'a'.,,','l.jtl:'a,.:.,,.1a.

.
:-:::-:-::::!

, r. ril

'

r:
t.

:
:,.

.:-'i ,..,. -.
.- ..:.....': ,:,-',

...

To
,

Pects

of valu
i

OPENING PROFILE

MARK ZUCKERBERG

333

334

PART

FROM THE BUSINESS PLAN TO FUNDING

fHE VENTT'RE

Zuckerberg originally targeted the site to 18- to 24-year-olds, and it was at first
lmted to Harvard students. In March of that year, TheFacebook.com expanded to

other lvy League schools. and by May 2005 was serving 800 colleges across the country. At that time, the site operated upon exclusivity; a corresponding college e-mail
address was required to sign up to become a member. In August 2005, the company
name was officially changed to "Facebook," and later that year it was opened up to
high school networks and a few companies, including Apple and Microsoft. By the
.l
end of 2005, the ste had grown to 5.5 million active users compared to million
exactly a year before.
ln September 2006, Zuckerberg removed all registration restrictions on Facebook and
opened up the site to the general public. Having anticipated a negative reaction from

the college students who made the site so popular, he, along with the other founders,
had proactivelytaken action to prepare and inform existing members of new privacy
features. For example, users could not only block other Facebook members from viewing
their profiles, but they could also avoid even being found on the site when their name
was searched. Opening Facebook to the public helped to more than double the site's
membershp within one year; by December 2006 Facebook had 12 million active users.
In anticipation of growing the site to 200 million users, Zuckerberg began looking

outside the confines of the Unted States, and in March 2007 two million Canadians
and one million British joined Facebook. ln early 2008, Facebook was launched in
French, Spanish, and German, and by April 2008 it was translated and launched in 21
additional languages. August 2008 saw a Facebook membership of 100 million active
users; five months later. in January 2009, this number reached 150 million, and February
2009's count revealed 175 million active users. By early 2009, five million new people
were joining Mark Zuckerberg's social network site every week, with the most common

new members being women over the age of

55.

As the site grew in membership, its platform blossomed as well. In September 2004,

the Groups application and Wall features were added, followed by the Photos application in October 2005. The Photo feature allowed users to tag everyone appearing in
the picture so the plcture shows up on the corresponding members'profiles as well.
This helped the application quickly gain popularity; in February 2008, 250 million photos wefe uploaded every month, and a year lateri February 2009, the number had risen
to 850 million monthly uploads. In April 2006, Facebook added the Mobile feature, al-

lowing

users

to upload Facebook onto their mobile phones and access the site any-

where, anytime. September 2006 saw the addition of the News and Mini-Feeds, which
created some backlash from members. The News feed informed users of all recent
activity taken on the profiles of all their friends, including potentially embarrassing
changes such as breakups or professional demotions. Though such information was
already accessible (since the member chose to change it on his or her profile), users

felt Facebook

was spreading the news and informing those who would otherwise

not

have noticed. A Facebook group entitled "Students Against Facebook News Feed"
was created and within 24 hours, 290,000 members had joined. Zuckerberg heard

cHAPTER

r2

INFoRMAL RlsK cAPlrAl- VENTURE cAptrAL, AND GorNG

puBlrc

33s

and listened to th outcry and reacted by creating and promoting

additional privacy
settings enablng users to decide what profile changes could and
could not be included
on the feed.

ln 20o7, another backlash occurred when Facebook launched a feature

called
Beacon, informing users whch Web sites their friends had visited,
including information on products they wgre purchasing. The user protest was overwherming
and even
included a filed lawsuit. This resulted in the allowance for users to disable
Beacon on

their profile, and an aporogy from Zuckerberg. admitting, "we simpry did
a bad job
with this release. and I apologize for iti'
In April 2008, a Chat feature was added, furthering the communication
capabilities

of the users among each other, and by 2009, Facebook had grown to become
more
than just a communiction tool among friends. lt has become the hub for
users to
store their pictures;organize parties, chat, pray games, and find jobs. From profesa
sional standpoint. companies such as Ernst & Young and Dell use the
ste to recruit new
hires. and governmentaf partes, such as the Democratic party in Maine,
use it to

'

organize meetings.
In 2008, Mark'Zuckerbeig was named one of "The World's Most Influential people
of 2008" by Time magazine, and Forbes calls him the youngest self-made
billionaire.
Many investors had recognzed Facebook,s value and potential early on; in 2005
Face_
book received $12.7 million in venture-capital moneyfrom Accel partners
and $27.5 mil-

lion from Greylock Partners in 2006. Also in 2006, Facebook and Microsoft formed
a
strategic relationship. and by October 2007. Microsoft took a $240 miltion equity
stake
in Facebook.
However, Facebook is not lacking challenges. Although the site is worth
93.7 billion
(in 2008), it has a unique financial predicament; its revenues
reached a mere $2g0 million in 2008. which did not even reach the break-even point. To bring the company
to

a position where it financially makes the most of its soaring attractiveness

to marketers. Zuckerberg brought sheryl 5andberg (who built Google,s Adwords program)
on board as the chief operating officer. Because each user on the site has
his or her
own unique story, the wealth of personal information allows advertisers to effectively
promote themselves to their target markets, based on each individual's profile.
lt also
gives marketers a better sense of new trends and popular activities.
For example. if a
particular Facebook group has hundreds of thousands of members,
it is vital for advertisers to join the group and stay aligned with current and upcoming trends
and societal
interests.
Facebook also faces the challenge of "staying on top.,, The world has seen
companies such as AOL and Yahool, who were each well positioned to become
the ultmate

leader in comrnunicaton platforms, fail. Zuckerberg and Facebook are working

on
coming up with ways to continue growing and expanding to remain the leading
social

network while making sure not to alienate its early adopters. Luckily, Zuckerberg,s
vision for the future is well algned with the needs for facebook; he wants
his site to
reach every person and every computer in the world.l

336

PART

FROMTHEBUSINESS PLANTO FUNDINGTHEVENTURE

Unlike Mark Zuckerberg, many entrepreneurs find it tlifftcult both to manage and expand
the ventures they have created. To successfully start and especially grow a ventute, an
entrepreneur must understand venture hnancing and obtain the necessary funding from a
variety of sources.

FINANCING THE BUSINESS

In evaluating the appropriateness of financing alternatives, particularly angel

eflrly-stage _frnancng
One of the first financings
obtained by a company

versus

venture-capital frnancing, an entrepreneur must determine the amount and the timing of
the funds required, as well as the projected company sales and growth. Conventional small
businesses and privately held middle-market companies tend to have a difhcult time
obtaining external equity capital, especially from the venture-capital industry. Most venture capitalists like to invest in software, biotechnology, or high-potential ventures like
Mark Zuckerberg's Facebook. The three types of funding as the business develops are
indicated in Table 12. I . The funding problems, as well as the cost of the funds, differ for
each type. Early-stage financing is usually the most difhcult and costly to obtain. Two
types of hnancing are available during this stage: seed capital and start-up capital. Seed
capital, the most difficult hnancing to obtain througb outside funds, is usually a relatively
small amount of funds needed to prove concepts and finance feasibility studies. Since

CHAPTER

development

I2

INFORMAL RISKCAPITAL, VENruRECAPITAL,ANDGOING

financing

Financing to rapidly
expand the business
acquisitnn

financing

Financing to buy another

company

risk-capal markcts
Markes providing debt
and equity to notrsecure
financing situations

infurmal risk-capital

mnrket Ateaofnskcapital markets consisting

mainly of individuals
yentare-capill mukeI
One ofthe risk-capital
markets consisting

of

formal firms
pubc-equity market
One of the risk-capital
markets consisting

of

publicly owned stocks of

companres

business angels

name for individuals in

the informal risk<apital

market

FORMAL RISK-CAPITAL MARKET

PUBLIC 337

OLD

BANKS.,.AIEW Cfniq(5'.,.' 1 .. ,,,..

,,;

".;.1,..:

"',-..,i,,j,-'+

long. -Thq
The economy
economy hasn't'yet
hasn't yet recov- rates aa
swaps, whose
That didn't take long.
r control.
ered from the implosion of risky nvestments that led for )a
of the borro
to the worst recession in deca es-and already some At the ot
another cont
of the world's biggest banks are peddling a new gen- banks are
prooucrs to
ro corporations,
corp{)rafrons, consumers,
consurlre[s, day
oay loans
roans
nrtesr
nterest rates
[.i{er
eraton of
eraon
or dicey
orcey products
ated by
and investors.
400%. Historicallythe market has b
In recent months such big banks as Bank of America. small nonbank lenders, which mainly operate in poQr
Citigroup, and JPMorgan Chase have rolled qut new- urban centers and offer iustomers an- advnce on
fangled corporate credit lines ted to comp{icate{ and their paychecks. But big lenders Fifth Third and U.S.
volatile derivatives. Others, including Wells .Fargo Bancorp started offering the loans, while Wells Fargo
and Fifth Third, are offering payday-loan progr.ams continues to boost its payday-loan program, which it
aimed at cash-strapped consumers. Still others are began in 1994.

marketing new, potentially risky "structured notes" More big ba

to small investors.
..:'a rece
There's no indication that the loans and instru- ,eri. ln
ments are doomed to fail. lf the economy keeps mv- , cappe
ing toward recovery, as many rneasures suggest, then out payday]ehde-r5 altogether; The .staJqo{ Oho,'for
the new products might well work out for buyers and example. has imposed a 2870 interest rate limit. But
sellers alike.
thanks to nterlate commerce rules, nationally charBut it's another scenario that worries regulators, tered banks don't have to follow local rules. After
lawmakers, and consumer advocates: that banks once Ohio limited rates, Cincinnati-based Fifth Third, which
again are making dangerous loans to borrowers has 400 branches in the state but also operates in
who can't repay them and selling toxic investments 11 others, introduced its Early Access Loan, with an
to investors who don't understand the risks-all of annual interest rate of 120%. "These banks are skirtng
which could cause blowups in the banking sector and
state laws." says Kathleen Day of advocacy group
weigh on the economy.
Center for Responsible Lending. Says a spokeswoman
Some of Wall Street's latest innovations give rea- for Fifth Third: "Our Early Access product fully comson for pause. Consider a trend in business loans. plies with federal regulations and applicable state
Lenders typically tie corporate credit lines to shortregulations. "
term interest rates. But now Citi, JPMorgan Chase,
Lenders argue they offer a valuable service for
and BofA. among others, are linking credit lines both those who need emergency cash. Wells Fargo says it
to short-term rates and credit default swaps (CDSs), warns customers using its Direct Deposit Advance that
the volatile and complicated derivatives that are sup- the loan is expensive and tries to offer alternatives.
posed to act as "insurance" by paying off the owners
"We have policies in place to prevent long-term usage
if a company defaults on its debt. JPMorgan, BofA, of the services," says a spokeswoman. U.5. Bancorp
and Citi declined to comment.
didn't return calls.
In these new arrangements, when the price of the
National regulators are taking notice, however. The
CDS rises--generally a sign the market thinks the comOffice of Thrift Supervision says it is "looking into"
pany's health is deteriorating-the cost of the loan two institutions that are offering the high-interest
increases. too- The result: The weaker the company,
loans. "We need to make sure there's no predatory
pay.
the higher the interest rates it must
which hurs lending and also ensure that there are no risks to the
the company further.
institutions," says an OT5 spokesman.
The lenders stress that the new products give them
Source: Reprinted from August 17 ,2009 issue of BuslnessWeek
extra protection against default. But for companies.
by special permission, copyright @ 2009 by The McGaw-Hill
the opposite may be true. Managers now must deal Companies, Inc.,'Old Banks, New Lending Tricks," by Jessica
with two layers of volatility-both short-term interest Silver-Greenberg, Theo Francis, and Ben Levisohn, pp 2W23.

