Financing Your Business

1. FinancingYour Business Presented by: David Hessler October 17, 2006 GBA 491

2. Financing Your Business • Outline: • Background • Hessler background/biases • Sources • “F, F & F” • Grants and Debt • Seed Equity • Venture Capital • Questions?

3. Financing Your Business • Why Financing? • Seems obvious, but not necessarily • Integral part of the plan for the business (and “Business Plan”) • Varies by type of business

4. Financing Your Business • How much spending is necessary/desirable before cash flow breakeven? • Financing should be a MEANS to an end, not an END in itself.

5. Financing Your Business • David Hessler: • Technology entrepreneur • $ from/to friends and family • Past guarantor of “serious” debt • Financed by Angels • Ran venture fund; “successful” Angel investor • Closed many debt & equity deals • BEEN ON BOTH SIDES OF THE DEAL

6. Financing Your Business • Sources of Growth Capital • Personal assets • Company balance sheet • Grants • Loans • Equity • Strategic Alliances/Licensing

7. Financing Your Business SOURCES OF GROWTH CAPITAL Personal Assets: • There IS a level below which you cannot start a company • “Need money to raise money” • Staying power • Responsibilities/need for current income • Part of this is short term salary expectations.

8. Financing Your Business SOURCES OF GROWTH CAPITAL Trade debt – accounts payable • Positive “float” can often be negotiated with vendors/customers • Pre-payments • Progress payments (Gov’t contracting) • Extended payment terms from suppliers • In hopes of future business • For equity (?) • Factoring

9. Financing Your Business SOURCES OF GROWTH CAPITAL For technology start-ups, grants can be key • Small Business Innovation Research (SBIR) • Cooperative Research & Development Agreement (CRADA) • Local government (few)

10. Financing Your Business SOURCES OF GROWTH CAPITAL • Senior, secured debt • Usually commercial banks • Common misperception: • – BANKS DON’T FINANCE LOSSES ! • Need multiple collateral sources • Assets: A/R – 80%, • Inventory – 20-60%, • Fixed assets – 50% • Cash flow – debt service as small % of earnings/cash

11. Financing Your Business SOURCES OF GROWTH CAPITAL Senior, secured debt(Cont’d) • Additional collateral / common issue: • Personal guarantee • (Almost) always required • Considered a show-of-faith by borrower • All 20% owners (?) • “Joint and several” • Important to equity investors as well • Can be reduced over time

12. Financing Your Business SOURCES OF GROWTH CAPITAL Senior, secured debt (continued) • Many costs beside interest rate • Usually includes difficult covenants • Profitability • Coverage ratio • Prohibited borrowing • Liquidity • UCC Filings • SBA Loans

13. Financing Your Business SOURCES OF GROWTH CAPITAL Junior secured debt • Sometimes used when collateral can be segregated • Used for unique asset • Vendor financing • Inter-creditor agreements

14. Financing Your Business SOURCES OF GROWTH CAPITAL Unsecured (subordinated) debt • Varies widely in terms, prices covenants, etc. • Used when bank rules cannot be met • Almost always more expensive • May include an “equity kicker” • Different “personality” • Gunslinger • Dealmaker • Tough • Inter-creditor (?) • May trigger bank covenants

15. Financing Your Business SOURCES OF GROWTH CAPITAL • Convertible, subordinated debt • Varies widely in terms, prices & covenants • Often really an equity investment, but with extra protection (liquidation preference) for the investor • Key features • Term • Interest – rate, timing • Conversion price (to what Security?) • With, without detachable equity feature • Terms are (usually) part of the Security

16. Financing Your Business SOURCES OF GROWTH CAPITAL • Convertible Preferred stock • Senior rights in liquidation, AND… • Security of choice for VC’s • Always convertible to Common (VC version) • Allows for numerous special terms • Can be issued in multiple classes (A round, B round, etc.) • Common stock • Typically held by founders, friends-and-family, etc.

17. Financing Your Business BREAK

18. Financing Your Business • Equity Financing

19. Financing Your Business • Venture Capital: • Part of the larger asset class of • “private equity” • Definition: • Money provided by professionals who invest alongside management in rapidly growing companies

20. Financing Your Business • History • 1920’s - DuPont Financing of GM • 1930’s - Rockefellers Back Entrepreneurs • 1946 - American Research & Development (ARD) • 1950’s - Shockley transistor/Fairchild; Haloid/Xerox • 1960’s - SBIC & Private Partnership Proliferation • 1970-75- Industry shakeout • 1978+ - “Boom” in Venture Capital --20% capital gains tax rate --SEC Rule 144; S-18 -- ERISA Exemption • 1980s – Growth of the “Mega fund” - Bigger Deals, Geographic concentration • 1990s – Bigger Funds, Bigger Deals - Record Returns (1999 Vintage, 100%+ IRR) • 2000+ - Serious Slowdown/Troubled Portfolios • 2004-06 - Coming Back to “Normal” (?)

