Part II

Initiating Entrepreneurial
Ventures

Chapter 8
Sources of Capital
for Entrepreneurial
Ventures

PowerPoint Presentation by Charlie Cook

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 Chapter Objectives
1. To differentiate between debt and equity as methods
of financing
2. To examine commercial loans and social lending as
sources of capital
3. To review initial public offerings (IPOs) as a source
of capital
4. To discuss private placements as an opportunity for
equity capital
5. To study the market for venture capital and to
review venture capitalists evaluation criteria for new
ventures

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 Chapter Objectives (contd)
6. To discuss the importance of evaluating venture
capitalists for a proper selection
7. To examine the existing informal risk-capital market
(angel capital)

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Figure
8.1 Who Is Funding Entrepreneurial Start-Up Companies?

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:
1. What do you plan to do with the money?
2. How much do you need?
3. When do you need it?
4. How long will you need it?
5. How will you repay the loan?

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 Debt Financing (contd)
Advantages Disadvantages
No relinquishment of Regular (monthly)
ownership is required. interest payments are
More borrowing allows required.
for potentially greater Continual cash-flow
return on equity. problems can be
low interest rates intensified because of
reduce the opportunity payback responsibility.
cost of borrowing Heavy use of debt can
inhibit growth and
development.

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 Social Lending, or Crowdfunding
Sources of Social Lending
Are often Internet-based sites that pool money from
investors willing to lend capital at agreed-upon rates.
Match borrowers and lenders based on loan size, risk
tolerance, and social familiarity (e.g., co-workers,
fellow alumni, hometown residents, etc.).
Possible Dangers
Low funding success rate
Business plan disclosure
No ongoing counseling relationship
Potential tax liability
Uncertain regulatory environment
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Table
8.1 Common Debt Sources

Business Type Financed Financing Term

Debt Start-Up Existing Short Intermediate Long
Source Firm Firm Term Term Term

Trade credit Yes Yes Yes No No

Commercial Sometimes, but Yes Frequently Sometimes Seldom
banks only if strong
capital or
collateral exists
Finance Seldom Yes Most frequent Yes Seldom
companies
Factors Seldom Yes Most frequent Seldom No
Leasing Seldom Yes No Most frequent Occasionally
companies
Mutual savings Seldom Real estate No No Real estate
banks and ventures only ventures only
savings-and-loan
associations
Insurance Rarely Yes No No Yes
companies

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).
Factoring
The sale of accounts receivable at discounted values
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 Financing
Gives 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 its 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 sources of equity funding
for new ventures who 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
8.2 Venture Capital Investments Comparison by Stages

Stage Amount Deals

Later Stage $1.8 billion 178

Early Stage $2.3 billion 364

Start up/Seed $134 million 80

Source: Adapted from: PricewaterhouseCoopers/National Venture Capital Association, MoneyTree Report, 2011.
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 Recent Developments in Venture Capital

More-Experienced
Venture Investors

More-Specialized Emergence of
Venture Funds Feeder Funds

Decrease in Small
More Sophisticated
Start-up
Legal Environment
Investments

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 Recent Developments in Venture Capital
More
experienced
investors
Stronger legal
Globalization
governance
of VCs
environment

Venture
More direct Capital Trends
More VC
involvement of
specialization
VCs

Reduced seed
Syndication of
and start-up
VC deals
financing

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 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: Venture capital firms want to own control of your
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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 Factors in Successful Funding of Ventures

Characteristics of
the Entrepreneurs

Characteristics Success in Seeking

Sources of
of the Funding Advice
Request (Demand Side)

Characteristics of
the Enterprise

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 Venture Capitalists and Business Plans

Proposal
Size

Financial Investment
Projections Recovery

Competitive Company
Advantage Management

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Figure
8.2 Venture Capitalist System of Evaluating Product/Service and Management

Level 4
Fully developed product/service
Established market
4/1 4/2 4/3 4/4
Satisfied users

Level 3
Status of Product/Service

Fully developed product/service

Few users as of yet
3/1 3/2 3/3 3/4
Market assumed

Level 2
Riskiest Operable pilot or prototype
Not yet developed for production
2/1 2/2 2/3 2/4
Market assumed

Level 1
Product/service idea
Not yet operable
1/1 1/2 1/3 1/4
Market assumed

Level 1 Level 2 Level 3 Level 4

Individual founder/ Two founders Partial management Fully staffed,
entrepreneur Other personnel not teammembers experienced
yet identified identified to join management team
company when
funding received

