Chapter 9 Capital, Valuation, and Exit Strategies

2. 9-1 Introduction The entrepreneurial venture requires cash to operate and grow. In the early stages, new ventures require capital from other sources to survive. Successful entrepreneurs learn how to articulate their venture’s business model and its market potential— elevator speech. The elevator speech is just one of the important skills that the entrepreneur must possess to be a successful fund-raiser.

3. Exhibit 9-1 Seed Cash Stash

4. 9-1 Introduction (cont.) To raise funds, entrepreneurs must be able to provide answers to two critical questions: What is the value of the venture? Calculated using several techniques, depending on the sophistication of the funding source. What is the exit strategy? The pathway that the entrepreneur intends to follow to turn invested capital into cash and provide a return to the investors. There are a number of exit strategies such as: To sell the venture to a larger company. Entrepreneur should have an exit strategy in mind at the very beginning of the venture.

5. 9-2 Sources of Capital Two major sources of funds for a business are: Debt capital: Funds obtained through borrowing Debt capital is categorized into two types: short term and long term. Equity capital: Does not require repayment Sources of equity capital include retained earnings.

6. 9-2a Short-Term Debt Financing Short-term debt: Used to finance current operations, with required payback within one year Can come from several different sources: Friends and family Such borrowed funds bring an extra risk Money borrowed should be handled like any other loan Commercial banks They can help with any cash flow problems and can give sound advice. Developing a close relationship with a local banker is a good idea. When an entrepreneur needs emergency funds, the banker will be more willing to help out.

7. 9-2a Short-Term Debt Financing (cont.) Statistics from the U.S. Small Business Administration indicate that commercial banks lent out micro-loans. Bank loans come in many different forms: Unsecured loans Secured loans backed by collateral Line of credit A revolving credit agreement Factoring Floor planning is another option in bank financing Trade credit The credit given to a firm by the trade—that is, by the suppliers that the company deals with. Entrepreneur may want to use such terms to encourage clients to pay their bills in a timely manner.

8. 9-2a Short-Term Debt Financing (cont.) Credit cards Some entrepreneurs rely on credit cards to help finance the early stages of their ventures. Using credit cards to finance a business can lead to problems if the cards are utilized without fiscal discipline. The advantages include: Ease with which they can be obtained Universally accepted Convenient to use Assists the entrepreneur in financial record keeping via monthly statements The disadvantage includes: Relatively high rate of interest

9. 9-2a Short-Term Debt Financing (cont.) Internal funds management The venture should attempt to obtain its needed funds from internal sources. A close review of the balance sheet and accounting ratios will reveal possible sources of funds that have been overlooked. Entrepreneurs should work hand-in-hand with their accountant to ensure that funds are not tied up in noncash assets.

10. 9-2b Long-Term Debt Financing Successful companies constantly refocus on their long-term goals and objectives. There are three primary sources of long-term debt: Term loans Most term loans have three- to seven-year terms. The business signs a term loan agreement called a promissory note. It requires some form of collateral. When determining the interest rate for such loans, the bank looks at: The length of time the loan is for The type of collateral The firm's credit rating The general level of market interest

11. 9-2b Long-Term Debt Financing (cont.) SBA loans: For a smaller business, the U.S. Small Business Administration (SBA) can often be a good source of loans. The eligibility requirements and credit criteria of the program are very broad in order to accommodate a wide range of financing needs. To qualify for an SBA guaranty, a small business must meet the SBA’s criteria. The lender must certify that it could not provide funding on reasonable terms without an SBA guaranty. Most cases, the maximum guaranty is $1 million.

12. 9-2b Long-Term Debt Financing (cont.) Leverage: The use of long-term debt to raise needed cash is sometimes referred to as leverage. The borrowed cash acts like a lever to increase the purchasing power of the owner’s investment. It maintains higher rates of return on owners' investments. It allows the owners to create a larger firm for the same investment. It also means a continued obligation to service the debt. Judicious use of leverage can help increase owners' returns.