21. Financing Your Business • Stages of Venture Capital: • Seed: Business plan; market validation; technical feasibility • Start-up: Prototype development; non- revenue customers; company infrastructure • First Stage: Initial Mfg.; revenue generation • Second Stage: Shipping , but not profitable • Third Stage: Profitable, need expansion • Bridge Financing: Additional growth prior to liquidity event

22. Financing Your Business • Venture Economics (Example): • $300M Fund Raised from: • Pension Funds • Endowments • Foundations • Corporations • Individuals

23. Financing Your Business • Venture Economics (Example): • Managed by ten principals • Annual Fee: 2.5%, ($7.5 Million/yr.) Pays office staff, travel, principal salaries, etc. • Returns: 5X growth over 5 yrs: - $300M becomes $1.5 B (35-40%) - Gain: $1.2 B - VC Team gets 20% $240M (split 10 ways)

24. Financing Your Business • Common Myths: • VCs want majority control • Founders/owners get ‘fired’

25. Financing Your Business • “Venture Capital is not for most companies.” • Millions of privately-held businesses • 700,000 new businesses formed annually • But only 3000-5000 venture financings annually Investors seek 10x return in 5 years - Very Rare

26. Financing Your Business • Equity Investment, therefore: • Liquidity event is required • Requires size and growth • Means the investor behaves like an owner

27. Financing Your Business • Valuation Example: Year Five Revenue: $100M Year Five Net Income: $ 10M Future Value (15 P/E) $150M BPlan Investment Req’d $ 10M VC Ownership: 67% (10X) If B. Plan investment required today is $5M, VC Ownership: 33%

28. Financing Your Business Why not (institutional) Venture Capital? Small deals cannot attract venture capital: - Financial capital has grown faster than human capital - VC requires intense management (Board seat) - Each VC can only do five boards - With $300M fund, 10 principals, each deal is $6M (Minimum)

29. Financing Your Business • The good news: • The rise of angel investment: • Institutional: $22.13B to 2239 companies • $9.9M/deal • Angel: $20 B to 40,000 +/- companies • $500K/deal

30. Financing Your Business-Term Sheet Discussion • The Term Sheet • “Shorthand” description of the terms of a proposed investment • Delays incurring legal costs until terms are agreed • Can be more or less company or investor “friendly”

31. Financing Your Business-Term Sheet Discussion Terms included: • Representations & Warranties • Positive and negative covenants • Securities description • - rights & responsibilities

32. Financing Your Business -Term Sheet Discussion The “mechanics”: • Three page cover letter • Four page security description

33. Financing Your Business -Term Sheet Discussion Why required? • Investors will (usually) be minority investors • They do not control day-to-day actions • Key management actions can “ruin” the investment The goal is not control of the company, it is protection of the investment!

34. Financing Your Business-Term Sheet Discussion • Key Terms: • Series A Redeemable, Convertible, Participating Preferred Stock • How many shares; how many $$ • Investors: individually or via a single purpose legal entity

35. Financing Your Business-Term Sheet Discussion • Key Terms: • Conditions of closing: • Business Plan Showing… • Receipt of info requested… • Declaration of capitalization • Employment agreements (salary) • Shareholder notes converted • “Definitive docs…,” “…no material change…”

36. Financing Your Business-Term Sheet Discussion Key Terms: • Company pays closing costs (no cap) • Exclusivity/no shop • 30 days (??) • Must terminate other deal discussions • Must disclose other offers to us • Company representations • No breach of any other contract • No broker’s fees

37. Financing Your Business-Term Sheet Discussion Key Terms: • Valuation – spells this out several different ways • “Fully diluted…” (including provision for options) • Pre-money total • Per share price • Dividends – provision for: • None • Cumulative/Non-Cumulative • Accrued or cash

38. Financing Your Business-Term Sheet Discussion Key Terms: • Liquidation preference • A specified amount first, PLUS • Continue to participate with the Common • Series A Investors get to determine if a sale/merger is a liquidation • Mandatory conversion (to Common) • 2/3 majority want it • IPO of at least $XXX

39. Financing Your Business-Term Sheet Discussion Key Terms: Redemption at Investor option • Specified return • After five years • With payment terms • Voting Rights • On an as-converted basis, except • As a class on matters of corporate control

40. Financing Your Business-Term Sheet Discussion Key Terms: • Board of Directors • Series A investors specify size of the Board and number of Series A members • Audit and Compensation committees with independent directors • Dilution protection – full ratchet

41. Financing Your Business-Term Sheet Discussion Key Terms : • Information rights • Financial statements • Annual audited; monthly and quarterly unaudited • Annual operating plan 30 days before fiscal year • Standard inspection and visitation rights • Two Demand Registration rights after IPO and unlimited Piggyback Registration rights • Pre-emptive rights (to hold % ownership constant)

42. Financing Your Business-Term Sheet Discussion Covenants: Need 2/3 majority of Investors to: • Issue stock; • Declare dividends; • Repurchase stock (except employee); • Incur debt greater than $X; • Acquire or dispose of assets greater than $Y; • Incur capital expenditure greater than $Z • Sell or merge

43. Financing Your Business-Term Sheet Discussion Key Terms (2/3 Majority): • Transact with related parties; • Amend By-Laws; • Create a subsidiary; • Change the business or enter a new business • Key Man Life insurance on….

44. Financing Your Business-Term Sheet Discussion Conclusions: • Sounds difficult, but… • There are reasons for the demands • Need alignment of goals and…. Everything is negotiable!

45. Financing Your Business QUESTIONS/DISCUSSION