DEAS Seminar Series

Michael J. Roberts

Sources of Financing

Access

Insurance

Parking

Fuel

Maintenance

Lease

Contribution Margin/ Member

Monthly interest

# Uses

Hours/Use

$/Hour

Miles/Use

$/ Mile

$/ member

i rate (monthly)

Key May ’00 Biz Plan/ Actual September Data

Recurring View (Monthly) – Blended Model

Hours used/ month

Utilization rate

Costs/ Car

Members/ Car

Revenues/ Member

# Members

Total Contribution Margin/ Month

Monthly Usage

Monthly Fee

Attrition

Beginning Members

New Members

Car Cost/ Member

Restaurant Business Model

• What do you think it looks like?

From the Business Model…build a set of financial statements

• P&L

• Balance Sheet

• Cash Flow

Balance Sheet

- The company’s financial position at one moment in time.

- Basic equation: Assets = Liabilities + Owners’ Equity

Assets: provide benefit to the firm in the future, valued at lower of cost or present market value.

Liabilities: amounts or obligations owed to third parties.

Owners’ Equity: what’s left. Also = to original paid-in capital and retained earnings, less dividends.

Income Statement (Profit & Loss Statement)

- Operations over a period of time (quarter, year).

- Basic equation: Revenue earned-expenses incurred = net income - dividends = retained earnings

Four main categories of expenses:

- cost of goods sold

- selling, general, and administrative costs

- interest cost

- provision for income taxes

Statement of Cash Flow

Beginning Balance

+/- Operating Activities: Money generated by and spent in doing business, and Interest & Taxes

+/- Investing Activities: Money used in things that support operations or in financial assets. Primarily used for purchasing assets that increase productive capacity.

+/- Financing Activities: Money used for issuing or retiring debt or equity, or paying dividends.

= Ending Balance

Beginning cash+cash inflow-cash outflow=ending cash

The Cash Flow Cycle for a Venture

CumulativeCumulative Cash Flow in $Cash Flow in $

TimeTime

BurnBurn RateRate

Date of First Cash Flow PositiveDate of First Cash Flow Positive

MaximumMaximum FinancingFinancing NeedsNeeds

DaDatete of Cumulative Cashof Cumulative Cash BreakevenBreakeven

Remember

• People who are giving you money want to get it back, plus a return

• Required Return is a function of perceived risk– Core risk of project– Capabilities/track record of entrepreneur– “Security”

Investor Background also Influences Perception

• Functional /Industry Experience

• Investing Experience

• Potential involvement in venture

Risk & RewardReward

Risk

Risk/Reward Management

Probability of

OccurrenceExpected Value

-100% +25% +100% Return on Investment

Probability ofLosing 100%

Goal # 1

Goal # 2

Goal # 3

The horse race……..

Time

Risk

Valuation

Sources of Financing

• Own Money/Customers/Suppliers• Friends and Family• “Angels” and Sophisticated Angels• Early Stage / Seed VC• Traditional VC• Banks• Corporate Partners or Strategic Investors• Public Capital Markets

No External Financing is the Best Option

• Keep control and equity upside

• Minimize pressure for exit / liquidity event

• Creative use of contracting, collect-in-advance, pay later strategies

• Not possible when large absolute amounts of capital are required

F&F & Angels

• Individual investors often invest for some reason other than pure cash return

• What are their reasons: a + or – for you

• Managing info flows is key

Venture Capital

• Require Probability of exceptional returns – swinging for the fences

• Need to put large amounts of capital to work

• High stakes – majority of founders do not make it

Banks

• Will always look to cash flow first

• Then to corp assets

• Then to personal assets, guarantees

• You can reach a point where it is in their interests to pull the plug – their last chance to get out whole - will not be in the equity holders’ best interests

Questions to Ask

• What are the venture’s MONTHLY cash flows?• How much cash is required in total – how deep is

the trough?• What size bites do we want it in?• What are the particular risks and rewards and who

has an appetite for them?• How can the Reward / Risk ratio be managed?• What returns will investors expect?

More ?s

• What terms matter other than price, and am I willing to live with these terms ?

• Do the deal terms align our interests, or not?• What alternatives do I have?• What do I need other than $$, and What do they

bring other than $$?• Likely exit routes / liquidity path?• What will the returns look like for me after I give

up what will be required?

Pluses and Minuses

21

Source + - Own money/Customers/ Suppliers

Relatively Easy Helps assure future success Retains control with minimum

oversight

Requires well-established network Requires some personal wealth Requires positive cash flow

Friends & Family Easily Accessible Good Terms Little Due Diligence

Thanksgiving Dinner Lack of sophistication

Angels & Sellers Eager/Knowledgeable “Good” Terms

Idiosyncratic More or Less sophisticated

Early Stage VC Expertise Legitimacy

Managerial control Scarcity of Early Stage VC firms

Traditional VC Expertise Legitimacy

Deal Terms It’s about the money

Asset Lenders Leverage Benefits No/Little Equity dilution

Covenants Bankruptcy Exposure

Corporations Extensive Resources Provide Credibility Exit Strategy

Slow Decision Making Process Foreclosing Exit Options

CEO’s average equity holdings by round of financing

25%

17% 16%

12%

8%6% 6% 6%

0%

5%

10%

15%

20%

25%

30%

1 2 3 4

Source: Noam Wasserman, “Inside the Black Box of Entrepreneurial Incentives.” Based on survey conducted in July/August 2000 of 211 private Internet/software firms.

Founder CEOFounder CEO

ProfessionalProfessionalCEOCEO

When do you need to consult a lawyer?

• Early

• There are lots of legal risks– forgotten founders– danger of unprotected intellectual property – employment/stock agreements

• You often can’t fix them later, even if you have more time and money

Valuation

• Implied or Implicit or Imputed Valuation is Different than “Calculated (NPV) Valuation”

• Have you ever bought a share of stock?

• do the math: $/% = Implicit Valuation

Investors generally Back into a valuation, don’t start there

• What is my best guess about terminal value and exit time

• What is my best guess about future funding requirements and resultant dilution

• What is the most I can afford to pay now i.e., what is the smallest % ownership I can walk away w/ and still get my required return

The Math

REQUIRED/TARGET RETURN = R

YEARS UNTIL EXIT = n

INVESTMENT = I

REQUIRED STAKE % = I * [(1+R)^n]

TV

I/POST$ = ACQUIRED STAKE %

I/POST = I * [(1+R)^n]

TV

The Lesson:

Good decisions come from having good

alternatives from among which to choose

Idea from previous job

71%

Discovered by luck20%

Swept in by PC revolution

5%

Systematic search

4%

Source: Amar Bhide (1994), “How entrepreneurs craft strategies that work,” Harvard BusinessReview (March-April).

Where 100 of the 1989 Inc. 500 founders got their ideas

7 casual job into business6 wanted as consumer4 happened to read about industry

Career Implications

If you are interested in finding an opportunity (or being involved in someone else’s), then the following matter a lot:

– Industry you work in– Whether you are known in your industry– Where you live– Your network of personal and professional

contacts– Your reputation– Planned serendipity