Chapter 11: Human and Financial Capital

1. Chapter 11: Human and Financial Capital • Questions answered in this chapter: • What is a startup? • What are the different sources of human capital that can play a role in a startup business? • What are the typical sources of funding for an early-stage startup business? • What elements are needed for a successful pitch to investors? • How is the value of a startup determined? • What are the factors involved in negotiating with investors? • What is an initial public offering? What process must an entrepreneur undertake to successfully complete and IPO?

2. Exhibit 11-1: Venture Capital — Market Size, 1995-2001 Source: Data from PricewaterhouseCoopers, MoneyTree Survey: Full Year & Q4 2001 Results: US Report.

3. Defining a Startup • A startup is a business that is in the process of developing the underlying infrastructure needed to support future growth • A startup is a business engaging in the the following three basic processes: • Developing and refining the offering and strategy to go to market • Obtaining initial funding to begin operations • Building a capable management team to handle operations

4. Exhibit 11-2: Startup Business Investment Stages Early Stage Expansion Stage Later Stage Seed Stage Startup First-Stage Second-Stage Mezzanine Bridge Financing Stages • Validate the business concept (e.g. build prototype, develop business plan, conduct market research) • Build management team and complete product development • Expand production, marketing, or sales capabilities • Provide working capital once shipping products or providing services • Fuel substantial growth (typically provided to business that are at least break even) • Prepare for initial public offering, usually planned in the next 6 months to a year Investment Purpose • Angel investors • Traditional VC • Consulting firms • Online VC firms • Incubators • Angel investors • Traditional VC • Consulting firms • Incubators • Traditional VC • Corporations • Traditional VC • Corporations • Traditional VC • Corporations • Buyout firms • Investment banks • Traditional VC • Corporations • Buyout firms • Investment banks Type of Investors Source: Gold Book of Venture Capital Firms, Bob Zider, “How Venture Capital Works,” Harvard Business Review

5. Relationship between Human and Financial Capital • Human and financial capital resources can influence the business planning process and, in turn, be influenced by the business plan • Human capital resources may include entrepreneurs, management team, strategic advisors and partners, and logistical advisors and partners • Sources for financial capital include debt financing and equity financing

6. Equity Bootstrapping Angels Venture Capital Corporate Ventures Holding Company Exhibit 11-3: The Relationship Between Human and Financial Capital Financial Capital Human Capital Entrepreneur Business Planning Process Management Team Strategic Advisors & Partners Debt Trade Credit Commercial Bank Loans Logistical Advisors & Partners

7. Elements of a Solid Business Planning Process • The major elements of a business planning process include the following: • Defining the value proposition • Framing the market opportunity • Detailing how to reach customers • Developing an implementation plan • Evaluating potential external influences • Articulating the revenue model • Identifying needed people • Calculating preliminary financial projections • Establishing critical milestones • Summarizing the advantage

8. Human Capital • The role of human capital in a startup business is especially critical because, for a time, it is the only resource available • When investors consider funding an early-stage company, they assess its human capital • Who is the entrepreneur? • Does she have the drive to see this business through? • Who is on the management team? • Will they be able to execute? • The human capital attracts the financial capital

9. Characteristics of Successful Entrepreneurs • Key characteristics common to successful entrepreneurs include the following: • Keenly Observant. Entrepreneurs are those who are able to make observations about the needs of industries, markets, and everyday life and find the best way to meet these needs • Willingness to take risks. Entrepreneurs are willing to leave stable jobs and guaranteed salaries for their enterprises • Drive. The entrepreneur’s personal drive is especially important in the early stages, when his enthusiasm spurs the drive of other employees • Flexibility. The ability to adapt and react quickly are especially important in the fast-changing Internet environment • Vision. The most successful entrepreneurs are not driven by money, but by a vision or a passion consistently pursued

