Raising Entrepreneurial Capital Chapter 3: Options in Venture Financing– Early Stage Equity Capital

Equity capital Private equity is any investment made, in exchange for ownership shares, in a company whose shares are not traded on a stock exchange. A private equity investor may be familiar with the management team and may be actively involved in the company. Public equity involves any sale of stock on a formal stock exchange.

Private equity investors Look for: an appropriate risk adjusted return on their investment. A liquidity event or exit strategy to enable early stage investors to sell their shares and realize the return on their investment.

IPO is seldom a realistic option IPOs require very high growth prospects and large markets Without high growth prospects there is little chance of a public stock offering, reducing exit opportunities for a potential investor.

Angels High net worth individual investors Angels invest in fifty times as many deals as venture capitalists, though in smaller amounts. In the United States in 2011 angels invested $22.5 billion.

Angel role and characteristics Angels provide a bridge between friends and family financing and more formal venture capital. They partially serve the capital gap that is created by venture capitals migration towards larger and larger deals. Many are cashed out entrepreneurs. An angel investor might be a successful entrepreneur, a professional (e.g. doctor or lawyer) or a person with inherited wealth.

SEC accredited investors Angels must have: net worth of $1 million or individual annual income greater than $200,000, or joint marital income greater than $300,000 in each of the past two years.

Finding angels Organizationally angels can range from: individual investors operating alone, investing in one deal a year, to highly structured LLCs that closely resemble venture capital partnerships. Most angels prefer to operate fairly anonymously. Angels are increasingly banding together into angel networks.

Networks Normally meet once a month to hear pitches from firms seeking financing. The network serves simply as a forum to reduce search costs and any deals are done directly between interested investors and the entrepreneur. More formal networks have investors contribute an amount annually, say $50,000, into a common pool. The pool proceeds are then invested according to a majority vote of the investors.

Niche Angel investors generally provide seed or early stage capital, in amounts ranging from $10,000 to $2 million. A $2 million commitment is seldom by one angel, but generally part of a pool. This level of financing is typically used to get the firm to the next major milestone, for example product development or the signing of a major contract.

Characteristics Angels typically invest in technologies with which they are familiar. Angels tend to invest in businesses near their homes (one to two hour drive). Angel investors are usually willing to wait 5 to 7 years for a return on their investment. Most commonly that return is realized through the sale of the business to another company.

Involvement of angels Some angels will invest in only one or very few ventures at the same time, in order to be more directly involved as an advisor. Others use the start-up market as an alternative investment vehicle to the stock market and take a much more hands off approach. Angels are generally less formal and less public in their approach to investing than VCs.

US SBA sponsors: The Small Business Investment Company (SBIC) program allows private investment partnerships (SBICs) to form venture capital funds by leveraging their initial investment capital with debt capital available to entrepreneurs through SBA guarantees.

Valuation Entrepreneurs tend to underestimate the risk involved in growing their venture into a successful enterprise. Investors, on the other hand, tend to consider the risk more realistically and discount the value proposition accordingly. Thus there is often a wide discrepancy between what the entrepreneur thinks the company is worth and what the outside investor thinks.

Motivation Entrepreneurs understand that, at any valuation, the more funding they ask for, the higher the percentage of the business they will have to give up. Investors realize however, that the financial agreement must leave company founders with enough ownership to provide incentive to make the business succeed. It is unusual for an outside investor to want more than 40 –50% of the business.

Early stages Development/Conception: owner and the business are indistinguishable. Startup: Facilities and equipment and employees are acquired to commence production. Early growth: the business has a demonstrated workable business model.

Later stages Profitability and rapid growth: retained earnings and debt finance rapid growth. External equity capital may be supplied by angels or venture capital. Maturity: Cash flow is positive, market penetration is good. No need for external financing.

Stage and valuation A business with revenue, even if operating at a loss, will usually receive a higher valuation than a company with no product revenues, little expense history, and an incomplete management team. Each successive stage commands higher valuations as the business achieves milestones, confirms the ability of the management team, and progresses in reducing fundamental risks.

Seed and concept stage financing To finance companies, the entrepreneur almost always starts with personal, relatives, and friends money, and may then proceed to seeking more formal investors, that is angel financing. Traditional venture capital firms have little interest in funding a company at this stage. The risk level is too high, and the time for achieving a payout or harvest is hard to determine.

Startup stage financing Companies at this stage commonly seek funding from angel investors, early-stage venture capital firms, and, in some cases, grants from foundations and government sources. Traditional venture capital firms may show an interest, assuming that a top-rated management team is assembled, patentability or proprietorship is proven, and rapid growth marketability is demonstrated.

Rapid growth stage financing Venture capital marketplace: Practical minimum investment for VCs is $3-5 million because of the considerable amount of due diligence required. VCs demand highly developed business plans with detailed financial projections. Their objective is to take a significant amount of venture ownership, keep a close rein on the firm, and achieve returns far larger than typical investment vehicles.

Mature stage financing Mezzanine, or bridge, financing Often a debt/equity hybrid used to allow the company to pursue the options in its exit strategy. May support transition to being acquired by one of the current stakeholders, or another company. Can also support some restructuring of ownership distribution where there are early investors who want to reduce or liquidate their positions.

Harvest Time Investors convert their stock to cash and claim the return on their investment, by: Initial Public Offering (IPO) Merger/Acquisition (M & A) Management buyout (MBO) by the management team or other insiders, or sale to outsiders.