13. Exhibit 9-4 Example of Leverage

14. 9-2c Equity Capital Equity capital: Funds invested by the owners of the venture. Five forms of equity capital are: Retained earnings Contributions Sale of partnerships Venture capital Public sale of stock Stock certificate Authorized stock Shares sold—issued stock, and unsold shares—unissued stock.

15. 9-3 Types of Stock Offerings Chaotic securities markets of the 1920s contributed to the stock market crash of 1929 and the ensuing Great Depression. The U.S. Congress enacted the federal securities laws and created the Securities and Exchange Commission (SEC) to administer them. The SEC allows several types of offerings.

16. 9-3a Intrastate Offering Exemption Section 3(a)(11) of the Securities Act of 1933—the intrastate offering exemption. This exemption facilitates the financing of local business operations. There is no fixed limit on the size of the offering or the number of purchasers. The company must determine the residence of each purchaser. It is difficult for a company to rely on the intrastate offering exemption unless the entrepreneur knows the purchasers and the sale is directly negotiated with them.

17. 9-3b Private Offering Exemption Section 4(2) of the Securities Act exempts from registration “transactions by an issuer not involving any public offering.” Precise limits of this private offering exemption are uncertain. If a venture offers securities to even one person who does not meet the necessary conditions, the entire offering may be in violation of the Securities Act.

18. 9-3c Regulation A Offerings Section 3(b) of the Securities Act authorizes the SEC to exempt from registration small securities offerings. By this authority, the SEC created Regulation A— exemption for public offerings not exceeding $5 million in any twelve-month period. Regulation A offerings share many characteristics with registered offerings. All types of companies that do not report under the Exchange Act may use Regulation A, except: Blank check companies Those with an unspecified business Investment companies registered or required to be registered under the Investment Company Act of 1940

19. 9-3d Regulation D Offerings Regulation D establishes three exemptions from Securities Act registration: Rule 504 Provides an exemption for the offer and sale of up to $1 million of securities in a twelve-month period. A company may use this exemption so long as it is: Not a blank check company Not subject to Exchange Act reporting requirements. The company may not use public solicitation or advertising to market the securities, and purchasers receive restricted securities.

20. 9-3d Regulation D Offerings (cont.) Rule 505 Provides an exemption for offers and sales of securities totaling up to $5 million in any twelve-month period. A company may sell to an unlimited number of accredited investors and up to thirty-five other persons. The issued securities are restricted; purchasers must buy for investment only and not for resale. The offering company must inform investors that they may not sell for at least a year without registering the transaction. Rule 506 A safe harbor for the private offering exemption.  

21. 9-4 Valuation Valuation: The term used to refer to the process of determining the monetary value of a venture. When financing is involved, valuation includes a pre-money and a post-money valuation figure. For a going business with an operating record, the valuation usually begins with the profit record and the cash flow record for the past years. The key to the value of the investment is the percentage of the company’s equity that is being transferred.

22. 9-4 Valuation (cont.) Factors to be taken into account: Stability of the key management Trends in the industry of the company Possibility of including additional products or services for increased revenues Expandability of the customer base Can investors add new value to the company through their contacts or talents In the public markets, the calculation of the relationship of the total shares outstanding to the total value of the company is calculated constantly to determine the price per share.

23. 9-4 Valuation (cont.) The total number of shares issued multiplied by the market price of a share equals the market cap, or market capitalization. The price per share, which includes an estimate of the future earnings potential is called the multiple. The multiple of a stock is the most important driver of the stock’s value. In an initial public offering (IPO) it is the result of an intense negotiation between the issuer of the stock and the investment banker. After a stock is in the marketplace, it is set by the collective wisdom of the marketplace.

24. 9-5 Exit Strategies The purpose of a venture’s exit strategy is: To outline a method by which the early-stage investors can realize a tangible return on the capital they invested. To suggest a proposed window in time that investors can tentatively target as their investment horizon. There are four basic categories of exit strategies in order of occurrence: Acquisition Earn-out Debt-equity swap Merger