10. The Trials and Tribulations of the Entrepreneur • From the outset, the entrepreneur is faced with reconciling several difficult paradoxes: • Being visionary vs. being realistic. The entrepreneur is faced with the challenge of coming up with unique ideas that are grounded in reality • Generating quick returns vs. investing in the future. The entrepreneur is challenged with staying the course to build the organization while meeting the demands of the investors who are needed to build the organization in the first place • Optimism vs. pragmatism. While optimism is an essential motivating force, it must be balanced with the pragmatism to evaluate potential weaknesses of the business

11. The Entrepreneur and the Idea • Some of the most common types of business ideas include the following: • Introduce a new product (new software—MP3) • Introduce a new service (overnight delivery—FedEx) • Improve an existing model of business (selling books on the Internet—Amazon.com)

12. The Management Team • The core team consists of individuals essential to the early formative days of the startup who will fill the following three roles: • Technology specialist: is the person who understands the specific mechanics of how the product works, how it is manufactured, and how it can be utilized • Sales and marketing specialist: is the person with an in-depth understanding of the startup’s customer • Execution specialist: is the person who keeps everything in perspective in the startup’s development making the vision for the business a reality

13. The Management Team (cont’d) • Extended management team can be created on an as-needed basis, depending on how quickly the startup is growing • Chief operating officer • Chief financial officer • VP of marketing • VP of sales • VP of business development • Chief people officer

14. Strategic Advisors and Partners • Strategic advisors and partners provide the startup with strategic direction, advice, and in many instances credibility for the organization as a whole • Advisory board members serve as an outsourced resource to fill a particular need and may receive stock options in exchange for their expertise • The board of directors consists of individuals who will be responsible for the well-being of the company, as well as holding the management team accountable for its actions when the business formalizes operations • A strategic association is the agreement of two entities to work together and exchange expertise in areas where they lack core competencies • A strategic alliance is a legally binding contractual agreement to share resources on a project for a particular timeframe

15. Logistical Advisors and Partners • Logistical advisors and partners differ from the strategic advisors and partners in that they are more involved in the day-to-day operations of the business • Necessary logistical advisors and partners include certified public accountants (CPA) and legal counsel • Supporting logistical advisors and partners serve as outsourced, human-capital leverage for the startup and may include intermediaries, consultants, and incubators

16. Financial Capital • Sources of debt financing (commercial banks, trade credit) • Sources of equity financing (bootstrapping, venture-capital) • Strategic investors are concerned how a certain business compliments their current activities (exposure to cutting-edge technology or business model, collaboration in research and development for a product, etc.) • Financial investors are concerned with return on investment (ROI), internal rate of return, cost of capital, and return on equity

17. Debt Financing • Trade credit is credit extended to a business by its suppliers. It is an interest-free loan covering the time period from when supplies are delivered to when the invoice is due • Suppliers typically offer trade credit to buyers with an established track record of making prompt payments • Hidden interest rate cost • Commercial bank loan is, typically, an installment loan in which the business borrows a certain amount of money for a specified period with either a fixed or variable interest rate • Commercial banks evaluate a business’ loan application by assessing the likelihood of loan repayment • Bank loans can be relatively difficult to obtain, especially for early-stage businesses with little collateral and no positive cash flow

18. Equity Financing: Bootstrapping • Bootstrapping is the art of using personal resources to finance the early stages of a startup • Bootstrapping may include taking a personal loan, mortgaging a home, using credit cards or savings accounts • Bootstrapping provides the most viable option for the entrepreneur when the startup is in the earliest stages of business, especially during the stages that involve proving the business concept • Bootstrapping allows the entrepreneur to control the company and refine his business strategy without pressure from outside investors • The disadvantage of bootstrapping is that it is unlikely to provide sufficient cash for a good business concept to grow quickly beyond the earliest stages

19. Equity Financing: Venture Capital • Venture-capital firms are usually private partnerships or closely held corporations that raise money from a group of private investors • A venture-capital firm typically invests $250,000 to $10 million in a business in exchange for a 30 to 40 percent equity stake and a seat on the board of directors • In addition to receiving cash, the entrepreneur receives guidance for building the startup • Venture capitalists, typically, charge management fees on the order of 1 to 5 percent of the capital investment in a startup • A venture-capital firm seeks opportunities that will return 10 times the original investment within five years, but realizes that each investment is a gamble and that only 10 percent are likely to succeed • The biggest disadvantage of venture capital funding is the source’s concern with the bottom line

20. Exhibit 11-5: Venture Capital Investments—Breakdown by Stage $BB Source: Data from PricewaterhouseCoopers, MoneyTree Survey: Full Year & Q4 2001 Results: US Report.

