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Financing Entrepreneurial Ventures
Professor Andrew Zacharakis
Babson College
Zacharakis 2
Almost always start with equity…
• Identify potential investors– List and prioritize
– develop funding strategy
• Can investors add value beyond $?
• What ROR requirements do they expect?
• How do you Value and price the deal?
Zacharakis 3
Sources of Seed Capital, Inc 500, 2001
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Zacharakis 5
Zacharakis 6
Staged Capital Commitments
• Seed financing
• Start-up
• First-stage financing
• Second-stage financing
• Third-stage financing
• Bridge financing
• Management / leveraged buy-out
• Secondary purchase of public shares
Zacharakis 7
What Rates of Return Do VC Investors Seek?
Expected
Annual Holding
Stage ROR% Period
Seed and Start-up 50-100+ ~10+years
1st Stage 40-60 5-10
2nd Stage 30-40 4-7
Expansion and Bridge 20-30 3-5
LBOs 30-50 3-5
Turnarounds 50+ 3-5
Zacharakis 8
WE ALMOST ALWAYS START WITH...
• THE ENTREPENEUR
– Personal savings account
– Credit cards
– Personal assets• mortgaged property
• computers
• in-home offices
• phone/fax machine
• furniture
• vehicles
Zacharakis 9
THE “NEST EGG PHENOMENON”
The need to feed yourself and family...and a recognition of risk. Six Months?
Zacharakis 10
SOME PERSONAL RISK
• Income from the job you are leaving or could have had.
• The foregone interest/opportunity on the initial investment.
• Difficulty in being re-hired or finding a job.
• Credit rating issues.
• Self-Confidence.
Zacharakis 11
FAMILY AND FRIENDS
• There is often a lack of a formal repayment schedule.
• But the funds are not free:
– family pressure
– unsophisticated input and monitoring
– unsophisticated & unpredictable repayment expectations
Zacharakis 12
Other Sources
• Professional advisors and acquaintances• “Angels” - private investors and business assocs.• Private placement finders/packagers• Present or potential customers, suppliers• Past employers• Prospective team members• SBIR program• Strategic alliances and partnerships• State and Federal programs
Zacharakis 13
VESTED INTEREST IN YOUR SUCCESS?
• Suppliers: spontaneous source of financing
– enhanced terms on payables
– use of assets
– $$$$$$$$$$
– sales• Customers= cash or receivables
Zacharakis 14
Valuation
Future Value = Present Value X (1 + IRR)n
Zacharakis 15
Valuation Example
AssumptionsCompany:
PAT in Year 5 $2.5MP/E 15 times PAT
Investor:Investment $2.0MROR 50%Holding Period 5years
Zacharakis 16
Valuation Example
FUTURE VALUE (FV) (Year 5)
PAT X P/E = ($2.5M X 15) = $37.5M
Zacharakis 17
VALUATION EXAMPLE(CONT.)
FV = PV (1 + IRR)n
= 2(1 + .50)5 = $15.1875M
OWNERSHIP REQUIREDinvestment $2Mfuture value to investor: $15.1875MFV of the company: $37.5M
Ownership to fulfill the investors return req’d
41%
Zacharakis 18
What is Venture Capital?
• Pool of equity capital used to invest in new ventures
• Patient money
• Originated in 1946 with American Research and Development Corporation (ARD)
Zacharakis 19
Types of Venture Capital
• Private venture capital firms – limited partners contribute to pool of equity that is managed by general partner
• SBIC firms – combination of private and government funds (created with 1958 act)
• Corporate venture capital – venture capital divisions of larger corporations, banks, etc.