338

].1 - ..

CHAPTER

12

INFORMAL RISK CAPITAI- VENTURE CAPTTAL. ANO GOING

PUBLIC 339

Simi
fi
viduals

examination of the funds raised by small technology_

lic offerings. The study revealed tat unafhliated indiarket) accounted for 15 percent of these funds, while
venture capitalists accounted for only 12 o 15 percent. During the start-up year,
unaffiliated individuals provided l7 percent of the external capital.a
A study of angels in New England again yielded similar results. The 133 individual investors studied reported risk-capital investments totaling over $16 million in 320
ventures
between l976and 1980. Thes
aver_
age size of $50,000. Alrhough
.0m.
24 percent averaged over $50
_ups,
based

80 percent involved ventures I

investors have

inc
of
U.S

various sectors

to the
sumer
These

of 1.3 million
families' represenfng about 2 percent of the population, accumulated most of their wealth
from earnings, not inheritance, and invested over $15l billion in nonpublic businesses in
which they have no management interest. Each year, over 100,(D0 individual investors
hnance between 30,000 and 50,)0 firms, with a total dollar investment of between $7 billion and $10 billion. Given their investment capability, it is impotant to know the characteristics of these angels.

The characteristics of these informal investors, or angels, are indicated nTable 12.2-

problem waiting for a period of 7 to l0 years before cashing out. This is in contrast to

3ro

PART

FR0M THE BUSINESS PLAN T0 FUNDING THE VENTURE

the more predominant five-year time horizon in the formal venture-capital industryInvestment opportunities are rejected when there is an inadequate risk/return ratio, a
subpar management team, a lack of interest in the business area, or insuffrcient commitment to the venture from the principals.
The angel investor market averages about $20 billion each year, which is about the same
level of yearly investment of the venture-capital industry. The angel investment is in about
eight times the number of companies. In normal economic conditions, the number of active

CHAPTER

12

INFORMAL RISK CAPITAL, VENTURE CAPITAL. AND GOING

PUBLIC 341

investors is aound 250,000 individuals in the United States, with five

or six investors typically being involved in an investment.

referral

sources

Ways

individual investors

fi nd
out about potential deals

is a pool of

is between
university-

VENTURE CAPITAL
The important and little understood area of venture capital will be discussed in
terms of its
nature, the venture-capital industry in the United States, and the venture-capital process.

Nature of Venture Capitat

equily

pool

Money

Venture capital is one of the least understood

venture capitalists do the early-stage financing
ogy companies. It is more accurate to view ven
aged pool of equity capital. Frequentl the e

raised by venture

capitalists to invest

equiQ particpation
Taking an ownership
posltlon

ment, the v
convertible
company, b

an equ
active
ancing

warrnts, and/or

of

each portfolio
the firm.

':r:.:.

' ''

l'N.,8,U5/ru ESSW

EE

SHE1S.AN ANGEL

Barbaia Boxer. a practicing attorney in Milwaukee,

knows just how difficult it can be for womein entrepreneurs to raise money. She ran her own mail-order
mg{ical supply company for 20 years before selling it
in.199O; and now many of her clients are women who

there's still plenty: of rgqm for

not only control 5oo/o of the cou
they also represent an increasing
trepreneurs. About hatf of private companiei :a.re
majority-owned by women, according to the.Cgntei

own

businesses. After participating in a conference

for women trylng to raise funding. the 56-year-old

for Women's Business Research.

decided to take matters into her own hands. Last summer, Boxer started Women Angels, a group of women
investors that focuses on women-owned businesses in

There are plenty of reasons. For one, only about

15%-20% of angels are organized into groups t all,
with the rest investing on their own. Angel .invefiors
tend to be serial entrepreneurs, and serial ent(epreneurs tend to be men. Social networks also play a role,
since angel groups usually form around investorl
social circles. "Men tend to socialize and affiliate with
people they do business with." says Maggie Kenefake,
manager of growth enfepreneurship for the Kauffman
Foundation. "lf you look at women, their networks
are more social, philanthropic, or family-based."
Just because many women are newer to the
investment game doesn't mean they're any less discerning than men. Although women angels actively
seek out, and tend to attract. more women entrepreneurs, the groups conduct the same amount of due
diligence and ultimately fund companies at the same
rate as men do, roughly 1O% of the proposals they
see. And while many of these new groups have every

the Midwest. Now the group's 22 members are getting ready to make their first investments. They will
put $150,000 to $500,000 in each of two companies,
one in biotech and one in transportation.
Boxer 'is part of a small but growing legion of

women angel investors, who are using their own

money to back young cornpanies; Often, those are
companies led by women. "We're seeing more women
entrepreneurs who are cashing out of their businesses," says Jeffrey Sohl, a professor of entrepreneur-

ship at the University of New Hampshire. "The more

women who are successful in business, particularly in
entrepreneurship, the more women angels we're likely
to see-" That's because the prime candidates to be
angel investors are former entrepreneurs. There are at
least six women-focused angel groups in the U.5., with
an additional dozen or so just getting started, according to a recent report from the Kauffman Foundation.

Angels are a rich source of capital

for entrepre-

Why aren't there more women angel

groups?

of helping other women entrepreneurs,

being an angel is, in the end, still an investment decision. Says Boxer: "This isn't about altruism. lt's about
intention

neurs. Last year, 225,000 angels invested $23.1 billion

making money."

in roughly 49,500 deals, according to the Center for

Venture Research. Women represented 9% of that
group, up from 5% in 2004. Part of that increase is
coming from new women-led investment groups, but

Source: Reprinted from Summer 2006 Small Biz Supplement issue

of BusinessWeek by special permission, copyright O 2006 by The
McGraw-Hitl Companies, Inc., "She's an Angel," by Adrienne
Carter,

3'1.

Overview of the Venture-Capitat Industry

Although the role of venture capital was instrumental throughout the industrialization of
the United States. it did not become institutionalized until after World War II. Before World
War II, venture-capital investment activity was a monopoly led by wealthy individuals,
investment banking syndicates, and a few family organizations with a professional manager.
The first step toward institutionalizing the venture-capital industry took place in 1946 with
the formation of the American Research and Development Corporation (ARD) in Boston.
The ARD was a small pool of capitat from individuals and institutions put together by General Georges Doriot to make active investments in selected emerging businesses.
The next major development, the Small Business Investment Act of 1958, married private capital with government funds to be used by professionally managed small-business

CHAPTER

SBICfirms

12

INFORMAL RISK CAPITAL VENTURE CAPITAL, AND GOING

PUBLIC 343

Smal-l

companies with sorne

government money that

invest in other companies

essary government regulations and increased the amount of capitalization

needed. There
are approximately 360 SBICs operating today, of which 130 are minority small-business
investment companies (MESB ICs) fu nding minority enterprises.
p

riv ale

ftrnas

ve

nlure - cap

ilal

Atypeofventure-

capita[ firm having general

and limited partners

lnsurance companies, endowment funds, bank trust departments, pension funds, and
wealthy individuals and families. There are over 900 of this type of vnture-capital estab-

lishment in the United States.

state-sponsored

venture-capital

funtl

A fund containing

In response to the need for economic development, a fourth type of venture-capital

firm has emerged in the form of the state-sponsorecl vettture-capitalfund.-these state-

state

government money that

invests primarily in
companies in the state

An overview of the types of venture-capital rms is indicated in Figure 12. l. Besides the
four types previously discussed, there are now emerging university-sponsored venture-capital

Industry
sponsored:
. Banks and
other financial
nstitutions
. Nonfinancial
compantes

34

PART

FROMTHEBUSINESSPLANTOFUNDINGTHEVENTURE

Source: PricewaterhouseCooperVThomson Venture Economics/National Venture Capital Assmiaon Money

Tre Suney

funds. These funds, usually managed as separate entities, invest in the technology of the particular university. At such schools as Stanford, Columbia, and MIT, students assist professors
and other students in creating business plans for funding as well as assisting the fund manager
in his or her due diligence, thereby learning more about the venture-funding process.
The venture-capital industry has not returned to the highest level of dollars invested
in 1999 , 2000, and 2001 . While the total amount of venture-capital dollars invested increased steadily from $7.8 billion in 1995 to a high of $104.7 billion in 2000
(see Table I2.3\,tt the total dollars invested declined to $40-7 billion in 2001. $21.7 billion in 2002, and $19.6 billion in 2003. There was a slight increase to $21.6 billion in
2004 and $21.7 billion in 2005. The total amounf invested increased again in 2006
($26.7 billion) and 2007 ($30.9 billion) before declining with the economic downturn to
$28.3 billion in 2fi)8.
The total amount of venture-capital dollars invested, disseminated across the number of
deals, is indicated in column 3 of Table 12.3. The number of venture-capital deals went from
1,173 in 1995 to a high of 7,809 in 2000. In 2003,2Cf,4, and 2005, the number of deals
stayed fairly steady, ar2,865,2,966, and 2,939, respectively. The number of deals increased
in 2006 (3,675) and again in2007 (3,952) before declining in 2008 to 3,808 dealsThese deals concentrated in three primary areas in 2008: software-$4,919 million
(17 percent), industriaUenergy-$4,651 million (16 percent), and biotechnology--$4,500 million (16 percent). This investment has signihcantly impacted the growth and development
of these three industry sectors. As indicated in Figure I2.2, other industry areas receiving

venture-capital investment include the following: medical devices and equipment$3,460 million (12 percent), media and entertainment-$2,039 million (7 percent), IT
services-$1,832 million (6 percent), telecommunications-$1,688 million (6 percent),
and semiconductors-$ 1,65 I million (6 percent).
At what stage of the business development is this money invested? The percentage of
venture-capital money raised by stage of the venture in 2008 is indicated in Figure 12.3.

Numbers rounded to the nffest whole perent.

Souce: PricewaterhouseCmpes/Thomson Venture Economics/Natioml
Venture capital Association Money TrM suryey.

Soure: PricewaterhouseCoorcnVThomson

venture Economics/Nationat veoture Capital Assrciation Money 'treeril Survey

346

PART

FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

Source: PricewaterhousecooperVThomson Venturc EconomicsAlational Venture Capital Assciation Money TreerM Suney.

