PhD course: Commercializing your research Lund, 26 April 2017 Entrepreneurial Finance Hans Landström Sten K. Johnson Centre for Entrepreneurship Lund University Email: Hans.Landstrom@fek.lu.se AGENDA 1. Capital needs in new ventures 2. The problem! 3. The financing of new ventures a) Debt and equity capital 4. Financing possibilities in new ventures 5. Bootstrapping finance 6. Venture Capital a) Institutional VC b) Informal VC Capital needs in new ventures 1
Resources in entrepreneurial ventures characteristics New ventures constitute a heterogeneous group of firms with a lot different needs for capital. In general the need for capital is limited The majority of new ventures begins with very limited resources, and generally with no employees or only family members to share the work. Many resources have become less expensive through the web, open innovation, etc. Even high growth companies start with small amounts of initial finance: according to an analysis of the Inc500 America s fastest growing private companies in 2000, 16% started with less than $1,000, 42% with $10,000 or less, and 58% with $20,000 or less. Inc. Magazine, October 17, 2000, p. 65. Discussion What are the key resources needed in your business project? How much money do you need to start your business? How will you finance your company (who will pay)? The problem! 2
Financial characteristics in young and growing firms Liability of newness (Stinchcombe, 1965) External: High information asymmetries, absence of a financial operating history, lack of collaterals, high ex ante failure risk High degree of uncertainty and legitimacy issue that makes it difficult for entrepreneurs to acquire resources from external actors. Difficulties in getting resources, not least financial resources Internal: Lack of organizational routines and lack of knowledge, but also a private and informal way of operating the business (including the intertwining between the firm and the individual/family). Difficulties in using/manage the resources efficiently Case: Flex Prop Propellers for passenger boats and cargo ships based on a composite material that makes the propeller blade flexible. Karl-Otto Strömberg CEO Propeller for turbines and power stations Propeller for ships Uncertainty and information asymmetry Uncertainty Newness and innovation-based venture Large knowledge base Early stage ventures Long lead times Information asymmetry The entrepreneur is more likely to be better informed about his/her venture than external capital providers, and entrepreneurs are often reluctant to disclose information about their ventures. but, information asymmetries are bidirectional! 3
and consequences Agency problems (principal agent relationship) Hidden information (before investment), creating uncertainty of capital providers and increased interest/rate of returns Adverse selection (only bad and most overvalued projects will be left) Hidden actions (after investment), due to different goals and risk of misallocation of resources Moral hazard (cost of controlling the behavior). Small amounts of capital Relative transaction and monitoring costs The financing of new ventures Debt and equity capital Debt capital: must be repaid over a period of time, usually with an interest Cash flow roles (e.g. overdraft and credit card) Capacity-building roles (e.g. term loans and commercial mortage) Asset-based capital Factoring, i.e., selling the rights to expected income (eg. invoices) to a third party Leasing, i.e., the leasing company makes an asset available for use by an another party Equity capital: capital in exchange of ownership shares Markets: crowdfunding, business angels, venture capital 4
Financial possibilities in new ventures Financial markets for entrepreneurial ventures (Black & Gilson, 1998) Bank-oriented markets Equity-oriented markets Government-oriented markets Life cycle approach (Berger & Udell, 1998) Business size Business age Very young and Small ventures Growth-oriented small ventures with high growth ventures with an potential but international limited track record market Internal finance Informal VC Public equity - Personal savings Institutional VC - Credit cards Customers - Gifts/loans/equity Suppliers (trade credits) from FFF Short-term loans (banks) Long-term loans Governmental finance 5
Bootstrapping finance InfoGate AB Consultancy: web-solutions Start: 1999 Customers: Golf industry Develop/host/managing administrative systems for golf clubs Ulf Isacson Employees: 12 Founder and CEO Sold to SYSteam Resource management in InfoGate Period 1 (pre start-up) Period 2 (start-up) Individual-based resources Teacher (university) No salary Credit card (Loan) from mother Social-based resources Student colleagues Family Founding team Contract-based resources First customer Period 3 (early growth) Retained earnings Bank loan Customers Business Angel 6
Bootstrapping Bootstrapping is a strategy through which small business managers acquire and use resources without the need to raise equity or borrow money. (Vanacker & Sels, 2009) Bootstrapping can takes two forms: 1. to minimize the need for external finance, and 2. to creatively acquire resource without using bank finance or outside equity. Examples: Use your social network Use available resources Borrow resources Obtain payment in advance from customers Lease instead of buy Bootstrapping modes Mode Characteristics Examples 1 Owner financing Use manager s credit card, loan from relatives and friends, withholding managers salary 2 Minimization of account receivable Cease business relations with late payers, routines to speed up invoices 3 Customer-related Tapping resources from customer, prepayment of prototypes, etc. 4 Joint utilization Borrow equipment from others, coordinate purchase with others, barter instead of buying 5 Delaying payment Lease equipment, delay payment to suppliers 6 Minimizing capital in stock Routines to minimize stock, best conditions from suppliers 7 Subsidy finance Subsidies from different governmental agencies Advice for entrepreneurs Don t start thinking in terms of external capital use your creativity even when acquire resources. Bootstrapping is an approach that is convenient and an easily obtainable source (don t require a business plan or collaterals), and it stimulates a lean mindset and resourceful solutions. However, be aware of - the necessary speed of launching the product/service - growth potential of the product/service There is always an other side of the coin pay back 7
