L5: Raising Finance

1. L5: Raising Finance EC10: Commercialisation & Innovation How to build structures and deliver results for stakeholders.

2. Raising Finance Outline • Seeking Venture Capital • Financial Support • Due Diligence • Venture Finance Strategies 5. Raising FinanceL1: Team Building

3. 1. Seeking Venture Capital EC10 Innovation & Commercialisation

4. The Route to Commercialisation Development Prototype Into To Market Market Penetration Idea Research Testing Active Sales Market Identification Source Scottish Enterprise - Commercialisation 1997 5. Raising Finance

5. Seeking Venture Capital (1) • Target a Venture Capital Partner • Does the VC team have experience with this sort of technology applications? • Do they take an active or passive role in the management of the new venture? • Are there competition technologies in the portfolio? • Are the personalities on both sides of the table compatible? • Does the VC firm has syndication ties with other institutions for additional funding rounds? • Can they provide access to supporting technologies, supply chains and customer groups? After PricewaterhouseCoopers 5. Raising Finance

6. Seeking Venture Capital • Write the Plan • Is the management team capable of growing the business rapidly and successfully? • Have they done it before? • Is the technology fully developed? • Is the product unique, and what value does it create so that buyers will want to purchase the product or service? • Is the market potential large enough? • Does the team understand how to penetrate the market? • Do significant barriers to entry exist? • How much money is required and how will it be utilized? • What exit strategies are possible? • Prepare for Negotiations • Prepare & Adjust Financials 5. Raising Finance

7. Sequential Model development and funding Based on research by Lewis Branscomb and colleagues – quoted from Harrison 2004 5. Raising Finance

8. Based on Branscomb – Harrison, Edinburgh Uni, Inaugural Lecture 2004 5. Raising Finance

9. 2. Financial Support

10. Short term overdraft short term loans trade credit hire purchase leasing factoring invoice discounting credit cards (company and/or personal) Long term initial equity retained profits long term loans external equity business angel funding venture capital Types of Finance 5. Raising Finance

11. Stages of Sources of Finance (adapted from Weston & Brigham, 1979) • Personal funds + overdraft + trade credit + (possibly grant, short term loans, leasing/hp, factoring) • Retained funds + long term loans (debt) • External equity (e.g. floatation (IPO), venture capital) • Decline (only internal funds) • Consider balance between short and long term sources at different stages….. • Evidence suggests many SMEs never get beyond stage 1. 5. Raising Finance

12. Internal Finance • Includes issued share capital, retained profits • Long term : no redemption (does not have to be paid back) • Dependent on (could be constrained by) • wealth of owner managers • profitability of firm • Young firms (and young owner managers) are more likely to face an internal equity constraint 5. Raising Finance

13. External Equity • Includes new shares issued privately (e.g. founding team) or publicly (e.g. Initial Public Offering (IPO) • Is long term with no redemption and from firm’s point of view less risk of liquidation than debt • Initial flotation and ongoing costs of compliance can be high so IPO not suitable for smaller amounts • In 1931, the MacMillan Committee identified an equity gap for firms seeking less than £200,000 (equivalent today = £4m) • Evidence suggests an aversion to external equity by entrepreneurs who would rather constrain the growth of the firm than lose any control 5. Raising Finance

14. Business Angels (Informal VC) • Individuals who invest in particular firms • Smaller amounts than formal VC (£10k - £100k) • More if invest as syndicate (e.g. £2million) • Source of advice/ expertise • May require involvement e.g. seat on board • For firm, finding an angel is difficult • Need to find high net worth individuals • Matching may be through intermediary • e.g. bank or business angel network • High return required so only high growth firms 5. Raising Finance

15. External Equity • All forms of external equity require current owners to give up part of the ownership and control of the firm, which many owner managers are averse to - the firm is their baby • External equity is permanent finance: gives stability • Costs inevitably lead to minimum thresholds • Providers require high returns which only very high growth SMEs can achieve 5. Raising Finance

16. Debt Finance • The major source of external finance for all firms • Includes bank debt (overdrafts, short and long term loans) and negotiable debt (e.g. bonds, convertibles) • Amounts required by SMEs too small for negotiable debt (issue costs) • Evidence shows SMEs rely heavily on short term bank debt. For example: Overdrafts • Gives flexibility but risk of not being able to renew • Long term assets should be financed with long term sources of finance. Evidence suggests SMEs use overdrafts and trade credit for long term assets e.g. plant /machinery 5. Raising Finance

