Introduction to Entrepreneurship and New Venture Creation Rui Baptista Masters in Engineering and Management of Technology Masters in engineering Design Introduction to Entrepreneurship and New Venture Creation Rui Baptista

New Venture Financing

Financial Steps in the Evolution of a Successful New Firm 1. Founding Stage: The entrepreneurial team begins with a vision, business model and strategy 4. Harvest Stage: IPO or acquisition provides returns to investors and founders 2. Seed Stage: Initial financial capital 3. Growth Stage: Growth capital required Entrepreneurship - Rui Baptista

Idealized Cash Flow Diagram for a New Firm Entrepreneurship - Rui Baptista

Entrepreneurship - Rui Baptista Early Stage Funding Most start-ups will not raise outside capital Niche markets that are too small No sustainable competitive advantage Strategy relies only on execution, personal selling and energy of the entrepreneur Team lacks industry experience Profit margins that are too low No Harvest/Exit Upside Entrepreneurship - Rui Baptista

Financing Rules for Startups Choose ventures with reasonable (low) capital requirements Get operational quickly Generate cash Stick to high value products Control growth Focus on cash, not profits or market share Entrepreneurship - Rui Baptista

Sources of Financing for Start-ups Founders Family and Friends Professional Investors — Business Angels Seed Capital Venture Capital Bank Loans Debts to Suppliers Customer Prepayments Leasing Companies Established Companies Government Grants and Credits Public Stock Offering Entrepreneurship - Rui Baptista

Sources of Start-up Capital in the United States 6.3% - Venture capital 4.0% - Mortgaged property 1.1% - Government guaranteed loan 3.4% - Other 78.5% - Personal savings 21.4% - Angels, employees, partners, friends 14.4% - Bank loans 12.9% - Family Members Entrepreneurship - Rui Baptista

Entrepreneurship - Rui Baptista Personal Resources Offers greatest return, if successful Investors and venture capital sources usually require it Personal funds can be treated as equity or debt Possible Sources: Savings Severance packages Personal asset sales “Moonlighting” “Bootstraping” Entrepreneurship - Rui Baptista

“Bootstrap” Financing To start a firm by one’s own efforts and to rely solely on the resources available from oneself, family, and friends Often applied to a current business that can reduce costs from current operation Usually overlooked as a source to entrepreneurs The entrepreneur becomes more efficient and cost conscious Entrepreneurship - Rui Baptista

Advantages and Sisadvantages of “Bootstrap” Financing Less pressure on generating profits fast Easy terms on ownership Control by founders Little time spent on finding investors Unable to fund growth phase Lack of funding commitment for the future Loss of advice from professional investors Entrepreneurship - Rui Baptista

Entrepreneurship - Rui Baptista “Moonlighting” Founder still working a regular job Income used to support the entrepreneur during needed cash flow When the venture begins paying as well or better – entrepreneur leaves job Entrepreneurship - Rui Baptista

Entrepreneurship - Rui Baptista Angel Financing Angels are wealthy individuals, usually experienced entrepreneurs, who invest in business start-ups in exchange for equity in the new ventures. Usually take interest in management Popular source in the US – in 1996, estimated 250,000 angels investing $10-$20 billion in 30,000 firms each year Entrepreneurs and business angels are often connected through intermediary companies – Angel Networks Entrepreneurship - Rui Baptista

Angel Investment Criteria Seek start-ups within the industry that the angel has experience Located near company Recommended by trusted associates/connections Entrepreneurs with attractive personal characteristics such as integrity and ‘coachability’ Good rapport with management team Good market and growth potential for the opportunity Exit strategy of merger, IPO, or buyback Expected performance smaller than with venture capital (ROI of 30% to 50%; sales growth of 10-20% per year) Seeking an investment of $100,000 to $1 million in exchange for minority ownership, less than 40% Entrepreneurship - Rui Baptista

Venture Capital Financing Venture capital is a source of funds for new ventures that is managed by investment professionals on behalf of the investors in the venture capital fund Requires a robust market, margin, and money-making features: High net profit potential – minimum 10 to 15% and durable Attractive returns for investors – 40-70% ROI Growth of more than 20% Gross Margins of 40% and durable Quick to break-even and positive cash flow The number of startups with venture capital is extremely small: there were about 8200 VC investments in 2000 in the US, while the number of startups/year is 1 to 3 million A significant part of the VC investments happens at a later stage – growth/IPO Entrepreneurship - Rui Baptista

Risk-Reward Profile for Various Investments Entrepreneurship - Rui Baptista

Characteristics of an Attractive Venture Capital Investment Outstanding opportunity: potential to become a leading firm in a high growth industry with few competitors Highly competent and committed management team and high human capital (talent) Strong competitive abilities and a sustainable competitive advantage Viable exit or harvest strategy Reasonable valuation of the new venture Founders capital invested in the venture. Recognizes competitors and has a solid competitive strategy A sound business plan showing how cash flow turns positive within a few years Demonstrated progress on the product design and good sales potential Entrepreneurship - Rui Baptista

Venture Capital Criteria Quick to gain customer base Product/service creates or adds significant value to customer Customers are reachable and receptive Competitive advantages “First mover” advantages Patents, trade secrets, special know-how Control over prices or costs Special relationships with customers or suppliers Attractive value creation and realization Low to moderate capital needs Viable exit strategy Good Risk/reward balance Good capital market timing Entrepreneurship - Rui Baptista

Entrepreneurship - Rui Baptista Bank Loans Strongly based on character and background Banks loan on assets but require demonstration of capacity to repay (cash-flow, management experience, competitive position, financial projections) Capital structure – about 30% loan + equity (own funds) Collateral – marketable assets; personal guarantees Requires business and key-person insurance coverage Entrepreneurship - Rui Baptista

Entrepreneurship - Rui Baptista Government Financing Government intervenes in the financing of new ventures to remedy market failure – incomplete markets occur when the risk perceived by the entrepreneur is significantly lower than the risk perceived by the financing institution Market failure is usually more serious at the very early stage of development of new business ideas, and in particular for ideas that require large initial investments and a long pre-market development period Financing can take the form of direct grants/subsidies, guaranteed loans, or low interest rates Portuguese Government Agency for Small Business: IAPMEI (http://www.iapmei.pt/) Entrepreneurship - Rui Baptista

Growth Financing and Harvest Initial Public Offering (IPO): the first public equity issue of stock made by a company Advantages Raising new capital with the possibility of later, additional offerings Liquidity — Ability to convert ownership to cash, potential of harvest for investors and founders Visibility — Build brand and reputation Disadvantages Costs and effort for mounting the operation Disclosure requirements and scrutiny of operations Perceived pressures on achieving short-term results Possible loss of control to a majority shareholder Entrepreneurship - Rui Baptista

Entrepreneurship - Rui Baptista Valuation The valuation rule is the algorithm by which an investor such as an angel or venture capitalist assigns a monetary value to a new venture: Initial Equity Value: M0 Expected Earnings of the Firm: G1+G2+…GN Initial Market Value: MN = M0 + G1+G2+…GN Capital Return at IPO: R = MN / M0 - 1 Entrepreneurship - Rui Baptista

Terms of an Investment Deal Percent ownership for the investor group or business angel Timing of investment and IPO Control exerted by investor Vesting periods for ownership by the entrepreneurial team Rights to require an IPO Type of security Reservation of ownership for employees (stock option pool) Anti-dilution provisions Milestones of achievement, if there are multiple tranches (steps) to the investment Entrepreneurship - Rui Baptista