Informal Risk Capital, Venture Capital, and Going Public Chapter 12 Informal Risk Capital, Venture Capital, and Going Public McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives To explain the basic stages of venture funding To discuss the informal risk-capital market To discuss the nature of the venture-capital industry and the venture-capital decision process To explain all aspects of valuing a company To identify several valuation approaches To explain the process of going public

Financing the Business Criteria for evaluating financing alternatives: Amount and timing of funds required Projected company sales and growth Types of funding Early stage financing: One of the first financings obtained by a company

Financing the Business Development financing: Financing to rapidly expand the business Acquisition financing: Financing to buy another company

Table 12.1 - Stages of Business Development Funding

Financing the Business Risk capital markets: Provide debt and equity to nonsecure financing situations Types of risk capital markets Informal risk capital market: Consists mainly of individuals Venture-capital market: Consists of formal firms Public-equity market: Consists of publicly owned stocks of companies

Informal Risk Capital Business angels: Individuals investing in the informal risk-capital market Investments range between $10,000 to $500,000 Provides first-stage financing Referral sources: Ways individual investors find out about potential deals

Table 12.2 - Characteristics of Informal Investors

Table 12.2 - Characteristics of Informal Investors

Venture Capital Nature of venture capital Long-term investment discipline Equity pool: Money raised by venture capitalists to invest Equity participation: Taking an ownership position

Venture Capital Found in: Creation of early-stage companies Expansion and revitalization of businesses Financing of leveraged buyouts of existing divisions of major corporations or privately owned businesses

Types of Venture Capital Firms SBIC firms: Small companies with some government money that invest in other companies Private venture-capital firms: Having general and limited partners State-sponsored venture-capital fund A fund containing state government money that invests primarily in companies in the state

Figure 12.1 - Types of Venture-Capital Firms

Venture Capital Venture-capital process: Decision procedure of a venture-capital firm Objective of a venture-capital firm Generation of long-term capital appreciation through debt and equity investments Criteria for committing to venture Strong management team Unique product and/or market opportunity Significant capital appreciation: Increase in value of the organization during a specific period of time

Figure 12.4 - Venture-Capital Financing: Risk and Return Criteria

Venture Capital Venture-capital process Preliminary screening: Initial evaluation of the deal Agreement on principal terms between entrepreneur and venture capitalist Due diligence: Process of deal evaluation Final approval: Document showing the final terms of the deal

Valuing Your Company Factors in valuation: Nonmonetary aspects that affect the fund valuation Nature and history of business Economic outlook Book (net) value Future earning capacity Dividend-paying capacity

Valuing Your Company Financial ratio Assessment of goodwill/intangibles Previous sale of equity Market value of similar companies’ stock Financial ratio Measure financial strengths and weaknesses of the venture Used on actual financial results

Valuing Your Company Liquidity ratios

Valuing Your Company Activity ratios

Valuing Your Company Leverage ratios

Valuing Your Company Profitability ratios

Valuing Your Company General valuation approaches: Methods for determining the worth of a company Types of approaches Assessing comparable publicly held companies and the prices of these companies’ securities Present value of future cash flow Valuing a company based on its future sales and profits Replacement value Cost of replacing all assets of a company

Valuing Your Company Book value Earnings approach Factor approach Indicated worth of the assets of a company Earnings approach Determining the worth of a company by looking at its present and future earnings Factor approach Using the major aspects of a company to determine its worth Liquidation value Worth of a company if everything was sold today

Valuing Your Company General valuation method

Table 12.7 - Steps in Valuing Your Business and Determining Investors’ Share

Evaluation of an Internet Company Financial projections are compared with the future market in terms of: Fit Realism Opportunity Management team is examined Opportunities available in the investor market are examined

Deal Structure Form of the transaction when money is obtained by a company Needs of the funding sources Rate of return required Timing and form of return Amount of control desired Perception of risks

Deal Structure Entrepreneur’s needs Degree and mechanisms of control Amount of financing needed Goals for the particular firm

Going Public Selling some part of the company by registering with the Securities and Exchange Commission (SEC) Provides the company with: Financial resources A relatively liquid investment vehicle Initial public offering:The first public registration and sale of a company’s stock

Table 12.8 - Advantages and Disadvantages of Going Public

Timing of Going Public and Underwriter Selection Timing - Issues to be considered before going public Size of offering Amount of the company’s earnings, and financial performance Favorability of the market conditions Urgent money requirement Needs and desires of the present owners

Timing of Going Public and Underwriter Selection Managing underwriter: Lead financial firm in selling stock to the public Underwriting syndicate: A group of firms involved in selling stock to the public

Timing of Going Public and Underwriter Selection Factors to consider in selection Reputation Distribution capability Advisory services Experience Cost

Registration Statement and Timetable Reasons for delays in registration process Heavy periods of market activity Peak seasons Attorney’s unfamiliarity with federal or state regulations Issues arising over requirements of the SEC Inexperienced managing underwriter

Registration Statement and Timetable Reviewing registration statement includes ensuring Full and fair disclosure: Nature of all material submitted to SEC for approval Registration statement constitutes of: Prospectus: Document for distribution to prospective buyers Registration statement: Materials submitted to the SEC for approval to sell stock

Registration Statement and Timetable Form S- 1: Form for registration for initial public offerings The Registration Statement-Provides information regarding: Offering Past unregistered securities offering of the company Other undertakings by the company

Registration Statement and Timetable Includes exhibits: Articles of incorporation Underwriting agreement Company bylaws Stock option and pension plans Initial contracts

Registration Statement and Timetable Procedure Red herring: Preliminary prospectus of a potential public offering Deficiencies are communicated through Comment letter: Letter indicating corrections that need to be made in the submitted prospectus Pricing amendment Additional information on price and distribution is submitted to the SEC to develop the final prospectus

Legal Issues and Blue-Sky Qualifications Quiet period: 90-day period in going public when no new company information can be released Blue-sky qualifications Blue-sky laws: Laws of each state regulating public sale of stock

After Going Public Aftermarket support Reporting requirements - File: Actions of underwriters to help support the price of stock following the public offering Reporting requirements - File: Annual reports on Form 10-K Quarterly reports on Form 10-Q Specific transaction or event reports on Form 8-K