The largest amount of money raised was for later-stage and expansion-stage investments
(38 percent), followed by early-stage (19 percent), and start-up/seed stage (5 percent). Traditionally the largest amount of money raised is for expansion-stage investmont. In 2002,
for example, 57 percent of the venture money raised was for expansion, followed by early
stage (23 percent), later scage (18 percent), and start-up (2 percent).
The money invested by stage and year from 1995 to 2008 is broken down in Table 12.4Venture-capital money invested at the start-up/seed stage (for seed capital) went from
$1,704 million in 1995 to a high of $6,605 million in 1999, before declining to a low of
$335 million tn 2002. The amount invested in this early-stage area increased to $ 1,268 million
in 2ClJ7 and again to $ I ,5 10 million in 2)8- Venture capitalists in 2008 showed a significant
interest in funding start-up/seed capital deals, despite the economic downturnWhere do these deals take place? Table 12.5 shows the amount of money invested in
2008 ($28.2 billion) by region of the country. It should come as no surprise that the areas
receiving the largest amount of venture capital were the Silicon Valley-$ I 1 1.7 billion in

CHAPTER

12

INFORMAL RISK CAPITAI- VENTURE CAPITAL. ANO GOING

Source: PricewaterhouseCmpers/Thomson Ventu Economics/Ntional

PUBLIC 347

Venture Capitat Aswiaton Money TreerM Suruey

1,170 companies (31 percent), and New England-$3.3 billion in 460 companies (12 percent)- Other areas receiving funding were metro New York-$ 1.9 billion in 308 companies
(8 percent), Los Angeles/Orange County-$1.9 billion in237 companies (6 percent), and
the Midwest-$l.3 billion in267 companies (7 percent).

Ventu re -Ca pital Process

v e,t t

ur e - cap ital pro

c ess

The decision procedure of

a venture-capital firm

To be in a position to secure the funds needed, an entrepreneur must understand the philosophy and objectives of a venture-capital hrm, as well as the venture-capital process. The
objective of a venture-capital hrm is to generate long-term capital appreciation through
detrt and equity investments. To achieve this objecve, the venture capitalist is willing to
make any changes or modifications necessary in the business investment. Since the objective of the entrepreneur is the survival of the business, the objectives of the two are frequently at odds, particularly when problems occur.
A typical portfolio objective of venture-capital frrms in terms of return criteria and risk
involved is shown in Figure 12.4. Since there is more risk involved in financing a business
earlier in its development, more return is expected from early-stage financing (50 percent
ROI) than from acquisitions or leveraged buyouts (30 percent ROI), which are later stages
of development. The significant risk involved and the pressure that venture-capital firms
feel from their investors (limited partners) to make safer investments with higher rates of
return have caused these hrms to invest even sreater amounts of their funds in laber stases

318

PART

FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

Source: @ 1992, Americm Eonomic Development Council (AEDC)- All rights resewed. Reprinted from tl
Developrcnt Reviu, vol. 10, no- 2, Spring 1992, p. 44. with tlc pemission of AEDC-

of financing. In these late-stage investments, there are lower risks, faster returns, less managerial assistance needed, and fewer deals to be evaluated.
The venture capitalist does not necessarily seek control of a company, but would rather
have the firm and the entrepreneur at the most risk. The venture capitalist will want at least
one seat on the board of directors. Once the decision to invest is made, the venture capitalist will do anything necessary to support the management team so that the business and the
investment prosper. Whereas the venture capitalist expects to provide guidance as a member of the board of directors, the management team is expected to direct and run the daily
operations of the company. A venture capitalist will support the management team with investment dollars, financial skills, planning, and expertise in any area needed,
Since the venture capitalist provides long-term investment (typically five years or more),
it is important that there be mutual trust and understanding between the entrepreneur and
the venture capitalist. There should be no surprises in the fitrm's performance. Both good
and bad news should be shared, with the objective oftaking the necessary action to allow
the company to grow and develop in the long run. The venture capitalist should be available
to the entrepreneur to discuss problems and develop strategic plans.
The venture capitalist expects a company to satisfy three general criteria before he or
she will commit to the venture. First, the company must have a strong management team
that consists of individuals with solid experience and backgrounds, a strong commitment
to the company, capabilities in their specific areas of expertise, the ability to meet chal-

lenges, and the flexibility to scramble wherever necessary. A venture capitalist would
rather invest in a hrst-rate management team and a second-rate product than the reverse.
The management team's commitment should be reflected in dollars invested in the company. Although the amount of the investment is important, more telling is the size of this
investment relative to the management team's ability to invest. The commitment of the
management team should be backed by the support of the family, particularly the spouse,
of each key team player. A positive family environment and spousal support allow team
members to spend the 60 to 70 hours per week necessary to start and grow the company.

CHAPTER

12

INFORMAL RISK CAPITAI-VENTURECAPTTAL, AND GOING

PUELIC YTg

One successful venture capitalist makes it a point to have dinner with the entrepreneur and
spouse, and even to visit the entrepreneur's home, before making an investment decision.
According to the venture capitalist, "I find it difficult to believe an entrepreneurcansuccessfully run and manage a business and put in the necessary time when the home envi-

ronment is out of control."

significant captal

appreciatbn
Significant capital
appreciarion is tlre
increase in value of the
organization during a
specific period of time

preliminary screening
Initial evaluaon of a deal

due

diligence Ttrc

process

of deal evluation

The second criterion is that the product and/or market opportunity must be unique, having a differential advantage in a growing markel Securing a unique market niche is essential since the product or service must be able to compete and grow during the investment
period. This uniqueness needs to be carefully spelted out in the marketing portion of the
business plan and is even better when it is protected by a patent or a trade secret.
The frnal criterion for investment is that the business opportunity must have signifrcant
capal appreciation. The exact amount of capital appreciation varies, depending on such
factors as the size of the deal, the stage of development of the company, the upside potential, the downside risks, and the available exits. The venture capitalist typically expects a40
to 60 percent return on investment in most investment situations.
The venture-capital process that implements these criteria is both an a.rt and a science.r2
The element of at is illustrated in the venture capitalist's intuition, gut feeling, and creative
thinking that guide the process. The process is scientific due to the systematic approach and
data-gathering techniques involved in the assessment.
The process starts with the venture-capital firm establishing its philosophy and investment objectives. The firm must decide on the following: the composition of its portfolio
mix, including the number of start-ups, expansion companies, and management buyouts;
the types of industries; the geographic region for investment; and any product or indusffy
specializations.
The venture-capital process can be broken down into four primary stages: preliminary
screening, agreement on principal terms, due diligence, and final approval. The preliminary
screening begins with the receipt of the business plan. A good business plan is essential in
the venture-capital process. Most venture capitalists will not even talk to an enffepreneur
who doesn't have one. As the starting point, the business plan must have a clear-cut mission
and clearly stated objectives that are supported by an in-depth industry and market analysis and pro forma incorne statements. The executive summary is an important part of
this business plan, as it is used for initial screening in this preliminary evaluation. Many
business plans are never evaluated beyond the executive summary- When evaluating the
business, the venture capitalist hrst determines ifthe deal or similar deals have been seen
previously. The investor then determines ifthe proposal fits his or her long-term policy and
short-term needs in developing a portfolio balance. In this preliminary screening, the venture capitalist investigates the economy of the industry and evaluates whether he or she has
the appropriate knowledge and ability to invest in that industry. The investor reviews the
numbers presented to determine whether the business can reasonably deliver the ROI required. In addition, the credentials and capability of the management team are evaluated to
determine if they can carry out the plan presented.
The second stage is the agreement on principal terms between the entrepreneur and the
venture capitalist. The venture capitalist wants a basic understanding of the principal terms
of the deal at this stage of the process before making the major commitment of time and effort involved in the formal due diligence process.
The third stage, detailed review and due diligence, is the longest stage, involving anywhere from one to three months. There is a detiled review of the company's history the
business plan, the resumes of the individuals, their financial history, and target market customers. The upside potential and downside risks are assessed, and there is a thorough evaluation of the markets, industry, hnances, suppliers, customers, and rnanagement.

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ftnal approval A
document showing the

final terms ofthe deal

In the last stage,filwl approvaL a comprehensive, internal investment memorandm is

prepared. This document reviews the venture capitalist's findings and details the investment
terms and conditions of the investment transaction. This information is used to prepare the
formal legal documents that both the entrepreneur and venture capitalist will sign to finalize the deal.13

Locating Venture Capitatists

One of the most important decisions for the entrepreneur lies in selecting which venturecapital firm to approach. Since venture capitalists tend to specialize either geographically
by industry (manufacturing industrial products or consumer products, high technology,
or service) or by size and type of investment, the entrepreneur should approach only
those that may have an interest in the investment opportunity. Where do you find this
venture capitalist?

Although venture capitalists ae located throughout the United States, the traditional areas of concentration are found in Los Angeles, New York, chicago, Boston, and San
Francisco. Most venture capital hrms belong to the National Venture Capital Association
and are listed on its Web site (www.nvca.org). An entrepreneur should carefully research
the names and addresses of prospective venture-capital firms that might have an interest in
the particular investment opportunity. There are also regional and national venture-capital
associations. For a nominal fee or none at all, these associations will frequentlv send the
entrepreneur a directory that lists their members, the types of businesses theii members
invest in, and any investment restrictions. Whenever possible, the entrepreneur should be
introduced to the venture capitalist. Bankers, accountants, lawyers, and professors are good
sources for introductions.

Approaching a Venture Capitalist

The entrepreneur should approach a venture capitalist in a professional business manner.
Since venture capitalists receive hundreds of inquiries and are frequently out of the office
working with portfolio companies or investigating potential investment opportunities, it is
important to begin the relationship positively. The entrepreneur should call any potential
venture capitalist to ensure that the business is in an area of investment interest. Then the
business plan should be sent, accompanied by a short professional letter.
Since venture capitalists receive many more plans than they are capable of funding,
many plans are screened out as soon as possible. Venture capitalists tend to focus and put
more time and effort on those plans that are referred, In fact, one venture-capital group said
that 80 percent of its investments over the last five years were in refened companies. Consequently, it is well worth the entrepreneur's time to seek out an introduction to the venture
capitalist. Typically this can be obtained from an executive of a portfolio company, an accountant, a lawyer, a banke or a business school professor.
The entrepreneur should be aware of some basic rules of thumb before implementing
the actual approach and should follow the detailed guidelines presented in Table 12.6. First,
great care should be taken in selecting the right venture capitalist to approach. Venture capitalists tend to specialize in certain industries and witl rarely invest in a business outside
those areas, regardless of the merits of the business proposal and plan. Second, recognize
that venture capitalists know each other, particularly in a specific region of the countqr.
When a large amount of money is involved, they will invest in the deal togethe with one
venture-capital frrm taking the lead. Since this degree of familiarity is present, a venturecapital frrm will probably find out if others have seen your business plan. Do not shop

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among venture capitalists, as even a good business plan can quickly become "shopworn."
Third, when meeting the venture capitalist, particularly for the first time, bring only one or
two key members of the management team. A venture capitalist is investing in you and
your management team and its track record, not in outside consultants and experts. Any
experts can be called in as needed.
Finally, be sure to develop a succinct, well-thoughrout oral presentation. This should
cover the company's business, the uniqueness of the product or service, the prospects for
growth, the major factors behind achieving the sales and prohts indicated, the backgrounds
and track records of the key managers, the amount of hnancing required, and the returns
anticipated. This first presentation is critical, as is indicated in the comment of one venture
capitalisl "I need to sense a competency, a capability, a chemistry within the hrst half hour

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PART

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PlN

TO FUNDING THE VENruRE

of our initial meeting. The entrepreneur needs to look me in the eye and present his story
clearly and logically. If a chemisny does not start to develop, I stat looking for reasons not
to do the deal."
Following a favorable initial meeting, the venture capitalist will do some preliminary investigation of the plan- If favorable, another meeting between the management team and
the venture capitalist will be scheduled so that both pafies can assess the other and determine if a good working relationship can be established and if a feeling of trust and confidence is evolving. During this muhal evaluation, the entrepreneur should be careful not to
be too inflexible about the amount of company equity he or she is willing to share. If the
entrepreneur is too inflexible, the venture capitalist might end negotiations. During this
meeting, initial agreement of terms is established. If you are turned down by one venture
capitalist, do not become discouraged. Instead, select several other nonrelated venturecapitalist candidates and repeat the procedure. A significant number of companies denied

funding by one venture capitalist are able to obtain funds from other outside sources,
including other venture capitalists.