21. Exhibit 11-6: Top 10 Venture Capital Dealmakers in 2001 [i] Source: Data from PricewaterhouseCoopers, MoneyTree Survey: Full Year & Q4 2001 Results: US Report.

22. Equity Financing: “Angels” • “Angels” are wealthy individuals who invest personal capital in startups in exchange for equity or sometimes a seat on the board of directors • Its critical for the entrepreneur to develop a network of individuals within the industry to gain introductions to potential financiers because “angels” seldom look at unsolicited business plans • Business plans are evaluated based on the quality of the management team, market potential for the business idea, and the track record of the entrepreneur • Typically, “angels” are more flexible in accepting changes in the original business plan if it is necessary • “Angels” tend to be more involved in the day-to-day” operations of startups

23. Equity Financing: Corporate Ventures • Large corporations sometimes set up venture funds as a subsidiary that can make investments on behalf of the parent company, referred to as either corporate venture or “direct investors” • Corporate-venture funds invest in complimentary business for primarily strategic reasons • In exchange for cash, capital ventures seek an equity stake in the company and access to the company’s technology or product • Established corporations can offer the operational expertise as well as the credibility and visibility that come from associating with an established high-profile parent • Because the investments are strategic rather than financial, the pricing of deals with corporations tends to favor the entrepreneur more than deals with venture-capital firms

24. The Business Plan • A business plan should provide the following information to a potential investor • Description of the product or service that will be offered and the value proposition for the customer • Summary of the size and nature of the market opportunity • Explanation of the revenue model • Profiles of the management team, advisory board, and board of director members describing specific relevant skills and expertise • Clear articulation of the startup’s core competencies and sustainable competitive advantage • Summary of financials and financing needs

25. Valuation • Valuation is the art/science of trying to determine the worth of a company • Methods used in valuing a company • The Comparables Method • Determine the worth of a company by comparing it to other similar companies • The companies should be similar with respect to industry focus, income statement ratios, location, relations with suppliers, customer base, potential growth, growth rate and capital structure • This method assumes that similar companies exist and that the information for comparison is available

26. Valuation (Cont’d) • The Financial Performance Method • Uses a company’s earnings (or potential earnings) to project future cash flows and applies a discount rate to determine the Present Value (PV) of those cash flows • The Discounted Cash Flow (DCF) is determined from • Proforma Income Statements – Projections about the company’s future income statements are made based on growth assumptions for cost and revenues • Free Cash Flow – The amount of cash the company will have at its disposal is estimated based on the proforma income statement • Terminal Value – The expected value of the company at the end of the projected period is estimated. A discount rate is then applied to this value to estimate the present value of the company

27. Valuation (Cont’d) • The Venture Capital Method • VC’s use a hybrid valuation method, looking at both comparables and free cash flows • To compensate for their high risk investments, VC’s apply a very large discount rate to estimate the company’s present value • To compensate for future dilution, VC’s require a higher percentage ownership (for a given investment) based on an estimated retention ratio • This valuation method is necessarily subjective

28. Exhibit 11-7: Typical Discount Rates by Funding State Source: Data from James L. Plummer, QED Report on Venture Capital Financial Analysis (QED Research, Palo Alto, CA), 1987

29. Negotiations • Principles for Entrepreneurs • Investors want to know two things: What is the opportunity and why is this management team the best to pull it off • Guidelines for pitching an investment opportunity • Know the audience • Keep the presentation concise • Talk about the management team • Term Sheet • A Term Sheet is a non-binding description of the proposed deal between the financier and the entrepreneur • The Term Sheet is analogous to a Letter of Intent (LOI) or Memorandum of Understanding (MOU)