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
8.3 Returns on Investment Typically Sought by Venture Capitalists

Stage Of Expected Annual Return Expected Increase

Business on Investment on Initial Investment

Start-up business 60% + 1015 investment

(idea stage)

First-stage financing 40%60% 612 investment

(new business)

Second-stage financing 30%50% 48 investment

(development stage)

Third-stage financing 25%40% 36 investment

(expansion stage)

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 Enters a new industry first
Late Enters an industry late in the industrys stage of development
follower
Key success High Requirements necessary for success will not change radically during
factor stability industry development
Low Requirements necessary for success will change radically during
industry development
Educational High Considerable resources and skills available to overcome market
capability ignorance through education
Low Few resources or skills available to overcome market ignorance
through education
Lead time 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

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
8.4 Factors in Venture Capitalists Evaluation Process (contd)

Attribute Level Definition

Competitive rivalry High Intense competition among industry members during industry
development
Low Little competition among industry members during industry
development
Entry wedge High Considerable imitation of the mechanisms used by other firms to
mimicry 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
Scope 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
Industry-related High Venturer has considerable experience and knowledge with the
competence industry being entered or a related industry
Low Venturer has minimal experience and knowledge with the industry
being entered or related industry

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
8.5 Venture Capitalists Screening Criteria

Venture Capital Firm Requirements Financial Information on the Proposed Business

Must fit within lending guidelines of venture firm for Financial projections should be realistic
stage and size of investment Proposal Characteristics
Proposed business must be within geographic area Must have full information
of interest
Should be a reasonable length, be easy to scan,
Prefer proposals recommended by someone known have an executive summary, and be professionally
to venture capitalist presented
Proposed industry must be kind of industry invested Proposal must contain a balanced presentation
in by venture firm
Use graphics and large print to emphasize key
Nature of the Proposed Business points
Projected growth should be relatively large within Entrepreneur/Team Characteristics
five years of investment
Must have relevant experience
Economic Environment of Proposed Industry
Should have a balanced management team in place
Industry must be capable of long-term growth and
profitability Management must be willing to work with venture
partners
Economic environment should be favorable to a
new entrant Entrepreneur who has successfully started previous
business given special consideration
Proposed Business Strategy
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
8.6 Essential Elements for a Successful Presentation to a Venture Capitalist

TEAM MUST: MARKET MUST:

Be able to adapt Have current customers and the potential for many more
Know the competition Grow rapidly (25% to 45% per year)
Be able to manage rapid growth Have a potential market size in excess of $250 million
Be able to manage an industry leader Show where and how you are competing in the
Have relevant background and industry experience marketplace
Show financial commitment to firm, not just sweat equity Have potential to become a market leader
Be strong with a proven track record in the industry Outline any barriers to entry
unless the company is a start-up or seed investment

PRODUCT MUST: BUSINESS PLAN MUST:

Be real and work Tell the full story, not just one chapter
Be unique Promote a company, not just a product
Be proprietary Be compelling
Meet a well-defined need in the marketplace Show the potential for rapid growth and knowledge of
Demonstrate potential for product expansion, to avoid your industry, especially competition and market vision
being a one-product company Include milestones for measuring performance
Emphasize usability Show how you plan to beat or exceed those milestones
Solve a problem or improve a process significantly Address all of the key areas
Be for mass production with potential for cost reduction 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 who 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
8.7 Angel Stats

Typical deal size $500,000$850,000

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: Jeffrey Sohl, University of New Hampshires Center for Venture Research, 2011; and the Halo Report, 2011.
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Figure
8.8 Pros and Cons of Dealing with Angel Investors

Pros Cons
1. Angels engage in smaller 1. Angels offer no additional
financial deals. investment money.
2. Angels prefer seed stage or 2. Angels cannot offer any national
start-up stage. image.
3. Angels invest in various industry 3. Angels lack important contacts
sectors. for future leverage.
4. Angels are located in local 4. Angels may want some decision
geographic areas. making with the entrepreneur.
5. Angels are genuinely interested 5. Angels are getting more
in the entrepreneur. sophisticated in their investment
decisions.

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 Key Terms and Concepts

accounts receivable factoring

financing finance companies
accredited purchaser informal risk capitalist
angel capital initial public offering (IPO)
bootstrapping private placement
business angel Regulation D
crowdfunding social lending
debt financing sophisticated investor
direct public offering (DPO) trade credit
equity financing venture capitalist

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