VALUING YOUR COMPANY

A problem confronting the

factors n valuation
Nonmonetary aspects that

entrepreneur in obtaining outside equity funds, whether from

the informal investor muket (the angels) or from the formal venture-capital industry is determining the value of the company. This valuation is at the core of determining how much
ownership an investor is entitled to for funding the venture. This is determined by consideinglhefactors in valuation. This, as well as other aspects of securing funding, has a potential for ethical conflict that must be caefullv handled

affect the fund valuation

ofa company

Faclors in Valuation
There are eight factors that, although they vary by situation, the entrepreneur should consider when valuing the venture. The first factor, and the starting point in any valuation, is
the nature and history of the business. The characteristics of the venture and the industry in
which it operates ae fundamental to every evaluation process. The history ofthe company
from its inception provides information on the strength and diversity of the company's operations, the risks involved, and the company's ability to withstand any adverse conditions.
The valuation process must also consider the outlook of the economy in general as well
the
as
outlook for the particular industry This, the second factor, involves an examination
of the hnancial data of the venture compared with those of other companies in the industry.
Management's capability now and in the future is assessed, as well as the future market for
the company's products. Will these markets grow, decline, or stabilize, and in what economic conditions?
The third factor is the book value (net value) of the stock of the company and the overall financial condition ofthe business. The book value (often called owner's equity) is the
acquisition cost (less accumulated depreciation) minus liabilities. Frequently, the book
value is not a good indication of fair market value, as balance sheet items are almost always
carried at cos! not market value. The value of plant and equipment, for example, carried on
the bools at cost less depreciation may be low due to the use ofan accelerated depreciation
method or other maket factors, making the assets more valuable than indicated in the book
value figures. Land, particularly, is usually reflected lower than fair market value. For valuation, the balance sheet must be adjusted to reflect the higher values of the assets, particularly land, so that a more realistic company worth is determined. A good valuation should
also value operating and nonoperating assets separately and then combine the two into the

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total fair market value. A thorough valuation involves comparing balance sheets and profrt
and loss statements for the past three years when available.
while book value develops the benchmak, the future earning capacity of the company,
the fourth factor, is the most important factor in valuation. Previous years'earnings are generally not simply averaged but weighted, with the most recent eamings receiving the highest weighting. Income by product line should be analyzed to judge future prohtability and

value. Special attention should be paid to depreciation, nonrecurring expense, offrcers'

salaries, rental expense, and historical trends.
The fifth valuation factor is the dividend-paying capacity ofthe venture. Since the entrepreneur in a new venture typically pays little if any in dividends, it is the future capacity to
pay dividends rather than actual dividend payments made that is important. The dividendpaying capacity should be capitalized.
An assessment of goodwill and other intangibles of the venture is the sixth valuation
factor. These intangible assets usually cannot be valued without reference to the tangible
asseLs

of the venture.

The seventh factor in valuation involves assessing any previous sale ofstock. Previous
stock sales accurately represent future sales if the stock sales are recent. Motives regarding
the new sale (if other than arriving at a fair price) and any change in economic or financial
conditions during the intermittent period should be considered.
The final valuation factor is the market price of the stocks of companies engaged in the
same or similar lines of business. This factor is used in the specific valuation method discussed later in this section. The critical issue is the degree of similarity between the publicly traded company and the company being valued.

Ratio Analysis
financinl ratbs
Control mechanisms to
test the financial strength

of the oew venture

Calculations offinancial ratios can also be extremely valuable as an analytical and control
mechanism to test the financial well-being of a new venture during its early stages. These
ratios serve as a measure of the financial strengths and weaknesses of the venture, but
should be used wi caution since they are only one control measure for interpreting the hnancial success ofthe venture. There is no single set ofratios that must be used, nof are
there standard dehnitions for all ratios. However, there are industry rules of thumb that the
entrepreneur can use to interpret the frnancial data. Ratio analysis is typically used on
actual financial results but can also provide the entrepreneur with some sense of where
problems exist in the pro forma statements as well. Throughout this section we will use
information taken from the financial statements of MPP Plastics (Chapter l0) to illustrate.

Liquidity Ratios
Current Ratio This ratio is commonly

used to measure the short-term solvency of the

venture or its ability to meet its short-term debts. The current liabilities must be covered
from cash or its equivalent; otherwise the entrepreneur will need to borrow money to meet
these obligaons. The formula and calculation of this ratio when current assets are
$108,050 and current liabilities are $40.500 is:

Currentassets
Currentliabilities

108.050
40,500

2.67 times

While a ratio of 2: I is generally considered favorable, the entrepreneur should also compare this ratio with any industry standards. One interpretation of is result is that for every
dollar of current debt, the company has $2.67 of current assets to cover it. This ratio

354

PART

FROM THE BUSINESS PLAN

IO FUNDING THE VENruRE

indicates thaf MPP Plastics is liquid and can likely meet any of its obligations even if there
were a sudden emergency that would drain existing cash.
Acid Test Ratio This is a more rigorous test of the short-term liquidity of the venture because it eliminates inventory, which is the least liquid current asset. The formula given the
same current assets and liabilities and inventory of $ 1O450 is:

- Inventory:
c"."trt lrbiliti*

Cunent assets

- 10,450 :
40J00

103,050

z'Zru trmes

The result from this ratio suggests that the venture is very liquid since t has assefs convertible to cash of $2.40 for every dolla of short-term obligations- Usually a 1:1 ratio
would be considered favorable in most industries-

Activity Ratios
Average Cotlection Period This ratio indicates the average number of days it takes to
convert accounts receivable into cash. This ratio helps the entrepreneur to gauge the liquidity of accounts receivable or the ability of the venture to collect from its customers. Using
the formula with accounts receivable of $46.1100 and sales of $995.000 results in:

Accounts receivable
Average daily sales

46.000

995ooo/3o

17 daYs

This particular result needs to be compared with industry standards since collection will
vary considerably. However, if the invoices indicate a20-day payment required, then one
could conclude that most customers pay on time.

Inventory Turnover This ratio measures the efhciency ofthe venture in managing and
selling its inventory. A high tumover is a favorable sign indicating that the venture is able
to sell its inventory quickly. There could be a danger with a very high turnover that the
venture is understocked, which could result in lost orders. Managing inventory is very important to the cash flow and profrtability of a new venture. The calculation of this ratio
when the cost of goods sold is $645,000 and the inventory is $10,450 is:
Cost of goods sold

645.000

Inventory

10,450

This would appear to be an excellent turnover as long as the entrepreneur feels that he
or she is not losing sales because of understocking inventory.

Leverage Ratios

Ratio

Many new ventures will incur debt as a means of financing the start-up. The
firm's ability to meet all its obligations (short
and long term). It is also a measure of risk because debt also consists of a hxed commitment in the form of interest and principal repayments. With total liabilities of $249,700 and
total assets of $308,450, the debt ratio is calculated as:
Debt

debt ratio helps the entrepreneur to assess the

Total liabilities
Total

assets

249,100
308.450

_ SlVo

This result indicates that the venture has financed about 8 I percent of its assets with debt.
On paper this looks very reasonable, but it would also need to be compared with industry data.

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Debt to Equity This ratio assesses the firm's capital structure. It provides a measure of
risk to creditors by considering the funds invested by creditors (debt) and investors (equity).
The higher the percentage ofdeh, the greater the degree ofrisk to any of the creditors. The
calculation of this ratio using the same total liabilities, with stockholder's equity being
$58,750. is:

Toral liabilities
Stockholder's equity

249.700

5SJ56

4.25 times

This result indicates that this venture has beon f,rnanced mostly from debt. The actual investment of the entrepreneurs or the equity base is about one-fourth of what is owed. Thus,
the equity portion represents a cushion to the creditors. For MPP Plastics this is not a serious problem because ofits short-term cash position.

Profitabitity Ratios
Net Profit Margin This ratio represents the venture's ability to translate sales into profits. You can also use gross profit instead of net proht to provide another measure of profitability. In either case it is important to know what is reasonable in your industry as well
as to measure these raos over time. The ratio and calculation when net profit is $8,750 and
net sales are $995,D is:

f-o

Net

P'9nt

sales-

9'7so
995.000

o.B8vo

The net proht margin for MPP Plastics, although low for an established firm, would not
ofgreat concem for a new venture. Many new ventures do not incur profits until the second or third year. [n this case we have a favorable profit situation.
be

Return on Investment The return on investment measures the ability of the venture to
its total investment in assets. You can also calculate a return on gquity, which substitutes stockholders'equity for totl assets in the following formula and indicates the ability of the venture in generating a retum to the stockholders. The formula and calculation of
manage

the return on investment when total assets are $200,400 and net profit is $8,750 is:

Netproht
Total

assets

8,750 :4Aen
200,400

The result of this calculation will also need to be compared with industry data. However,
the positive conclusion is that the rm has earned a profit in its first year and has returned
4.4 percent on its asset investment.
There are many other ratios that could also be calculated. However, for a start-up these

would probably suffrce for an entrepreneur in assessing the venture's hnancial strengths
and weaknesses. As the firm grows, it will be important to use these ratios in conjunction
with all other hnancial statements to provide an underslanding of how the firm is performing financially.

General Valuation Approaches

general valualiott

approaches Methods
for delermining the worth
of

company

There are several general valuation approaches that can be used in valuing the venture.
One of the most widely used approaches assesses comparable publicly held companies
and the prices of these companies' securities. This seach for a similar company is both
an art and a science. First, the company must be classihed in a certain industry, since

356

PART

FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

present volue offuture

cash

fiore

Valuing a

compay based on its

future sales and profits

replacemenl

value Tlte

cost of replacing all

assets

of

a company

value The
idicated worth of the
assets of a company
book

truly comparable company is not found.

