Financing Your Business

1. FinancingYour Business Presented by: David Hessler October 19 2006 ENT 422

2. Building the Team & Financing Your Business • Outline: • Hessler background/biases • Building the Team—”War Stories” • Financing Sources • “F, F & F” • Grants and Debt • Seed Equity • Venture & Angel Capital

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

4. Building the Team & Financing Your Business • Building Your Team • Do you agree with Baron & Shane? • Similarity vs. Complementarity? • No “one man band” • Special caution to engineers

5. Building the Team & Financing Your Business • Building Your Team (more) • Have a “pre-nup” (Vesting) • Think like a lawyer • Someone has to be “top guy”

6. Building the Team & Financing Your Business • Building Your Team (more) • Perceived Fairness • Always think “fair market value” • Division of Responsibility-DELEGATE!

7. 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

8. 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.

9. Financing Your Business • Sources of Growth Capital • Personal assets • Company balance sheet • Grants • Loans • Equity—Venture & Angel Capital

10. 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.

11. 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

12. 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)

13. 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

14. 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

15. 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

16. Financing Your Business SOURCES OF GROWTH CAPITAL • Junior secured debt; • Unsecured (subordinated) debt; • Convertible, subordinated debt; • Convertible Preferred stock • Common Stock

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 • Common Myths: • VCs want majority control • Founders/owners get ‘fired’

23. 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

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

25. 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%

26. 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)

27. 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

28. 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”

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

30. 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!

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

32. 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 • 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

33. 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

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

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

36. Financing Your Business QUESTIONS/DISCUSSION