• State-sponsored venture capital – states creates funds that foster business within state
Zacharakis 20©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14
Organizational Structure of Venture Capital Investment
Portfolio Companies–Value creation
– Generate deal flow – Screen opportunities– Harvest investments
– Negotiate deals– Monitor and advise
General Partners
Venture Capital Fund
– Pension plan– Endowments– Life insurance companies
– Corporations– Individuals
Limited Partners
Effort and 1% of capital
Annual Management
Fee 2-3%
Carried Interest 20-
30% of Gain
99% of Investment Capital
Capital Appreciation 70-80% of Gain
Investment Capital and
Effort
Financial Claims
Zacharakis 21
The Venture Capital Investment Process
Development of Fund Concept
Secure Commitments from Investors
Generate Deal Flow
Closing of FundFirst Capital Call
Screen Business
Plans
Evaluate and Conduct Due
Diligence
Negotiate Deals and
Staging
Additional Capital Calls
Invest Funds
Distributing Proceeds– Cash – Public Shares
– OtherHarvesting Investment– IPO– Acquisition
– LBO – Liquidation
Value Creation and Monitoring– Board service– Performance evaluation and review– Recruitment management
– Assist with external relationships– Help arrange additional financing
Year 0
2-3 years
4-5 years
2-3 years or more
7-10 years plus extensions
Zacharakis 22
Inside the VC Firm
Partner
Proposal
Associate
Screen
Pitch
Weekly Meeting
Associate
Screen
Zacharakis 23
VC Capital Flow
Pension
Individuals
Corporations
VCs$50B
Angels$110B Early Stage
Expansion Stage
Later Stage
TradeSale
IPO
60%
11%
11%
29%
45%
25%
OtherEndowments, Foreign, etc.
18%
Zacharakis 24
VC Portfolio Returns
• Homeruns – 10X or 60% ROR
• Singles and Doubles – 5x or 30% ROR
• Living Dead – 0x or 5% ROR
• Failures – complete loss
Zacharakis 25
Key Events: 1999-2000
Zacharakis 26
VC Investments
0
5
10
15
20
25
30
35
40
45
50
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999Year
Early S tage Expans ion Stage Later S tagea Wicks Business Information company
1995 1996 1997 1998 1999 2000 YTD01
$6.8 $9.8 $12.7$17.5
$46.9
$90.5
$25.4
$0
$10
$20
$30
$40
$50
$60
$70
$80
$90
1-3Q Investment Annual Investment
YTD Investment Pace at ’99 LevelsEquity into Venture-Backed Companies
Am
ount
Inve
sted
($B
)
Source: VentureOne/PwC
Zacharakis 27a Wicks Business Information company
$4.6 $4.8 $5.9
$10.2 $11.4
$19.5
$26.4
$6.5$8.4
$24.1$22.1
$17.8
$10.6600
717790
11281289
15531656
1430
11081056
743658620
$0
$5
$10
$15
$20
$25
$30
$35
3Q98 4Q98 1Q99 2Q99 3Q99 4Q99 1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q010
400
800
1,200
1,600
Amount Invested ($B) Number of Deals
But Declining Every Quarter Equity into Venture-Backed Companies, Quarterly
Am
ount
Inve
ste d
($ B
)N
umber of D
eals
Source: VentureOne/PwC
Zacharakis 28a Wicks Business Information company
$5.0$4.6
$5.0$5.6
$6.0
$8.0
$10.0$9.5
$10.0 $10.1
$8.5$8.0
$6.6
$0
$2
$4
$6
$8
$10
3Q98 4Q98 1Q99 2Q99 3Q99 4Q99 1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01
Median Round Size Continues DeclineMedian Amount Invested Per Round
Med
ian
Am
ount
Inve
ste d
($ M
)
Source: VentureOne/PwC
Zacharakis 29a Wicks Business Information company
Especially Affecting Later-Stage RoundsMedian Amount Invested by Round Class
$9.5$6
$22
$7
$15
$10
$5 $5
$8
$1 $0.5$1.7
$0
$5
$10
$15
$20
$25
3Q98 1Q99 3Q99 1Q00 3Q00 1Q01 3Q01
Later Round