A second widely used valuation

Book value

Add (or subtract) any adjustments such as appreciation or

depreciation to arrive at figure on next line-the fair market value
Fair market value (the sale value of the company's assets)

earnings approach
Determining the worth of
company by looking at
its present and future
earnrngs

factor approach \Jsing

the major aspects of a
company to determine its

worth

ture cashflow.This

method adjusts the value of the cas

value of money and
the business and economic risks.
nts) can be used in
reinvestment, this valuation approach generally gives more accurate results than profits.
With this method, the sales and eamings are projected back to the time of the valuation
decision when shaes of the company are offered for sale. The period between the valuation and sale dates
the potential dividend payout and expected
price-earnings ratio o
the end of the period are calculated. Finally, a
rate of return desired
lished, less a discount rate for failure to meet
those expectations.
Another valuation method, used only for insurance purposes or in very unique circumstances, is known as replacement value. This method is used when, for example, there is a
unique asset involved that the buyer really wants. The valuation ofthe venture is based on
the amount of money it would take to replace (or reproduce) that asset or another important
asset or system of the venture.
The bookvalue apptoachuses the adjusted book value, or net tangible asset value, to determine the firm's worth. Adjusted book value is obtained by making the necessary a_djustments to the stated book value by taking into account any depreciation (or appreciation) of
plant and equipment and real estate, as well as necessary inventory adustments that result
from the accounting methods employed rhe following basic procedure can be used:

$_
$
$

Subtract all intangibles that cannot be sold, such as goodwill

Adjusted book value

Since the book valuation approach involves simple calculations, its use is particularly
good in relatively new businesses, in businesses where the sole owner has died or is disabled,
and in businesses with speculative or highly unstable earnings.
The earnings approach is the most widely used method of valuing a company since it
provides the potential investor with the best estimate of the probable return on investment.
The potential earnings are calculated by weighting the most recent operating year's earnings after they have been adjusted for any extraordinary expenses that would not have
normally occurred in the operations of a publicly traded company. An appropriate priceearnings multiple is then selected based on norms of the industry and the investment risk.
A higher multiple will be used for a high-risk business and a lower multiple for a low-risk
risk business in an industry with a seven-times-earnings mulmillion if the weighted average earnings over the past three
$0.6 million).
An extension of this method is thefactor approach, whercin the following three major
factors are used to determine value: earnings, dividend-paying capacity, and book value.

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INFORMAL RISK CAPITAI- VENTURE CAPITAL, AND GOING

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for the particular company being valued are developed and multi_
ed value, resulting in an overall weighted valuation. An example is

000s)
Earnings: $4O x 10
Dividends: $f5 x 20
Book value: $600 x 0.4
Approach (in

Capitalized

Value

Weght

Weghted Value

$4OO

o.4

f160

l3OO

0.4

S24O

o.2

$aa

l20

Average: $328
10% discount: $33
Per-share value: $295

quidalion

valae

of a companv

everything was

Worth

A final valuation approach that gives the lowest value of the business is liquidation value.
Liquidation value is often difficult to obtain, particularly when costs and losses must be essold today dmated for selling the inventory, terminating
employees, collecting accounts receivable,

if

selling assets, and performing other closing-down activities. Nevertheless, it is also good
risk value in appraising a company.

for

an investor to obtain a downside

GeneraI Valuation Method

One approach an entrepreneut can use to determine how much of the company a venrure
capitalist will want for a given amount of investment is indicated here:

Venture-capitalist _

ownership (%)

VC $ investment X VC investment multiple desired

Company's projected profits in year 5 x Price-eamings multiple
of comparable company

Consider the following example:

A company needs $500,0fi) of venture-captal money.

The company is anticipating profits

of $650,000.

The venture capitalst wants an investment multiple of 5 times.

The price-earnings multiple of a similar company is i2.

According to the following calculations, the company would have to give up 32 percent
ownership to obtain the needed funds:

$500,000x5 _.)..u
: 32Vo

$650.000

12

A more accurate method for determining this percentage is given in Table 12.7. The step
by-step approach takes into account the time value of money in determining the appropriate investor's share. The following hypothetical example uses this step-by-step procedure.
H&B Associates, a start-up manufacturing company, estimates it will earn $l million after
taxes on sales of $10 million. The company needs $800,000 now to reach that goal in five
years. A similar company in the same industry is selling at 15 times earnings. A venturecapital firm, Davis Venture Partners, is interested in investing in the deal and requires a

358

PART

FROM THE BUSINESS PLAN TO FUNDING THE VENruRE

50 percent compound rate of return on investment. What percentage

have to be given up to obtain the needed capital?
Present

value

$800,000

$1,975,000

:
:

$1,000,000

of

the company

will

15 times earning multiple

(1 + 0.50)5
$1,975,000
4LVc will have to be given up

Evatuation of an Internet Company

The valuation process for early-stage Internet companies is quite different from the traditional valuation process. Traditionally, private-equity companies would examine historical
financials and operations as part of a very quantitative process using such things as discounted cash flow (DCF), comparables, and/or multiples of EBITDA (earnings before interest, taxes, depreciation, and amortization). Following this, the culture and management
are examined in a more qualitative way. When institutional investors focus on earlier-stage
companies-in particular Internet companies that have little or no history, no historical
financials, and no comparables-a different approach has to be taken in the valuation
process.

For these companies, the qualitative portion of due diligence carries much more
weight than in other evaluations. The focus is more on the market itself. How big is it?
How is it segmented? Who are the players? How will it evolve? Once these questions are
resolved, the potential entrepreneurial company's frnancial projections are compared
with the future market in terms of ht, realism, and opportunity. After getting comfortable
with the market size and potential revenue of a company, the investor examines the management team. Is this a management team that will take the company "all the way''? Who
will they need to bring in? How much should be set aside for an employee stock ownership

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INFORMAL RISK CAPITAL. VENTURE CAPI"TAL, AND GOING

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plan (ESOP)? The more complete the management team is, the higher the valuation. If
the management team is stilt thin, then a substantial portion of the company,s assets
needs to be set aside to attract and retain good employees. Different industries require
different valuations. For example, an infrastructure business is viewed differently from a
business-to-business firm.
After going through the process ofderiving a value, the investor looks at all the opportunities available in the investor ma-rket. Generally, the value in early-stage technology companies
is driven by a combination of market structure and management team maturity, modified by
the supply and demand forces that exist in a market that is highly competitive for gooO,
solid companies.
An entrepreneur seeking financing should keep in mind that makets are changing and
traditional systems are being turned upside down. Investors and entrepreneurs who have a
sense of how this is going to occur and can predict the impact new technologies will have
on traditional and newly formed markets are the ones who will be more hiehlv rewarded.

DEAL STRUCTURE
deal

of

structure

The form

the transaction when

money is obtained by a
company

In addition to valuing the company and determining the percentage of the company that
may have to be given up to obtain funding, a critical concern for the entrepreneur is the deal
structure, or the terms of the transaction between the entrepreneur and the funding source.
To make the venture look as attractive as possible to potential sources of funds, the entrepreneur must understand the needs of the investors as well as his or her own needs. The
needs of the funding sources include the rate of return required, the timing and form of return, the amount of control desired, and the perception of the risks involved in the particular funding opportunity. While some investors are willing to bea a signifrcant amount of
risk to obtain a signihcant rate of return, others want less risk and less return. Other investos are more concerned about their amount of influence and control once the investment has been made.
The entrepreneur's needs revolve aound similar concerns, such as the degree and mechanisms of control, the amount of hnancing needed, and the goals for the particular firm.
Before negotiating the terms and the structure of the deal with the venture capitalist, the
entrepreneur should assess the relative importance of these concerns to negotiate most
strategically. Both the venture capitalist and the entrepreneur should feel comfortable with
the hnal deal structure, and a good working relationship needs to be established to deal
with any future problems that may arise.

GOING PUBLIC
going

public

Selling

some part of the company

by registering with the

SEC

Going public occurs when the entrepreneur and other equity owners of the venture offer
and sell some paft of the company to the public through a registration statement hled with
the securities commission of the country. In the United States, this is the Securities and Exchange Commission (SEC) pursuant to the Securities Act of 1933. The resulting capital infusion to the company from the increased number of stockholders and outstanding shares
of stock provides the company with financial resources and generally with a relatively liquid investment vehicle. Consequently, the company will have greater access to capital markets in the future and a more objective picture of the public's perception of the value of the
business- However, given the reporting requirements, the increased number of stockholders
(owners), and the costs involved, the entrepreneur must carefully evaluate the advantages
and disadvantages of going public before initiating the process. A list of these advantages
and disadvantages is given in Thble 12.8.

--:

_ .,

Monerr s lftei/atei] lt's b-est when clear;nd it needs

to flow freely or it can stagnate. In order to f low, the

money system'mst be trusted by everyone around

the world. Today, that most vital trust is broken. A
short while ago money flowed freely, and investors
asked few questions other than what their returns
would be. Now it is exceptionally difficult for even
rock-solid businesses to finance their daily operations. A lack of transparency led us into this situation,
and only an abundance of transparency can deliver
us

to better times.

Many of the ecoiomic challenges we face are the

function of a global crisis in confidence. Investors,
employees, and analysts have good.eason to pausg
and consider:where their efforts and .nvestments
witL be safe.:This lack of confidence is preventing
basic, sound busjness from thriving and is ultimately
prolonging the downturn. The complex inventions
of investment banks and hedge funds allowed clever

financial engineers to hide bad business fundamentals and allowed risk to be spread and distanced
from its original creators. A lack of transparency
hid the true exposure of giants like AIG and to the
detriment of international stakeholders and the
American public.

Advantages
The three primary advantages of going public are obtaining new equity capital, realizing an
enhanced valuation due to the greater liquidity of an equity investment in the company, and
enhancing the company's ability to obtain fuhrre funds. Whether it is first-stage, second-stage,
or third-stage hnancing that is desired, a venture is in constant need of capital. The new

ter
One common theme throughout the evolution of
corporate governance is increased transparency. But
there is only so much regulators can do. and trying
to regulate for every possibility surely will stifle
growth. Corporate leaders must seize this opportu_
nity to prioritize openness in their organizations.
Promoting transparency not only covers greater dis-

client

Source: Reprinted from February 27, 2009 issue of BusinessWeek by

special permission, copyright @ 2009 by The McGraw-Hill Companies,
Inc., from "Infosys CEO: Financial Trarsparency a Must," by Kris
Gopalakrishnan. BusinessWeek magzine: www-businessweekcom/
gtobalbi/contenlfeb2009/9b20090226_80374
Lhtm.

capital provides the needed working capital, plant and equipment, or inventories and supplies necessary for the venture's growth and survival. Going public is often the best way to
obtain capital on the best possible termsGoing public generally results in a public trading market and provides a mechanism for
valuing the company and allowing this value to be easily transferred among parties. Many
family-owned or other privately held companies may need to go public so that the value of
the company can be disseminated among the second and third generations. Venture capitalists view going putrlic as one of the most beneficial ways to attain the liquidity o."..rury
to exit a company with the best possible return on their investment. Other investors benefrt
as well due to easier liquidation of their investment when the company's stock takes on
value and transferability. Because ofthis liquidity, the value ofa publicly traded security is
sometimes higher than shares of one that is not publicly traded. In addition, publicly traded
companies often find it easier to acquire other companies by using their securities in the
transactions.

As noted earlier, the third primary advantage is that publicly traded companies usually
hnd it easier to raise additional capital, particularly debt. Money can often be borrowed more
easily and on more favorable terms, the company's balance sheet is strengthened by the new
equity capital, and the company has better prospects for raising future equity capital.

