Introduction to Entrepreneurial Finance
Entrepreneurial Finance Philippe Gregoire Louvain School of Management – Universite catholique de Louvain Reference book : Entrepreneurial finance, a casebook.Paul A.Gompers and William A.
Sahlman. John Wiley & Sons, Inc. 2002 1 Entrepreneurial finance Project assessment (POCD) Funding (amount, firm’s value, best partner) Deal (ownership / control / incentives) Exit (IPO) Project Assessment • 4 critical success factors for entrepreneurial ventures ? ? ? ? People Opportunity Deal Context 3 People I’d rather back a ‘A’ team with a ‘B’ idea than a ‘B’ team with an ‘A’ idea • Who are the key players What is their experience • How does this experience prepare or not prepare them for the opportunity that exists • What are strengths and weakness of the people involved on all sides of the transaction • Are there key individuals that the company should add or replace 4 Opportunity • New product / service ? Smartphone, • New method of delivery ? Amazon. com • New production technique ? Ernest Solvay patent (1861) to manufacture soda ash (enter in detergent, glass, …) • Is there a sustainable competitive advantage • Must the opportunity be exploited immediately • Are there intermediate milestones 5
Deal • Spending money is not enough. Incentives and contingencies are important considerations. ? Key to all these structural features is the concept of the entrepreneur earning his/her equity through value creation. • Moral hazard and adverse selection ? Entrepreneur bear the downside risk • Choice of appropriate investors ? for whom you raise capital is often more important than the terms • Selection of the proper financial instrument ? ? ? Debt Equities Convertibles / preferred convertibles 6 Securities held by Venture Capitalists • (Source: Kaplan-Stromberg, 2003) Context • Competition • Regulation • International environment • Economic conditions 8 Introduction to entrepreneurial finance • Finance ? Study of value and resources allocation (capital budgeting) • • • Value of cash stream = f(magnitude, timing, riskiness) Economic value = Expected return = PV ? ? T t ? 1 E? Rt ? ? rf ? Risk premium CFt ? 1 ? E ? Rt ?? t ? Cost of capital • Capital rationing • Entrepreneurship ? Focus on opportunities rather than controlling existing resources • Entrepreneurial finance ? ? Financial management within entrepreneurial firms
Study on both sides of the balanced sheet 9 The Balance Sheet of a Corporation Assets = use of funds Current (Short-term) assets Cash Accounts receivable Inventories Others (various claims) Fixed (long-term) assets Land Buildings Machineries & Equipment Liabilities = sources of funds (Capital structure) Current (Short-term) Liabilities Accounts payable Short-term debt … Long-term Liabilities: Equity: Provided by shareholders (= owners of the company) Long-term Debt: Provided by creditors such as banks 10 Others Accounting Income versus Cash Flow • Cash income ? ccounting income • Whereas accountants try to match revenues with expenses, managers and investors focus on the difference between cash inflow and cash outflow. • Cash flow = the amount of cash income (= inflow – outflow of cash) that is generated in any period • Formally, 11 The Cash Cycle of a Firm • Cash cycle: average time between when a firm pays for its inventory and when it receives cash from the sale of its product 12 Sources of Entrepreneurial Finance Bootstrapping Stock markets (IPO) 3Fs Leasing Governmental organizations 13 Section 1. Investment analysis Module 1. A : Source of value ? ? Introduction to entrepreneurial finance Case study • Module 1. B : Financial statements and pro forma models ? Case study • Module 1. C : Purchasing firms, buyouts, and valuation ? ? Valuation in entrepreneurial finance Case study • Additional (Optional) Reading and References: Smith/Smith: Entrepreneurial Finance, Wiley Edition. Sahlman/Stevenson/Roberts/Bhide: The Entrepreneurial Venture, HBS Press. 14 Section 2. Financing the entrepreneurial firm • Module 2. A : Venture capital ? ? Private equity Case study • Module 2.
