someone known
to venture capitalist
Should be a reasonable length, be easy to scan,
have an executive summary, and be professionally
presented
Proposed industry must be kind of industry invested
in by venture firm
Proposal must contain a balanced presentation
Nature of the Proposed Business
Use graphics and large print to emphasize key
points
Projected growth should be relatively large within
five years of investment
Entrepreneur/Team Characteristics
Economic Environment of Proposed Industry
Industry must be capable of long-term growth and
profitability
Economic environment should be favorable to a
new entrant
Proposed Business Strategy
Must have relevant experience
Should have a balanced management team in
place
Management must be willing to work with venture
partners
Entrepreneur who has successfully started previous
business given special consideration
Selection of distribution channel(s) must be feasible
Product must demonstrate defendable competitive
position
Source: John Hall and Charles W. Hofer, Venture Capitalists Decision Criteria
in New Venture Evaluation, Journal of Business Venturing (January 1993): 37.
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Venture Capitalist Evaluation Process
Stage 1: Initial Screening
This is a quick review of the basic venture to see if it meets the
venture capitalists particular interests.
Stage 2: Evaluation of the Business Plan
This is where a detailed reading of the plan is done in order to
evaluate the factors mentioned earlier.
Stage 3: Oral Presentation
The entrepreneur verbally presents the plan to the venture
capitalist.
Stage 4: Final Evaluation
After analyzing the plan and visiting with suppliers, customers,
consultants, and others, the venture capitalist makes a final
decision.
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Table
8.7
Essential Elements for a Successful Presentation to a
Venture Capitalist
TEAM MUST:
Be able to adapt
Know the competition
Be able to manage rapid growth
Be able to manage an industry leader
Have relevant background and industry experience
Show financial commitment to firm, not just sweat equity
Be strong with a proven track record in the industry
unless the company is a start-up or seed investment
PRODUCT MUST:
Be real and work
Be unique
Be proprietary
Meet a well-defined need in the marketplace
Demonstrate potential for product expansion, to avoid
being a one-product company
Emphasize usability
Solve a problem or improve a process significantly
Be for mass production with potential for cost reduction
MARKET MUST:
Have current customers and the potential for many more
Grow rapidly (25% to 45% per year)
Have a potential market size in excess of $250 million
Show where and how you are competing in the
marketplace
Have potential to become a market leader
Outline any barriers to entry
BUSINESS PLAN MUST:
Tell the full story, not just one chapter
Promote a company, not just a product
Be compelling
Show the potential for rapid growth and knowledge of
your industry, especially competition and market vision
Include milestones for measuring performance
Show how you plan to beat or exceed those milestones
Address all of the key areas
Detail projections and assumptions; be realistic
Serve as a sales document
Include a strong and well-written executive summary
Show excitement and color
Show superior rate of return (a minimum of 30% to 40%
per year) with a clear exit strategy
Source: Andrew J. Sherman, Raising Capital, 2nd ed. AMACOM Books, 2005; p.175.
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Informal Risk Capital
Business Angel Financing
Wealthy individuals in the United States are looking for
investment opportunities.
They are referred to as business angels or informal
risk capitalists.
Types of Angel Investors
Corporate angels
Entrepreneurial angels
Enthusiast angles
Micromanagement angels
Professional angels
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Table
Main Differences Between Business Angels and
Venture Capitalists
8.8
Main Differences
Business Angels
Venture Capitalists
Personal
Entrepreneurs
Investors
Firms funded
Small, early-stage
Large, mature
Due diligence done
Minimal
Extensive
Location of investment
Of concern
Not important
Contract used
Simple
Comprehensive
Monitoring after investment
Active, hands-on
Strategic
Exiting the firm
Of lesser concern
Highly important
Rate of return
Of lesser concern
Highly important
Source: Mark Van Osnabrugge and Robert J. Robinson, Angel Investing (San Francisco:
Jossey-Bass, 2000), 111. This material is used by permission of John Wiley & Sons, Inc.
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Table
8.9
Angel Stats
Typical deal size
$250,000
Typical recipient
Start-up firms
Cash-out time frame
5 to 7 years
Expected return
35 to 50% a year
Ownership stake
Less than 50%
Source: William E. Wetzel, University of New Hampshires Center for Venture Research, and the Indiana Venture Center, 2008.
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Figure
8.3
The Pros and Cons of Business Angel Investments
Source: Mark Van Osnabrugge and Robert J. Robinson, Angel Investing (San Francisco:
Jossey-Bass, 2000), 64. This material is used by permission of John Wiley & Sons, Inc.
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Key Terms and Concepts
accounts receivable
financing
accredited purchaser
angel capital
business angel
debt financing
equity financing
factoring
finance companies
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informal risk capitalist
initial public offering
(IPO)
private placement
Regulation D
sophisticated investor
trade credit
venture capitalist
835