Second Round
First Round
Seed Round
Source: VentureOne/PWC
Med
ian
Am
o un t
Inve
sted
($M
)
Zacharakis 30a Wicks Business Information company
$0.2$0.3$0.5$1.4
$6.6
$3.5
$7.4$7.4
$5.3$5.3
$1.5
$0.4$1.1
17
445
70
42
69777575
21
7
18
$0
$2
$4
$6
$8
3Q98 4Q98 1Q99 2Q99 3Q99 4Q99 1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01
0
20
40
60
Amount Raised ($B) Venture-Backed IPOs
IPO Liquidity Evaporates...Deals and Amount Raised Through IPOs
Source: VentureOne
Am
ount
Inve
sted
($B
) Num
ber of Deals
Zacharakis 31a Wicks Business Information company
$2.9$4.9
$8.7
$4.6 $3.7
$19.4 $18.8
$113
198
248
68
119
216
142
121
$0
$5
$10
$15
$20
$25
1994 1995 1996 1997 1998 1999 2000 YTD'010
50
100
150
200
250
Amount Raised ($B) Venture-Backed IPOs
… and is the Worst in Many YearsDeals and Amount Raised Through IPOs
Source: VentureOne
Am
ount
Inve
s te d
($B
) Num
ber of Deals
Zacharakis 32a Wicks Business Information company
$16
$101
$43
$14$12
$26
$10
153186
217238
298
441
249
$0
$30
$60
$90
$120
1995 1996 1997 1998 1999 2000 YTD2001
0
100
200
300
400
Amount Paid ($B) Number of Transactions
2001 M&As still Exceed 1998Transactions and Amount Paid in M&As
Source: VentureOne
Am
ount
Inve
sted
($B
) Num
ber of Deals
Zacharakis 33a Wicks Business Information company
$4.0$4.9$7.1
$11.7
$20.2$23.7
$45.4
$15.5
$8.5$13.1
$5.4$4.2$3.7
71
8494
99
114107
121
8377
85
53
6959
$0
$10
$20
$30
$40
$50
3Q98 4Q98 1Q99 2Q99 3Q99 4Q99 1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01
0
25
50
75
100
Amount Paid ($B) Number of Transactions
M&A Booms Slows, Prices Drop Transactions and Amount Paid in M&As
Source: VentureOne
Am
ount
Inve
sted
($B
) Num
ber of Deals
Zacharakis 34a Wicks Business Information company
$11.5$9.8$10.7
$8.5$8.1
$13.0$15.7
$22.7
$27.2
$18.9
$0
$5
$10
$15
$20
$25
$30
1992 1993 1994 1995 1996 1997 1998 1999 2000 YTD01
Median Premoney Valuations Fall Below 1999 Levels
Median Premoney Valuation by Year
Source: VentureOne
Med
ian
P rem
oney
Val
uati
on (
$M)
Zacharakis 35a Wicks Business Information company
$16 $17 $18
$23$25 $24
$30
$26
$29
$25
$20 $20
$15
$0
$5
$10
$15
$20
$25
$30
3Q98 4Q98 1Q99 2Q99 3Q99 4Q99 1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01
After 2Q Plateau, Valuations Drop AgainMedian Premoney Valuation
Source: VentureOne
Med
ian
P rem
oney
Val
uati
on (
$M)
Zacharakis 36a Wicks Business Information company
Valuations Have Diminished Across All Financing Stages
Median Premoney Valuations by Round Class
$101
$29$30
$44
$15$21
$7$8
$14
$2 $2
$6$0
$20
$40
$60
$80
$100
3Q98 1Q99 3Q99 1Q00 3Q00 1Q01 3Q01
LaterRounds
SecondRound
First Round
Seed
Source: VentureOne
Med
ian
P rem
oney
Val
uati
on (
$M)
Zacharakis 37a Wicks Business Information company
Silicon Valley Is 1/3 of US Venture IndustryRegional Investment in the US
DC Metroplex5%
Southeast4%
Midwest5%
Northwest2%
All Other US18%
Silicon Valley34%
New England10%
Southern California8%New York Metro
7%
Texas7%
Source: VentureOne/PWC
Zacharakis 38
It’s a New Ballgame…
January 2000 Today
Cost of CapitalNearly zero:
raise as much asyou can get
Nearly infinite:make the most of what you’ve got
Wall Street Values
Growth, brandand share
Profits and cash
Capital Budgets Loose Tight (airtight)
Business Risk Boil the ocean Make a nickel
Employee Strategy
Recruit like crazy
Motivate, screen, cut
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