362

PART

FROMTHEBUSINESS PLANTO FUNDINGTHEVENTURE

Disadvantages

inilinl pubc oJfering

(IPO) Tllre first public
registration and sale of a
company's stock

Although the advantages of going public are signicant for a new venture, they must be
carefully weighed against the numerous disadvantages. Some entrepreneurs want to keep
their companies private, even in times of a hot stock market. Why do entrepreneurs avoid
an initial public offering (IPO)?
Two major reasons ae the increased reporting and the potential loss of control that can
occur in a publicly traded company. Yet, to stay on the cutting edge of technology, companies frequently need to sacrifice short-term profits for long-term innovation. This can
require reinvesting in technology that in itself may not produce any bottom-line results,
particularly in the short run. Making long-term decisions can be diffrcult in publicly traded
companies where sales and profit results indicate the capability of management via stock
values.
Some of the most ffoublesome aspects of being public are the resulting loss of autonomy
as well as increased duties to public stockholders and administrative burdens. The company
must make decisions with respect to the hduciay duties owed to the public shareholder,
and it needs to disclose to the public all material information regarding the compan its operafions, and its management. One publicly traded company had to retain a more expensive
investrnent banker than would have been required by a privately held company to obtain an
"appropriate" faimess opinion in a desired merger. The investment banker increased the expenses of the merger by $150,000, in addition to causing a thee-month delay in the merger
proceedings. Management of a publicly traded company also spends a significant amount
of additional time and expense addressing queries from shareholders, press, and f,rnancial
analysts and ensuring compliance with the complicated accessing, reporting, and securities
trading regulations. CEOs of most publicly traded companies set aside one day per week

for this.

Finally, when enough shares are sold to the public, the company can lose control of decision making, which can even result in the venture being acquired through an unfriendly
tender offer.
With the enactment of the Sarbanes-Oxley Act in 2002, corporate governance and disclosure requirements of public companies and the practices and conduct of accountants and
lawyers engaged by public companies became subject to signihcantly greater regulation
enforcement by the Securities and Exchange Commission and the stock exchanges. As a result, the expense and administrative responsibilities of being a public company, as well as
the liability risks of offrcers and directors, are greater than ever. Among the other consequences of the new regulation, the recruitment of qualihed independent directors has
become a much more difcult challenge for most public companies.
If all these disadvantages themselves have not caused the entrepreneur to look for alternative financing rather than an IPO, the expenses involved may. The major expenses of going public include accounting fees, legal fees, underwriter's fees, registration and blue-sky
hling fees, and printing costs. The accounting fees involved in going public vary greatly'
depending in part on the size of the company, the availability of previously audited hnancial
statements, and the complexity of the company's operations. Generally, the costs of going
public average $700,000, although they can be much greater when significant complexities
ae involved. Additional reporting, accounting, legal, and printing xpenses can run anywhere from $50,000 to $250,000 per year, depending on the company's past practices in
the areas of accounting and shareholder communications. [n addition to the SEC reports
that must be filed, a proxy statement and other materials must be submitted to the SEC for
ieview before distribution to the stockholders. These materials contain certain disclosures
concerning management, its compensation, and transactions with the company, as well as

CHAPTER

12

pub
mill
er's

INFORMAL RISK CAPITAL. VENTURE CAPITAI. AND GOING

PUBLIC 363

urity. For example, the SEC fee would be

fee is 9100. The SEC fee must be paid by
e is also small in relation to the size

of

the

offering; $100 plus one-hundredth of I percent of the maximum public offering price.
In
the preceding example of a $20 million offering, this would oe
$2, too, with the FINRA
fee being $5,100.

more significant
ell as from other
However, use of

3il

PART

FROMTHEBUSINESSPLANTOFUNDINGTHEVENIURE

this medium is still somewhat in its infancy state. The SEC is continually rehning its rules
in this regard in an effort to allow companies to take advantage of this technology while
maintaining the disclosure principles originally developed in the 1930s'
Not only can going public be a costly event, but also the process leading up to it can be
exasperad;g. luit ask ning Yeh, who went through some trying circumstances starting
when he decided to go public in July 1995 and ending when his company, Silicon Storage
Technology (SST), issued its IPO on November 22 of that same year-r4 While the exact
pfocess vaes wth each company, the goal is the same as it was for SST-make sure fhe
io.rrp-y is well received by Wall Street. For some companies, getting ready to go public
can involve eliminating members of the managemeot team and boad, dropping marginal
products, eliminating treasured perks such as the corporate jet, hiring a new accounting
firrrU subduing some personality traits, dressing up the senior management, of hiring new

members of the management team- For Bing Yeh and SST, the makeover centered aound
four primary tasks: (i) hiring a chief hnancial offrcer, (2) reorganizing the financials,
(3 writing a company biography, and (4) preparing for the road show (this is the time when
management will present the company to potential investors)'
is
Regardless of how much reading is done, like Bing Yeh, almost every entrepreneur
for
a
successful
unprepared and wants to halt the preparation process at some point' Yet
IPO, each entrepreneur must follow Yeh's example by listening to the advice being given
and making any recommended changes-

TIMING OF GOING PUBLIC AND UNDERWRITER SELECTION

Two of the most critical issues in a successful public offering are the timing of the offering
adand the underwriting team. An entrepreneur should seek advice from several financial
decisions
making
process
in
the
visors as well as other entrepreneurs who ae familiar with

in these two areas.

Timing
public?"
The critical question each entrepreneur must ask is, "Is the company ready to go
section'
following
the
in
Some criteria to help answer this question are indicated

First, is the company large enough? while it is not possible to establish rigid

minimum-size standards that must be met before an entrepreneur can go public, New
of
York investment banking firms prefer at least a 100,000 share offering at a minimum
of
value
apostoffering
have
to
have
would
the
company
$20 per share. This means that
willis
company
the
given
that
offering,
million
this
$20
at least $50 miltion to support
ing to sell shares representing not more than 40 percent of the total number of shafes
outstanding after the offering is completed. This size of offering will occur only with
past signilicant sales and earnings performance or a solid prospect for future growth and
earnrngs.
Second, what is the amount of the company's earnings, and how strong is its financial
performance? Not only is this performance the basis of the company valuation' but it also
underetermines if a company can successfully go public and the type of firm willing to
marreflecting
year,
thereby
write the offering. While the exact criteria vary from year to
sales
and
earnings
year
ofgood
ket conditions, generally a company must have at least one
before its stock offering wilt be acceptable to the market - Larger underwriting ftrms have
or
more stringent criteri, such as sales as high as $15 million to $20 million' a $1 million
growth
rate'
more net income, and a 30 to 50 percent annual

CH

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INFORMAL RISK CAPITAL, VENTURE CAPITAL, AND GOING

Third,

PUBLC 365

underlying the
ral mafket con-

and
dition. M
the stock
sales

will receive for

its inirial sale.

Some market conditions are mote favorable for IPOs than others. Unless the
need for
money is so urgent that delay is impossible, the entrepreneur should attempt to take
his or
her company public in the most favorable market conditions.

s
li
s

Sometimes the present

ofthebusiness, orthey

thod by which present

Underwriter Setection
managing unden riter
Lead financial hrm in

selling stock to the public

wtde rw rit n g sy ndicat e
Group

offirms involved

Although most public offerings are conducted by a syndicate of underwriters, the

in selling stock to the

public

banker helps structure the initial financial anangements to position the company to go
public later.
Since selecting the investment banker is a major factor in the success of the public offering, the entrepreneur should approach one through a mutual conact. Commercial banks.

The success of the offering also depends on the underwriter's distribution capability. An
entrepreneur wants the stock of his or her company distributed to as wide and varied a base
as possible- Since each investment banking firm has a different client base, the enrepreneur
should compare client bases of possible managing underwriters. Is the client base strongly

366

PART

FROMTHEBIJSINESSPLANTOFUNDINGTHEVENTURE

institutional or is it composed of individual investors? Or is it balanced between the two?

Is the base more internationally or domestically oriented? Are the investors long term or
specularors? What is the geographic distribution-local, regional, or nationwide? A strong
managing underwriter and syndicate with a quality client base will help the stock sel[ and
perform well in the aftermarket.
Some underwriters are better able than others to provide financial advisory services.
Although this factor is not as important as the previous two in selecting an underwriter,
financial counsel is frequently needed before and after the IPO. An entrepreneur should
pose such questions as the following: Can the underwri0er provide sound frnancial advice?
Has the underwriter given good financial counsel to previous clients? Can the underwriter
render assistance in obtaining future public or private hnancing? The answers to these
questions will indicate e degree of ability among prospective underwriters.
As reflected in the previous questions, the experience of the investment banking hrm is
important. The hrm should have experience in underwriting issues of companies in the
same or at least similar industries. This experience will give the managing underwriter
credibility, the capability to explain the company to the investing public, and the ability to
price the IPO accurately.
The final factor to be considered in the choice of a managing underwriter is cost. Going
public is a very costly proposition, and costs can vary significantly among underwriters.
Costs associated with various possible managing underwriters must be carefully weighed
against the other four factors. The key is to obtain the best possible underwriter and not try
to cut comers, given the stakes involved in a successfut initial public offering.

REGISTRATION STATEMENT AND TIMETABLE

Once the managing underwriter has been selected, a planning meeting should be held
among those company ofhcials responsible for preparing the registration s[atement, the
company's independent accountants and lawyers, and the underwriters and their counsel.
At this important meeting, frequently called the "all hands" meeting, a timetable is prepared that indicates dates for each step in the registration process. This timetable establishes the effective date of the registration, which determines the date of the final hnancial
statments to be included. The timetable should indicate the individual(s) responsible for
preparing the various parts of the registration and offering statement. Problems may arise
in an initial public offering due to the timetable not being carefully developed and agreed
to by all parties involved.
After the completion of the preliminary preparation, the first public offering normally
requires six to eight weeks to prepare, print, and hle the registration statement with the
SEC. Once the registration statement has been filed, the SEC generally takes 6 to l2 weeks

to declare the registration effective. Delays frequently occur in this process, especially
(l) during heavy periods of market activity; (2) during peak seasons such as March,
when the SEC is reviewing a large number of proxy statements; (3) when the company's
attorney is not familiar with federal or state regulations regarding the registration process;
(4) when issues arise over requirements of the SEC resulting from its review of the filing;

JulI

and

fair dkclasure

The nature of all material

submitted to the SEC for
approval

or (5) when the managing underwriter is inexperienced.

In reviewing the registration statement, the SEC attempts to ensure that the document
makes afuIl andfair disclosure of he material reported. The SEC has no authority to withhold approval of or require any changes in the terms of an offering that it deems unfair or
inequitable, as long as all material information concerning the company and the offering

is fullv disclosed. However, the Financial Industry Regulatory Authority (FINRA) will

CHAPTER

prospectus Document

12

INFORMAL RISK CAPITAT- VENruRE CAPTAI. AND GOING

PUBLIC 367

review each offering, principally to determine the fairness of the underwriting

compensation and its compliance with FINRA bylaw requirements.

for distribution to
prospective buyers of a

public offering
registrofon sfutement
Materials submitted to the
SEC for approval to sell
stock to the public

Fom

S-I

Form for

registration for most

initial public offerings of

stock

The Prospectus

A brief intoduction of the company follows, which describes the nature of the business,
the company's histor major products, ad location.

dividend history and any restrictions

have not paid any dividends but have

368

PART

FROMTHEBUSINESSPLANTOFUNDINGTHEVENTURE

The capitalization section indicates the overall capital structure of the company both
before and after the public offeringWhenever there is significant disparity between the offering price of the shares and the
price paid for shares by officers, directors, or founding stockholders, a dilution section is
necessary in the prospectus. This section describes the dilution, or difference between the
share price paid by the public investors and the weighted average price at which all shaes
have been issued, including the pre-IPO shares sold to officers, directors, and founding
stakeholders.
Form S-1 requires that the prospectus contain selected hnancial data for each ofthe last
five years of company operation to highlight signihcant trends in the company's financial
condition. There must also be a discussion of management's analysis of the company's frnancial condition and results of operations. This analysis should cover at least the last thee
years of operation.
The next section, the business, is the largest part of the prospectus. It provides information on the company, its industry, and its products, and includes the following: the historical development of the company; principal products, markets, and distribution methods;
new products being developed; sources and availability of raw materials; backlog orders;
export sales; number ofemployees; and nature ofany patents, trademarks, licenses, franchises, and physical property owned; competition; and effects of governmental regulations.
Following the business section is a discussion of management and security holders. This
section covers background information, ages, business experience, total remuneration, and
stock holdings of directors, nominated directors, and executive off,rcers. Also, any other
stockholder (not in the preceding categories) who beneficially owns more than 5 percent of
the company must be indicated.
The description of the capital stock section, as the name implies, indicates the par and
stated value of the stock being offered, dividend rights, voting rights, liquidity, and transferability if more than one class of stock exists.
Following this, the underwriter information section explains the plans for distributing
the securities, such as the amount of securities to be purchased by each underwriting participant involved.
The prospectus part of the registration statement concludes with the actual f,rnancial
statements. Form S-l normally requires audited balance sheets for the last two fiscal years,
audited income statements and statements of retained earnings fbr the last three hscal
years, and unaudited interim hnancial statements as of 135 days prior to the date when the
registration statement becomes effective. It is this requirement that makes it so important to
pick a date for going public in light of year-end operations and to develop a good timetable.
This will help avoid the time and costs of preparing additional interim statements.