Venture Capital Venture capital - definition Equity capital Minority ownership Temporary partners Active partnership Institutional venture capital vs informal venture capital (DeClerq et al, 2006) Informal VC (BA) Institutional VC Status Wealthy individuals Limited partnership Type of investments Start up/very early stage Generally more mature projects Amounts invested 0.03m to 0.4m 0.8m to 6m Time horizon 4-6 years 6-8 years Speed of decision Weeks Months Selection criteria Commercial Entrepreneurial Syndication Yes Yes Strictly commercial 8
Institutional VC Structure of a VC fund Investor (limited partners) (e.g. individuals, pension funds insurance companies, foundations, etc.) Capital Return on investment Management VC firm Capital (general Mgmt fee VC fund Venture partner) Sale of Return on equity investment Monitoring and advising Time restrictions of a VC fund Year 1 2 5 8 9 10 Structure Investments Add value Add value Fund of fund (first round) Investments Harvest raising (second round) 9
The venture capital process Investment process Structuring Monitoring and add value Exit The venture capital process Investment process Structuring Monitoring and add value Exit 1. Deal generation Unsolicited deal flow negative Personal network flow +/- VC search positive 2. Initial screening Non-negotiable criteria Industry Amount of money Geographical location VCs investment strategy etc. The venture capital process 3. Detailed screening Entrepreneur Entrepreneur Entrepreneur Attitude/Experience/Openness Technology Market need/unique idea/feasibility/intellectual property rights Market attraction Market attraction and growth of markets/unique selling points VC portfolio Synergies Resource complementarities BUT IN THE END: IT IS AN INTUITIVE DECISION! 10
The venture capital process Investment process Structuring Monitoring and add value Exit Valuation No universally agreed method of valuing new ventures method are imprecise, subjective and based on rule of thumbs (or gut feeling ) it s often a guess! Structuring (contract), e.g.: Capital and ownership Investor s control over key decisions Investor s involvement in the company Compensation scheme for management Downsize protection etc. The venture capital process Investment process Structuring Monitoring and add value Exit Activities: 1. Monitoring 2. Providing value-added Management support - Strategic issues - Recruit and compensate key individuals - Routines/discipline (adm./board) - Financial management/raising capital Ownership goals - Joint goals/distinct milestones - Market focus Legitimize Network The venture capital process Investment process Structuring Monitoring and add value Exit Exit strategies: Initial Public Offering (IPO) Acquisition (or trade sale) Secondary sale Buyback or management buy out Write-off, reconstruction, bankruptcy, etc. General performance: 2-3 failures 4-6 living deads 2-3 successes 11
Advice for entrepreneurs Are you sure that you want an external investor in your venture? Develop a comprehensive and competitive business plan. A venture capital investment is often a once in life-time investment learn as much as possible about the market and the venture capitalists way of work in order to find the best venture capitalist for your venture. Your venture must be investment ready e.g. management team, board of directors, economic control system, etc. Informal VC Informal venture capital Private individuals who invest risk capital (equity capital) directly in unquoted ventures in which they have no family connection (Mason & Harrison, 2000) 12
Micro-investors role Capital High Capital-oriented role Classical Business Angel role Low Micro-investors Knowledge-oriented role (crowd funding) role Low High Knowledge Crowdfunding The collective effort of individuals who network and pool their money, usually via the Internet (e.g. platforms such as FundedByMe and Kickstarter ), to support efforts initiated by other people or organizations Example of forms of crowdfunding: Equity-based Donation-based Debt-based Buy-based Advertising First product Crowdfunding: Experience (equity) Success rate: 37% of the projects, and 94% of failed projects have amounted less than 40% of its goals (Kickstarter, 2015) Average amount of funded projects: US$ 7,825 per project (Mollick, 2014) but also: + Makes the project visible (marketing) + Receive feedback and advice The rules of the game differs between platforms Setting the goals is a key issue: not too low and not too high The campaigns are limited in time (eg. 3 weeks) Trust is the key: Good web-page (video, no spelling mistakes, quick updates of the project) Show that you are ready and capable of manage the project Show constant communication, not display any opportunistic behavior (eg. misinformation), offering good security and guaranteeing privacy Longer campaigns tend to perform worse than shorter The first hours are critical (the first 4 hours will predict the results with 74% accuracy) 13
Classical business angel role Capital High Capital-oriented role Classical Business Angel role Low Micro-investors Knowledge-oriented role (crowd funding) role Low High Knowledge Business Angels in Sweden (See also Kelly, 2007) Gender (male) 96% Age 58 years (mean) 40 years or less 6.1% 65 years or more 24.9 % Number of ventures in portfolio 4.4 companies Number of informal investments made the last three years 4 investments (mean) 1 or less investments 16.5% 7 or more investments 11.7% Capital invested in informal investments 1.4 m (mean) 0.26 m (median) Business Angels investment portfolio Stocks in quoted companies Informal investments Privately ow ned companies 7% 2% 27% Bonds Art 30% Real-estate Insurances Other 2% 8% 14% 11% 14
What do business angels look for? General criteria Average 1 Leadership potential of lead entrepreneur 4.3 2 Market/sales capabilities of team 4.2 3 Track record of lead entrepreneur 4.1 4 Recognized industry expertise in management team 4.0 5 Information available to investor on investment 4.0 6 Organizational/administrative capabilities of team 3.9 7 Degree of product-market understanding of team 3.8 8 Financial/accounting capabilities of team 3.8 9 Market growth and attractiveness 3.7 10 Production capabilities of team 3.6 11 Expected rate of return 3.5 12 Ability to cash-out 3.5 13 Uniqueness of product 3.3 14 Relative familiarity of BA with industry and technology 3.3 15 Ability to create post-entry barriers in market 3.1 Advice for entrepreneurs The first question to ask: Do you have any money to invest for the moment? Make detailed assessments of the potential investor Business Angels are no philanthropists, it is a heterogenous market and business angels use different investment criteria, but first impression and a trustworthy management team important. Value added from business angels is individual and related to the situation ( look for experience) Q&A Thank you for your attention! Hans Landström Hans.Landstrom@fek.lu.se 15