B : Angel financing ? Case study 15 Section 3. Harvesting • Module 3. A : Initial Public Offerings ? ? IPO process Case study • Module 3. B : Acquisitions ? Case study 16 Module 1A. Sources of value • 4 stages of entrepreneurship ? ? ? ? Identifying opportunities Acquiring the financial, professional, and productive resources Implementing a plan of actions Harvesting the rewards • 4 critical success factors for entrepreneurial ventures ? ? ? ? People Opportunity Deal Context 17 The Knot – People – Opportunity – Valuation – Deal structuring – Source of capital 18 Business Case Success as one of the early AOL Greenhouse companies – 3-book deal with Bantam Doubleday – Strong interest from advertisers – Significant traffic at its website 2 issues – Out of cash within 3 months – Race for scale economies on the internet To build the country ‘s number-one wedding resource, Liu needs 10 millions 19 People (Core founding team) • • All media people with experience in software, video, etc. Good understanding of design and presentation • Lack of operational expertise, retail experience, and marketing 20 Opportunity • • • Stable number of wedding
Recessions have very little impact Event tied to significant expenditures ? ? Wedding party Guests • • • • Size of the market (35 billion) High advertising rate Stagnant competition, lethargic and not very innovative Couples planning to get married ? ? ? have relatively high income Are fairly young plan major life purchases ? are not very price sensitive 21 Opportunity ? Cash Flow Transformed the opportunity into cash flow = Business model = set of factors that together determine the cash flows a company can generate and create value The Knot : registry / advertising / merchandise / publishing and others 2 22 The Knot – People – Opportunity – Valuation – Deal structuring – Source of capital 23 Valuation • Cash flow is the source of value • To date, the Knot has posted losses and is expected to post losses for at least 2 more years • It is difficult to use earnings to estimate the probability of generating future cash flows. • Revenues and mix of revenues appear to be a better measure • Multiple of revenues method. Compare to firms on the basis of ? ? ? ? Stage of development Business model Target market size Size of the investment round 24 List of comparable transactions 25
Discount cash flow analysis Most forecasts are widely optimistic. Discounted cash flow valuations only work when one gets an estimate of the expected CF 26 Actual income statement 27 Split of Revenues 28 Forecasted statement of cash flows 29 Actual statement of cash flows In Millions of USD (except for per share items) Net Income/Starting Line Depreciation/Depletion Amortization Deferred Taxes Non-Cash Items Changes in Working Capital Cash from Operating Activities 2011 5. 99 3. 74 0. 96 2. 78 11. 89 -1. 31 24. 05 2010 3. 65 3. 43 1. 78 2. 3 8 -8. 11 11. 06 2009 -4. 87 4. 75 5. 09 -1. 6 13. 83 -4. 92 12. 33 2008 4. 13 4. 84 3. 98 0. 56 6. 16 0. 2 19. 87 30 The Knot – People – Opportunity – Valuation – Deal structuring – Source of capital 31 Initial deal • Initial investment : strategic partner ? Expect from AOL money, exposure and distribution « more than just dollars to the deal » AOL invested 1. 85 million in return for 45%, for royalties amounting to 20% of ad revenues on The Knot’s AOL site and a lesser % of ad revenues on The Knot’s internet site. ? • The deal with AOL provided instant reach and credibility to The Knot • Is the deal expensive for The Knot? 32
Ownership after AOL deal 33 Financing the Knot (new deal) 34 Convertible preferred • Preferred has higher priority than common stock ? In the event of a firm’s sale or liquidation, holders of preferred stock get paid before common stockholders do. Entrepreneurs have greater incentive because if things don’t go well, the investor will be paid first Downside risk is borne by the entrepreneur ? ? • Tax considerations ? Entrepreneurs pay taxes on the value of common stock that they have received. ? Investing in preferred stock does not change the price of common stocks. 35 Financing the Knot Why should they invest? To develop The Knot brand, to build out the technological infrastructure, to develop the gift registry business ? Practically, The Knot needs capital to fund the payroll and pay for day-to-day operating expenses • How much money? Forecasted statement of cash flow • Who should invest in The Knot? Business Angel, Venture Capitalist, Strategic Partner • How should they value The Knot? Comparable deals on the market, multiple of revenues 36 Investor’s profile • Angels + Higher valuation + – Someone with an experience in the registry business Limited capital ? ay not be able to provide capital in the future if needed Less helpful in recruiting others to the team • Venture Capitalist + + – Large pools of capital and make multiple rounds of investment Network of contacts in the management and financial community Lower valuation • Strategic partner + + – Experience in the business (retailer, wedding registries,…) Provide distribution and name recognition Conflicts of interest 37 What happened? May 1998, Venture Capitalist invested $3m for 22% ? $10. 6m pre-money valuation (3/(10. 6+3)=22%) April 1999, Venture Capitalist invested $15m December 1999, IPO 38