The Registration Statement

This section ofForm S-l contains cerain information regarding the offering, the past unregistered securities offering ofthe company, and any other undertakings by the company. The
registration statement also includes exhibits such as the articles of incorporation, the underwriting agreement, company bylaws, stock option and pension plans, and initial contracts.

Procedure
red.herrirxg Preliminary
prospectus of a potential

public offering

Once the preliminary prospectus is frled as a part of the registration statement, it can be distributed to the underwriting group. This preliminary prospectus is called a red herring, because a statement printed in red ink appears on the front cover- The registration statement

CHAPTER

comment

liler

12

INFORMAL RSK CAPITAI- VENTURE CAPITAL, AND

GOING

PUBLIC 369

Aleltef

from the SEC to a

company iodicating
coEections that need to
be made in the submiued

prcspec$s

pricing amendment
Additional information on
price ad distribution
submitted to the SEC to
develop the final
prospectus

LEGAL ISSUES AND BLUE-SKY OUALIFICATIONS

Legal lssues

quietperiod 90-day
period in going public
when no new company

information should be
released

Btue- Sky Quatifications

hlue-sk1

lavs

Laws

of

each state regulating

public sale of stock

mlnlsttators to prevent an offering from being sold in their state

on such substantive

grounds as past stock issuances, too much dilution,

or too much compensation to the un_
derwriter, even though all required disclosures have been met and
clearance has been
granted by the SEC.
aftermarket supporl
Actions of u nderwriers
to help support the price
of stock following the

public offering

AFTER GOING PUBLIC

After the initial public offering has been sold, there are still some areas
of concern to the
entrepreneur. These include aftermarket support, relationship
nity, and reporting requirements.

with the hnancial conunu-

vEruruRr,caPtrAL NEVER vENTURED BEFoRE

The fishermen from the lndian village of Chidambaram

'

look for opportunities in the developing world' "The

live a hard life. They sleep most of the day. then

spend the night out on the water. For light during
those dark hours, they have long depended on wobbly kerosene lamps that were easily blown out or,
worse, toppled by the wind, risking a deadly fire
on their boats. But these days. the kerosene lamps
have been replaced with Mightylights. $50 solar-

of the pyramid is often ignored but offers a

tremendous opportunity,f' says Katie Hill, the India
representatve of Acumen Fund, an $8 million fund
backed by the Cisco Systems Foundation and the

powered fixtures. "l save 100 rupees [$Z.SO] a month

on kerosene alone," says K Kanimuri, a fisherman's
wife who also uses the Mightylight in her makeshift

of the city's vast slums.

The trend is due in part to the amount of money
chasing deals. VCs these days are forced to '''invest in
less fished areas," says Sumir Chadha, managing

kitchen.

Kanimuri and her fellow villagers may not know it,

but the change in their fortunes is rooted in global
finance. Mightylights are the brainchild of New Delhibased Cosmos lgnite Innovations, a startup that aims
to provide simple products for the world's poorest
people. And Cosmos got ts start with backing from
Vinod Khosla, a veteran 5ilicon Valley venture capitalist. Now Cosmos is in talks with other groups including London-based 3i and eBay Inc. founder Pierre
M. Omidyar for a second round of funding. "For us,
it's not just the light, but using a sustainable model to
effect social change," says Matthew Scott, chief executive of Cosmos.
Just a few years ago, most venture capital funds
focused on pure technology companies operating in
industrialized countries. But now, VCs are startng to

base

Rockefeller Foundation. Acumen has put $1.5 million

into Ziqitza, a Mumbai-based ambulance company
that offers deep discounts on its service for residents

Sequoia Capital India, an arm of the

Silicon Valley VC firm. But don't mistake such investments as charity. Santa Monica (Calif-)-based Clearstone Venture Partners has put $5 million into DigiBee
director

of

Microsystems, which expects

to pocket handsome
to poor

profits by selling low-end mobile phones

lndians. And two California VC funds are considering

a $5 millon investment in Novatium, a Chennai company that has developed a $100 PC and expects to sell
3 million of them by 2010. Says Novatium CEO Alok
Singh: "We have always been market-driven and

make money."

Sou
ciat
Inc.

Iy
@

tal

Lakshman. o. 97

Aftermarket Support

stock not to be adversely affected by an initial drop in price'

Retationship with the FinanciaI Cornmunity

CHAPTER

.I2

INFORMAL RISK CAPTIAI- VENTURE CAPITAI- AND GOING

PUBLIC 371

investment advice, the entrepreneur should attempt to meet as many of these individuals as
s of security analysts should be a part of
disclosures through formal press releases.
the company to be the information offrcer,
ensuring that the press, public, and security analysts are dealt with in a friendly, efhcient
manner. There is nothing worse than a company not responding in a timely manner to

possible.
establishi
Frequentl

information requests.

Reporting Requirements
The company must file annual reports on Form lO-K, quarterly reports on Form 10-e, and
specific transaction or event reports on Form 8-K. The information in Form lO-K on the
business, management, and company assets is similar to that in Form S-1 of the registration
statement. Of course, audited f,rnancial statements are required.
The quarterly report on Form 10-Q primarily contains the unaudied financial information for the most recently completed hscal quarter. No Form 10-Q is required for the fourth

hscal quarter.

A Form
tion or

dispo
the

:k":i:

business,
ounranrs, or
a change in control of the company.
Under the Sarbanes-Oxley Act, the due dates for reports have been accelerated. In addition, by adopting its Regulation FD, the Securities and Exchange Commission has tried to
minimize selective disclosures of important corporate developments and information. Under this regulation, public companies are required to make immediate and broad public disclosures of important information at the same time they release the information to anyone
outside the company.

The company must follow the proxy solicitation requirements in connection with holdritten consent of security holders. The timing and type of
n Regulation 14A under the Securities Exchange Act of
reporting requirements of public companies that must be
carefully observed, since even inadvertent mistakes can have negative consequences for the
company. The reports required must be filed on time.

INI REVIEW

SUMMARY
In financing a business, the entrepreneur determines the amount and timing of funds
needed. Seed or start-up capital is the most difficult to obtan, with the most likely
source being the informal risk-capital market (angels). These nvestors, who are
wealthy individuals, average one or two deals per yeat ranging from g100,000 to
$500,000, and generally find their deals through referralsAlthough venture capital may be used in the first stage, it is primarily used in the second or third stage to provide working capital for growth or expansion. Venture capital
is broadly defined as a professionally managed pool of equity capital. since 195g, smallbusiness investment companies (5BlCs) have combined private capital and governrnent

372

PART

FROM THE zuSINESS PLAN TO FUNDING THE VENTURE

funds to finance the growth and start-up of small businesses. Private venture-captal
firms have developed since the 1960s, with limited partners supplying the funding. At
the same time, venture-capital divisions operatng within major corporatons began
appearing. States also sponsor venture-capital funds to foster economc development.
To achieve the venture capitalist's primary goal of generating long-term capital appreciation through investments in business, three criteria are used: The company must have
strong management; the producUmarket opportunity must be unique; and the capital
appreciation must be significant. offering a 40 to 60 percent return on invefment. The
process of obtaining venture capital includes a preliminary screening, agreement on principal terms, due diligence, and final approval. Entrepreneurs need to approach a potential venture capitalist with a professional business plan and a good oral presentation.
Valuing the company is of concern tothe entrepreneur. Eightfactors can be used as
a basis for valuation: the nature and history of the business. the economic outlook,
book value, future earnngs, dividend-paying capacity, intangible assets, sales of stock.
and the market price of stocks of similar companies. Numerous valuaton approaches
that can be used were discussed.
ln the end, the entrepreneur and investor nust agree on the terms of the transaction, known as the deal. When care is taken in structuring the deal, the entrepreneur
and the investor will maintain a good relationship while achieving their goals through
the growth and profitability of the business.
Going public-transforming a closely held corporation into one in which the general public has proprietary interest-is indeed arduous. An entrepreneur must carefully
assess whether the company is ready to go public as well as whether the advantages
outweigh the disadvantages of doing so.
Once the decision is made to proceed, a managing investment banking firm must be
selected and the registration statement prepared. The expertise of the investment
banker is a major factor in the success of the public offering. In selecting an nvestment
banker, the entrepreneur should consider reputation, distribution capability, advisory
services, experience, and cost. To prepare for the registration date, the entrepreneur
must organize an "all hands" meeting of company officials, the company's independent accountants and lawyers, and the underwriters and their counsel. A timetable must
be established for the effective date of registration and for the preparation of necessary financial documents, including the preliminary and final prospectuses. Following
the initial public offering, the entrepreneur should strive to maintain a good relationship with the financial community and adhere strictly to the reporting requirements of
public companies.

RESEARCH TASKS
1. Go to a directory of venture capitalists and ascertain what percentage of funds
for a typical venture-capital firm are invested in seed, start-up, expansion or
development, and acquisitions or leveraged buyouts. What criteria do venture
capitalists report using in their initial screening of business proposals?
2. Obtain an initial public offering prospectus for three companies. Use at least tvvo
different approaches for valuing each company.
3. Search the Internet for services that provide access to business angels or informal
investors. How do these sites work? lf you were an entrepreneur looking for
funding, how much would it cost to use this service? How many business angels
are registered on the typical database? How many entrepreneurs are registered on

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PUBLIC 373

the typical database? How effective do you believe these services are? (Use data
where possible to back up your answer.)

4. How many companies wnt public per year over the last

1O-year period? How do

you explain this variation in the ,,popularity,, of going public?
5. Analyze the prospectuses of 10 companies that went public in 2005. In your
opinion. which companies are likely to do well in the public offering, and
which are less likely to do well? Conduct the following calculation to test your
propositions: Stock price after 1 week Offering price + Offering price. Compare
this price with the original lpO price.

6. Analyze the prospectuses of five companies going public. What are the reasons
they state for going public? How are they going to use the proceeds? what are
the major risk factors presented?