17. Asset Based Finance • Includes hire purchase, leasing, factoring • Finance is for a specific asset e.g. van, office equipment, debtors • Widely available to all sizes of firms and frequently used by SMEs • Security provided by asset mitigates problems in risk assessment of SME 5. Raising Finance

18. Trade Credit • Trade credit is a very expensive form of finance if SMEs are foregoing early payment discounts. • Paying late can put a strain on relationships with suppliers • Suppliers are in effect financing their customers’ operations • Chasing outstanding debt is time-consuming and expensive • Uncertainty inherent in late payment makes it difficult to plan cash flows • And yet 84% of small firms pay late • The majority say that it is a necessary part of managing cash flow 5. Raising Finance

19. Questions • Consider whether the high use of short term sources of finance is because SMEs cannot get any other type of finance (because they are at the mercy of bigger players i.e. finance providers) or do they choose/prefer to juggle short term sources? • Is it reasonable to assume technology businesses will behave differently from (say) family business? OR 5. Raising Finance

20. 3. Due Diligence Failure and the opportunities that en2020sue.

21. Assessing the Team • Is the management team capable of growing the business rapidly and successfully? • Have they done it before? • Is the technology fully developed? • Is the product unique, and what value does it create so that buyers will want to purchase the product or service? • Is the market potential large enough? • Does the team understand how to penetrate the market? • Do significant barriers to entry exist? • How much money is required and how will it be utilized? • What exit strategies are possible? 5. Raising Finance

22. Business Valuations • Stage 1: • Ventures have no product revenues to date and little or no expense history, usually indicating an incomplete team with an idea, plan, and possibly some initial product development. • Stage 2: • Ventures still have no product revenues, but some expense history, product development is underway. • Stage 3 • Ventures show product revenues, but they are still operating at a loss. • Stage 4 • Companies have product revenues and are operating profitably. 5. Raising Finance

23. Why Businesses Fail • Management Controls • Accounts • Stock • Liabilities • Funding • Overheads • Borrowings • Credit-control • Market Conditions • Competition • Market Trends • Selling • Management • Staff • Equipment • Warranties & Liabilities 5. Raising Finance

24. Types of Failure • Cessation • harvesting • succession • change of identify • Living Dead • Disposal • Throwing in Towel • Buy-outs, But-ins • Withdrawal of Backers • Banks • Private Investors • Trade creditors • Legal • Take-over • Reconstruction • Mergers • Involuntary Discontinuance of Business. 5. Raising Finance

25. Exit Routes Merger Maturity Steady- State Assets Accumulation Closure Growth Reversal Steady- State Closure Growth Reinforcements Merger Generate Resources Closure Merger Mobilise Resources Steady- State Access to resources Closure Time 5. Raising Finance Understanding Enterprise, p6.3, Bridge,O’Neill & Cromie, Macmillan, 1998

26. Emerging Industries • Newly formed or reformed industries, created by technology innovations, shifts in relative cost relationships, emergence of new consumer needs or economic and social changes. • The rules are that there are no rules. The Environment: • Technological uncertainty, strategic uncertainty, initial high costs but steep cost reduction • Adoption rates Buyers of emerging technology are inexperienced. • Need to induce substitution, inform about functions and overcome perceived risks. • Short time planning horizons Porter, Competitive Strategy, Collier Macmillan Publishers, 1980, pp237 -253 5. Raising Finance

27. Planning Problems For Early Entrants • Inability to secure supply lines & maintain quality • Escalation of material prices & labour costs • Absence of infrastructure – channel, servicing, complementary products • Absence of standardisation and regulatory framework • Perceived likelihood of obsolesce • Image credibility with Financial Community • Response of (entrenched) companies • Cost of Failure • Introduction of incentives to switch costs 5. Raising Finance Porter

28. Strategic Opportunities for New Entrants • Shaping Industry Structures • Managing Externalities • Changing Role of Suppliers & Channels • Changing the mobility/transferability barriers • Timing Entry 5. Raising Finance