30. Negotiations (Cont’d) • Securities • Types of Securities: The type of securities chosen by the company and the investor reflect the risk/reward appetite • Zero Coupon Bonds- Upon maturity of this security, the investor redeems the initial investment and interest at a predetermined rate. This type of security provides ultimate protection to the investor • Convertible Debentures– These securities are loans that are ‘converted’ into common stock (equity). The investor is considered to be a creditor until the company is past its high-risk stage • Preferred Stock– This is the most commonly used security with VCs • Convertible Preferred • Redeemable Preferred • Participating Convertible Preferred

31. Negotiations (Cont’d) • Rights and Privileges of Investors • Common rights that investors demand are • Right of First Refusal– Investor has the right to meet any offer of outside financing in future investment rounds • Preemptive Right – Investor has the right to maintain his percentage of ownership by investing additional funds in future investment rounds • Redemption Rights– Investor has the right to achieve liquidity if the company has not been sold or undergone IPO within a predetermined time period • Registration Rights– Investor has the right to demand that shares be registered, forcing the company into liquidity (public offering) • Covenants– Terms designed to ensure that the money provided by the investor is used in a manner that is consistent with the agreement between the entrepreneur and investor • Antidilution Provisions– Provisions that protect the investor from dilution in ownership that might occur in future round of financing

32. Cumulative Round of Financing Amount invested this round % Received this round VC’s Share Founder’s Share Implied Valuation (Post Money) Seed-stage Round $1,000,000 40% 40% 60% $2,500,000 First Round $4,000,000 20% 52% 48% $20,000,000 Second Round $15,000,000 20% 62% 38% $75,000,000 Exhibit 11-8: Pre- and Post-Money Valuations Made Easy

33. Exhibit 11-9: Venture-Backed IPOs, 1995-2001 Number of IPOs Source: Data from VentureOne research.

34. Exit (The Path to Liquidity) • Initial Public Offering (IPO) • Determining the Right Time for an IPO • Asses if the company is ready for an IPO • Asses if the market is ready to accept their offering • The IPO Process • Selection of Underwriters – The underwriters are the bankers that will arrange for the purchase of stock for a commission • Preparation of Registration Statement for SEC – Create prospectus outlining the company’s business and financial fundamentals • Distribution of Preliminary Prospectus - or ‘Red Herring’ • Preparation for and Completion of the Road Show – The company’s offering is presented directly to potential investors • The Incorporation of SEC comments into the Registration Segment • Agreement on a final share price and number of shares to be offered • Close of the offering and distribution of the final prospectus

35. Pro Con Provides founders and shareholders with liquidity (although not immediate liquidity because of lock out periods, signals to the market, etc.) IPOs are expensive and time-consuming. An unfavorable market (something that the company can not control or predict) might necessitate pulling the IPO at the last second Provides capital to fuel expansion and growth within the company Strict SEC reporting requirements Possibility of attracting and retaining employees at lower than market rates because of granting of stock options and promise of eventual liquidity Pressure to product quarterly numbers for analysts The price of the company’s shares should increase dramatically with an IPO, providing (at least paper) wealth to the founders and other shareholders Increased Officer and Director liability As long as the company is performing well, it can return to the market to raise additional cash Hostile takeover is possible The ability to use stock as currency Doesn’t necessarily provide a liquid market for all shareholders because of restrictions on trading the stock Exhibit 11-10: IPO Pros and Cons

36. Exit (Cont’d) • Mergers and Acquisitions (M&A) • M&A can often achieve the same goals as IPO (e.g. liquidity and increased valuation) with lower potential risk • In a Merger, two companies combine to achieve a financial and/or strategic objective, usually through the exchange of shares • In an Acquisition, one company buys another, usually with cash and/or stock • Analysts predict that M&A will become increasingly popular

37. Exhibit 11-11: Internet Mergers and Acquisitions in 2001 Number of Deals per Year Billions of dollars Year 2001 Source: Data from Webmergers.com database.