Equity Financing for High Growth Chapter 8 Equity Financing for High Growth

Objectives When and how to attract angel investors. How to attract venture capital financing. Process of finding investors. Different methods to value a business.

Introduction Equity funding means selling part of the ownership of the company to investors through the purchase of shares. Earlier the investment, riskier the venture, and higher the expected returns. The most common way for investor returns is for the company to be sold to a larger firm. Golden rule: Do not take cash from external shareholders unless you intend to build a company for sale.

Equity Investment Fundamentals Public Stock: Holding shares in publicly traded companies. Public companies freely trade on stock exchanges such as New York Stock Exchange (NYSE) and NASDAQ. Going public requires a significant amount of expensive legal work. Private Equity: 1. Venture Capital: Equity investment made in less mature companies for the launch, early development, or expansion of a business. 2. Leveraged Buyout: generally more mature companies generating operating cash flows. 3. Growth Capital: Equity investments in mature companies looking for capital to expand, restructure, enter new markets, or finance major acquisition. 4. Distressed or Special Situations: Investment in equity or debt securities of a distressed company. 5. Mezzanine Capital: Subordinated debt or preferred equity.

Rounds of Equity Finance 1. Pre seed: Status is you have an idea and a rough business plan. Likely sources of funds are friends, family, bootstrapping, and grants. Expected rate of return is up to 40%. 2. Seed: Status is you have a prototype or proof of principle, but no ales. Likely sources of funds are angels, grants, or possible local venture capital firm. Expected rate of return is 20 to 40%. 3. A Round: Status is the development is nearly complete, and are in final trials with customers. Likely sources of funds are angels and early stage venture capitalists (VC). Expected rate of return is 30%+. 4. B Round: Status is you have customers and are in the first growth phase. Likely sources of funds are venture capitalists or other institutional sources. Expected rate of return is 30%+. 5. C/D Rounds: Status is cash flow neutrality or point of exit. Likely sources of funds are late stage VCs in syndicate. Expected rate of return is 20%+. 6. Mezzanine: Status is preparation for sale or initial public offering (IPO) or acquisition. Likely sources of funds are large private equity funds. Expected rate of return is 15 – 20%.

Classes of Stock Any professional investor will require that an LLC or partnership be converted into a full corporation, usually a C corporation. The founders and employees who own stock will have common shares that carry few rights except their ownership position. Investors will demand preferred stock. This carries certain preferences, the most important of which is preference on liquidation. Another form of investment often used is convertible preferred. The initial investment is made in the form of a loan (debenture) that carries interest. The investor has a right to recall the loan plus interest or convert to preferred stock.

Preferences and Covenants Board Membership: Investors usually request a board seat in the company. If several investor groups participate then one investor will be the lead. Investors look for a balanced board, not control of the board. Management Decisions: Investors owning preferred stock may request the right to change the management team under certain conditions – often it is better to step aside for more seasoned management to be brought in with mutual consent. Registration Rights: Investor shares can convert to common shares. Later Rounds: A right of first refusal to participate in future investment rounds. Anti dilution Rights: The investors are freely issued an amount of common stock to bring their ownership back to their original stake so they do not suffer dilution. Forcing Exit: Investors may request and find a buyer and impose it on the company. Piggybacking: This gives shareholders rights to sell their shares at an IPO.

Angel Investors Angels are high net worth individuals who have some funds they are willing to risk in startup companies. They usually invest locally because they like to have personal interaction with the entrepreneur. They look for investments in areas they know well. Angels invest their own money in the range of $50,000 to $ 500,000. Venture capitalists invest $ 1 million or more institutional funds usually later in a company’s life – early stage and mid stage.

Guide to Selecting a Venture Capitalist 1. Scrutinize your business with a critical eye: Can your business give returns that a venture capitalist demands? 2. Beef up management: Venture capitalists do not want unseasoned executives. 3. Keep a high profile so VCs will visit: Edison Venture Funds initiates contact with about 35% it funds. 4. Target the search: Look for firms that specialize in your industry and size of investment. 5. Keep a lookout: Look for smaller VC firms that may be more flexible. 6. Investigate possible venture partners: Find out what the VC needs so that a meeting is more successful.

Learning how to value a business 1. Cash flow estimates: By looking at forecasted earnings (profits) and multiplying by a factor relevant to the industry. For consumer business the multiple is between 2 to 10. 2. Strategic sale: Major corporations invest in small companies. The basis for comparison is other purchases made recently in the same industry sector. 3. Earnings valuation: For established companies, the market price of common stock (# of shares of common stock times the cost per share). 4. Discounted cash flow valuation: Projected 3 to 5 year earnings discounted to present value.

Summary Equity funding means selling part of the ownership of the company to investors through the purchase of shares. Earlier the investment, riskier the venture, and higher the expected returns. The most common way for investor returns is for the company to be sold to a larger firm. Angels are high net worth individuals who have some funds they are willing to risk in startup companies. Angels invest their own money in the range of $50,000 to $ 500,000. Venture capitalists invest $ 1 million or more institutional funds usually later in a company’s life – early stage and mid stage. Any professional investor will require that an LLC or partnership be converted into a full corporation, usually a C corporation. Board Membership: Investors usually request a board seat in the company. Guide to selecting a venture capitalist:1. Scrutinize your business with a critical eye 2. Beef up management 3. Keep a high profile so VCs will visit 4. Target the search 5. Keep a lookout 6. Investigate possible venture partners Earnings valuation: For established companies, the market price of common stock (# of shares of common stock times the cost per share).

Home Work 1. What is equity funding? 2. What is the most common way for investor returns? 3. Name the 6 rounds of equity financing. 4. Who are Angel investors and how much do they usually invest? 5. Who are venture capital investors and how much do they usually invest? 6. Name 6 guides to selecting a venture capitalist?