DISCUSSION
1. An investor provides an entrepreneurialfirm with the capital that it needs to
grow. over and above providing the capital, in what other ways can the nvestor
add value to the firm? what are the possible downsides of having a venture
capitalist as an investor in the business?
2. Assume that you have been very lucky and have been given a considerable
fortune. You want to become a business angel (straight after graduation). How
would you go about setting up and running your "business angel" business? Be
specific about generating deal flow. selection criteria, the desired level of control
and involvement in the investee, etc.
3. What drives the market for lPOs? Why is it so volatile?
4. lf you were an entrepreneur in a "hot" marke! would you invest the substantial
amount of time, energy, and other resources necessary to try and go public before
the bubble bursts? or would you prefer to utilize those resources to build your
business and create value for customers?

SELECTED READINGS
Betros, chris. (september 2008). From startup
Entrepreneur. J@pan lnc., no.80, pp. 37-39.

to lpo: New Zealand's Most

successful

This article profiles an entrepreneur-Ted williams-from New Zealand who has

had great success launching an lnternet business in Japan. During this interview
Mr. Williams recounts his first days in Japan from being a tourist to trading whisky
for office furniture to reorganizng the management structure of his company in
preparation for an lPo. valuecommerce, Mr. wiltiams's company, is Japan's first interactve I nternet marketing site.
Defaney, Laurel. (April 2007). Howdy, Partner. Entrepreneu1 vol.35, no.4, p. g7.

M\

ther tactic for boosting capital:

author, Laurel Delaney, owns a
ional endeavors. ln her column,

Delaney asserts that strategic global alliances can offer successful avenues for
defraying informal risk. The anecdote in
food to lapan- Ms Delaney atso hightig
tially auspicious SGA partner: good che
mance results.

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FROM THE BUSINESS PLAN TO FUNDNG THE VENTURE

Duffner. Stefan; Markus M. Schmid; and Heinz Zimmermann. (February 2009). Trust
and Success in Venture Capital Financing-An Empirical Analysis with German Survey
Data." Kyklos, vol.62. no. 1, pp. 'l 5-43.
This research paper is the collaborative effort of a Goldman Sachs analyst (Duffner)
and two Swiss finance experts (Schmid and Zimmermann). Leaving nothing to
chance or to opnon, these authors have designed a research study to scrutinize
the importance of trust in venture-capital funding decisions. The authors conducted a survey of German venture capitalists in 2003 and again in 2006, the data
from which suggest that mutual trust between the venture-capital firm and the entrepreneur is an indicator of the venture's successful performance. Also relevant to
these resu/tt the more trust a venture capitalist had in an entrepreneur, the less
vigilance he tended to impose on the entrepreneur in the formative stages of the
ventureKaplan, Steven N.; Berk A. Sensoy; and Per Strmberg. (February 2009). Should Investors Bet on the Jockey or the Horse? Evidence from the Evolution of Firms frorn
Early Business Plans to Public Companies. Journal of Finance, vol. 64, no. 1, pp. 75-115.
This study includes evidence-based research on the behavioral development of the
venture-captal-backed firm. From the start-up phase to the search for funding and
finally to the lPO. the authors have based their research on 50 firms that received
seed funding from venture-capital groups and eventually went pubtic. The study design is formidable, accounting for all sorts of variations in company dynamics. The
hypothesized results suggest fhat venture capitalists, when assessing start-up ventures, should focus their attention on the viability of the start-ups' core business
idea, rather than on the chemistry of the management team; as companies evolve,
so typically will the leadership structure.
Patrick, Darren. (June 1,2008). Going Private. Benefits Canada, vol.32. no. 6, p. 63.
The author of this article is an investment analyst at a Vancouvel Canada, consult-

ing firm. ln an effort to expand the firm's net worth, the author recommends
investors increase their odds by betting on companes that are not listed in the
public domain. Funding from private-equity firms, the author suggests, s an
attractive alternative to ambiguous capital markets. ln this article, the author
specifies the many ways n which one can invest in private equity, underscoring
the relaxed pricing models and return conditons promised by the current trends
in private-equity deals.
Spindfer. James C. (May 2007). IPO Liability and Entrepreneurial Response. University
Pennsylvania Law Review, vol. 155, no. 5, pp. 1181-1228.
This scholarly article,

authored by a University of Southern California

(USC)

of

law pro-

fessor, details the legal implications of taking a private company public by issuing an
initial public offering (lPO) on the stock market. ln addition to the heightened level
of scrutiny and the redoubled number of shareholders to please, a newly public
company may find that its option performance also takes a ht. The author explores

some of the more technical ramifications of becoming a publicly traded entity,

citing the Securities Act of 1933 as a virtual insurance policy for shareholders against
a company's potential missteps. Entrepreneurs, or company owners, may shy away
from going public because of the increased rsk thrust on them by the Securities Act
liabilita opines the author.
When to Postpone Efforts to Raise Capital. BusnessWeek
Online, www.businessweek.com/smallbiz/contenVfeb20O9/sb2009025_538531 .htm.
This article deals with raising equity capital for an early-stage company and the cur'
rent state of the early-stage investing marketplace. Getting a meeting with a VC or
angel investor is not easy. This article drscusses things to keep in mind when dealing

Tauf f i, Tom. (February 2009).

with

VCs

and angel investors.

CHAPTER

Z
ti
P

12

INFORMALRISKCAPITAL.

VENTURECAPITAL,AND GOING

PUBLIC 375

aris; Pek-hooi Soh; and poh-kam Wong. (July 2008). A Con_

Utilization in Early Financing of Technoiogy Ventures. Entre_

no.4, pp.593-613.

ctrce, vol.32.

A U.S.
policy
iting s

fessor;

and two Singaporean

international habits of solicocial networks when direct-

cayyassing
funding

exhaust persona! relationships or recurring sources

data from over 200 high-tech start-up firms in both

of

Singapore

EtND NOTES
'f

Hempel, "How Facebook ls Taking over eur Lives," Fortune (March 2,

2009); " I nspirin g Stories f rom Famous Entrepreneurs-Mark Zuckerberg,,.
see Jessi

www.yousaytoo.com/amerazone/inspiring-stories-from-famous-entrepreneursmark-zuckerbergl27452;Simon Garfeld, "5o How Many Friends Do you Have,

Mark? " The o bse rve r (November 1 6, 2008), www.guardian.co.uk/medi al2}ogl
nov/'16/mark-zuckerberg-facebook-social-networking; Katharine A. Kaplan,
"facemash creator 5urvives Ad Board," The Harvard crimson online Editon
(November 19,2003'), www.thecrimson.com/article.aspx?ref=350i43; Michael

Arrington, " Facebook Just Launched Open Registrations,., TechCru nch

(September 26, 2006), vrww.techcrunch.com/2006 l}9/261f acebook-just-launched-

open-registrations/; and Erik Sass. "Users Throw Book at Facebook,'. Mediapost

News (September 7, 2O061, www.mediapost.com/publications/index.cfm?
fuseaction=Articles.showArticle@art aid=4781 1 &art_type=1 3.
2- Report of the use of the Rule 146 Exemption in Capita! Formation (washington,
DC: Directorate of Economic Policy Analysis, Securities and Exchange
Commission, 1983).

3. An Analysis of Regulation

D (washington, DC: Directorate of Economic policy

Analysis, Securities and Exchange Commission, 1984).
4. charles River Associates, lnc., An Analysis of Capital Market lmperfections
(Washington, DC: National Bureau of Standards, February 1976).
5. W. E. Wetzel, Jr., "Entrepreneurs, Angels, and Economic Renaissance.,, in R. D.
Hisrich (ed.), Entrepreneurship, lntrapreneurship, and Venture Captal
(Lexington, MA: Lexington Books, 1986). pp. 119-40. Other information on
angels and their investments can be found in w. E. wetzel, Jr., "Angels and Informal Risk Capital," Sloan Management Review 24 (Summer 1983), pp. 23-24; and
W. E. Wetzel, Jr., "The Informal Venture Capital Market: Aspects of Scale and
Market Efficiency," Journal of Business Venturing (Fall 1987), pp.299-314.
6. R. B. Avery and G. E. Elliehausen, "Financial Characteristics of High-lncome
Families,

" Federal

Reserye Bulletin, Washington, DC (March l9g6).

7.

M. Gannon, "Financing Purgatory: An Emerging Class of Investors ls Beginning

to Fill the Nether Regions of Start-Up Financing-The Murky world between
the Angefs and the Venture capitalists," venture Capital Journal (May 1999),

8.

5. Prowse,

pp.40-42.

"Angel Investors and the Market for Angel lnvestments,,' Journal of

Banking and Finance 23 (1998), pp.785-92.

376

PART

FROM THE BUSINESS PI-AN TO FUNDING THE VENruRE

9.

Joseph Bell, Kenneth Hugginl and Christine McClatchey, "Profiling the Angel
f nvestor;" Proceedings, Small Business lnstitute Directors Association 2002 Conference, February 7-9,2OO2, San Dego, CA, pp. 1-3.
10. For the role of 58lCs. see Farrell K. Slower, "Growth Looms for 58lCs," Venture
(October I 985), pp. 4647; and M. H. Fleischec "The SB|C 1o0-More Deals for
11.

the Bucks," Venture (October 1985), pp. 50-54.

Most of the information on the venture-capital industry in this section as well
as other information can be found in the PricewaterhouseCoopers/Thomson

Venture Economics/National Venture Capital Association Money TreerM Survey.

12. For a thorough discussion of the venture-capital processr see B. Davis, "Role
of Venture Capital in the Economic Renaissance of an Area;" in R. D; Hisrich
(ed.), Entrepreneurship, lntrapreneurship, and Venture Capital (Lexington,
MA: Lexington Books, 1986), pp. 107-18; Robert D. Hisrich and A. D. Jankowicz,
"lntuition in Venture Capital Decisions: An Exploratory Study Usirg a New
Technique," Journal of EusinessVenturing 5 (January 1990), pp. 49-63; Robert
D. Hisrich and Vance H. Fried, "The Role of the Venture Capitalist in the Management of Entrepreneurial Enterprises," Journal of lnternational Business and
Etepreneurship 1, no.1 (June 1992), pp. 75-106; Vance H. Fried, Robert D.
Hisrich, and Amy Polonchek, "Research Note: Venture Capitalists'lnvestment
Criteria: A Replication," Journal of Small Business Fnance 3, no. 1 (Fall 1993),
pp.3742; and Vance H. Fried and Robert D. Hisrich, "The Venture Capitalist: A
Ref ationship Investor," California Management Review 37, no. 2 (Winter 1995),

pp.101-13.
13. A discussion of some of the important sectors in this decision process can be
found in l- MacMillan. L. Zemann, and Subba Narasimba, "Criteria Distinguishing Successful from Unsuccessful Ventures in the Venture Screening Process,"
lournal of Business Venturing 2 (Spring 1987), pp. 123-38; Robert D- Hisrich
and Vance H. Fried, "Towards a Model of Venture Capital Investment DecisionMaking," Financial Management23, no.3 (Fall 1994), pp.28-37; and Vance H.
Fried. B. Elonso, and Robert D. Hisrich, "How Venture Capital Firms Differ,"
Journal of Busness Venturing 10, no. 2 (March 1995), pp. 157-7914. For the full details of this story see John Kerr, "The 100-Day Makeovet" /nc.
(May 1996). pp.5tt-63.