29. Recovery Positions • Non-recoverable • Technology or cost advantages have been lost. • Retrenchment • retrenchment strategy is successfully implemented but cannot be sustained in the longer term. • Sustained Survival • the turnaround is achieved and the business is able to protect its existing position in the market. • Sustained Recovery Slatter (1984) 5. Raising Finance

30. Recovery or Retrenchment • Galvanisation • Team recognise they are no longer able to manage the situation. • Management changes required for the business to survive and thrive. • Business will be required to raise extra financial resources from external sources and this may result in a change of ownership and moving control away founding entrepreneurs. • Simplification • clear focus of direction is defined and resources are allocated and targeted to build a strong and sustainable core business. • Competency Building • The business then builds new competencies and competitive advantages into its business model. In a recovery situation there will be pressure on resources that are available and this is likely to create internal challenges. • Leaverage • New Team buys in competencies and diversifies into new products, services, markets and opportunities. 5. Raising Finance

31. Disinvestment • Alternative to organisational changes and the financial changes. • Business focuses on its core profitable business. • It discards new ventures, subsidiaries and/or sites. • Technologies or assets sold off to raise money that can be reinvested into strategies to strengthen the core business. • Disinvestment strategies divide between those that are internal to the organisation, such as the closure of a plant, and external, such as sale of the business. • Not usually part of a long-term strategy but reaction to trading conditions or cash-flow crisis. • Disinvestment decisions are less well thought through in terms of their long term impact of the business. Thompson, J, 2002 5. Raising Finance

32. 4. Venture Finance Strategies

33. Access to Finance • According to the Bank of England (Finance for Small Firms 1999), 39% of SMEs are financed through (internal) debt funding. • This indicates that smaller firms are either adverse to external borrowing or else they are excluded. • This is the “funding gap”. 5. Raising Finance

34. Trajectories • Bootstrapping • founders, friends & family (the "3Fs" • business angels • venture capital (VC) • initial public offering (IPO) or mergers & acquisitions (M&A) 5. Raising Finance

35. Venture Capital • Long term equity finance • VC firm manages fund which is invested in portfolio of other companies • Usually £500,000 minimum, average investment = £3.5m (1999) • Rigorous assessment of proposal and monitoring of investment • High return required so usually only high growth (and high risk) SMEs 5. Raising Finance

36. Venture Capital • Typically only 1 in 40 proposals is funded • VC may insist on appointing a non-executive director • VC redeems investment at exit e.g. by IPO or trade sale 5. Raising Finance

37. Raising Equity Plan • Purpose and Objectives • Proposed Financing • the amount of money needed from the beginning to the maturity of the project proposed, how the proceeds will be used, how you plan to structure the financing, and why the amount designated is required. • Market-place • a description of the market segment the firm controls or plans to get, the competition, the characteristics of the market, and marketing plan (with costs) for getting or holding the market segment being targeted.. • History of the Firm • a summary of significant financial and organisational milestones, description of employees and employee relations, explanations of banking relationships, recounting of major services or products the firm has offered during its existence. • Product or Service • a full description of the product, process or service offered by the firm and the costs associated with it in detail. 5. Raising Finance

38. Raising Equity • Financial Statements • for the past year and pro forma projections (balance sheets, income statements, and cash flows) for the next 3-5 years, showing the effect if the project is undertaken and if the financing is secured. • Should include analysis of key variables affecting financial performance, showing what could happen if the projected level of revenue is not attained.) • Capitalisation • a list of shareholders, how much is invested to date, and equity/debt. • Biographical Sketches • the work histories and qualifications of key owners/employees. • Principal Suppliers, partners and Customers • Problems Anticipated and Other Pertinent Information • a candid discussion of any contingent liabilities, pending litigation, tax or patent difficulties, and any other contingencies that might affect the project. • Advantages • a discussion of what's special about product, service, marketing plans or channels that gives the project unique leverage. 5. Raising Finance

39. Types of Entrepreneurs • Studies have revealed that different types of entrepreneurs exist (Smith, 1967; Westhead, 1990, 1995; Birley and Westhead, 1994; Woo et al., 1991). • Nascent entrepreneurs: individuals considering the establishment of a new business. • Novice entrepreneurs: individuals with no prior business ownership experience as a business founder, an inheritor or a purchaser of a business. • Habitual entrepreneurs: individuals with prior business ownership experience. • Serial entrepreneurs: individuals who have sold / closed their original business but at a later date have inherited, established and / or purchased another business. • Portfolio entrepreneurs: individuals who have retained their original business but at a later date have inherited, established and / or purchased another business. 5. Raising Finance

40. Habitual Entrepreneurs • No accepted definition (Starr and Bygrave, 1991). • A wider definition of 'habitual' founders was used by Birley and Westhead (1993, p.40) who suggested: • "...'habitual' founders had established at least one other business prior to the start-up of the current new independent venture". • Hall (1995) divided habitual entrepreneurs into serial and portfolio entrepreneurs. • Westhead and Wright (1998a) have claimed that habitual entrepreneurs are individuals who have established, inherited and / or purchased more than one business. • They suggested that serial entrepreneurs have sold / closed their original business but at a later date have inherited, established and / or purchased another business. • In the United States, it is widely reported that many entrepreneurs have established / owned several businesses before they established / owned a successful business (Ronstadt, 1982). 5. Raising Finance

41. Portfolio & Novice Entrepreneurs • Portfolio entrepreneurs • Individuals who own two or more businesses at the same time. Entrepreneurs building a portfolio of ventures may dispose of some of them over time thus introducing a serial element to their behaviour. Westhead and Wright (1998a) • Rather than becoming involved in further ventures as controlling owners, individuals use wealth from initial ventures to acquire minority stakes in ventures controlled by other entrepreneurs (business angel) (Scott and Rosa, 1996b). • Novice entrepreneurs • individuals who own one business and have no prior business ownership experience as a business founder, an inheritor or a purchaser of a business. Westhead and Wright (1998a) • Novice Founders in this novice category may themselves at a later date become serial or portfolio founders (Hall, 1995). 5. Raising Finance

42. Habitual Entrepreneurs & Angels 5. Raising Finance

43. The Firm as the Unit of Policy Support • Business support agencies provide financial, managerial and technical support and assistance towards new and existing businesses rather than entrepreneurs. • These agencies have encouraged individuals to make the transition from being nascent entrepreneurs (Carter et al., 1996), that is in the position of considering starting a business, to actually establishing new businesses (Reynolds, 1997). 5. Raising Finance

44. Influence of Financial Institutions • Financial institutions and professional advisers view some types of customers as more ‘risky’ than others. • Financial institutions and professional advisers may be prepared to provide additional advantage to customers (i.e., habitual entrepreneurs) who have a proven track record of success. • Financial institutions and professional advisers require additional information surrounding the assets and liabilities associated with prior business ownership experience. 5. Raising Finance

45. Financing Ventures • A Habitual entrepreneur’s background and can have a profound influence on the types of finance used during the launch period of surveyed businesses. • Habitual entrepreneurs, if previously successful, may be expected to have greater access to funds than novice entrepreneurs. • Funds from private business sales may be used by serial (and portfolio) founders to invest in subsequent ventures. 5. Raising Finance

46. Funding Serial Entrepreneurs • Serial entrepreneurs who have successfully exited from their initial venture may generate funds to use personal resources to finance their subsequent venture(s). • Serial founders who have relinquished their equity stakes in previously owned businesses have no trading partners to leverage-up. • If serial entrepreneurs are not successful in their first venture, they may be able to raise funds, as venture capitalists seek evidence of an ability to succeed the next time around and not just previous experience per se (Wright et al., 1997b). • To achieve ownership of a larger business, serial entrepreneurs may purchase or buy into rather than establish their second venture. 5. Raising Finance

47. Funding Portfolio Entrepreneurs • Portfolio founders who have not exited from their earlier venture(s) may be able to lever up resources from the existing business and may make use of finance from existing customers and suppliers. Further, they may be able to lever up funds for a portfolio business from venture capitalists who (in the UK at least) appear to be reluctant to fund completely new start-ups (Murray, 1995). • Habitual entrepreneurs may also have developed more sophisticated skills in searching for finance. • The sources of start-up financed used by novice, portfolio and serial entrepreneurs with surveyed businesses, located in rural areas in Great Britain, were explored by Westhead and Wright (1998b). 5. Raising Finance

48. Suggested Reading • Freel, M, 2003, Entrepreneurship and Small Firms, Sources of Finance, McGraw Hill, Chp 5-6, p115 - 165