Textbook Reference: Entrepreneurship, 8th edition by R.H. Hisrich, M.P.

Peters and
D.A. Shepherd, Mc Graw Hill Irwin, Copyright 2010.

Chapter 12: Informal Risk Capital, Venture Capital, and Going Public

Financing the Business

 Acquisition financing is used to buy another company.
 Risk capital markets provide debt and equity to non-secure financing situations.
 Informal risk capital is a market consisting mainly of individuals.
 Venture Capital Markets consist of formal companies.
 Public Equity Markets is risk capital consisting of publicly owner stocks of
companies.
 Business Angels is named for individuals in the informal risk capital market.
 Equity participation is taking an ownership position.
 SBIC firms are small companies with some governmental money that invest on other
companies.

Venture Capital Process

 The objective of the venture capital firm is to generate long term capital appreciation
through debt and equity investments.
 The venture capitalist is willing to make any changes or modification necessary in the
investment which is often at odds with the entrepreneur.
 The venture capital sometimes moves from start ups to late stage investment to reduce
risk and increase profits.
 The venture capitalist does not necessarily seek control but they want the entrepreneur
to be in the more risk position.
 Once the investment is made, the venture capitalist will do whatever is necessary to
make the new venture work.
 Since the venture capitalist is a long term investment (usually 5 years) there must be
mutual trust and understanding between the venture group and the entrepreneur.
 The Venture Capitalist expects a company to satisfy three general criteria:
1. The company must have a strong management team who individually must have
solid experience and backgrounds
 Have a strong commitment to the capabilities.
 Capabilities in a specific area of expertise.
 The ability to meet challenges.
 The flexibility to scramble whenever necessary.
 Each spouse of each management team member must also be committed to the
new venture.
2. Is the product and/or market opportunity unique?
 Will the venture have a differential advantage in a growing market?
 Securing a unique market niche is essential.
 This niche must be spelled out and is even stronger when it is protected by a
patent or trade secret.
3. The business must have significant capital appreciation.
 The venture capitalist generally expects a 40 to 60 percent return on
investment in most situations.
 This is both art (intuition) and science. (business plan)
Preliminary Venture Capital Screening
 The screening is the initial evaluation of a deal.
 Begins with the receipt of the business plan.
 The plan must have clear cut mission, in depth industry study and a strong pro forma
income statement and balance sheets.
 The Executive Summary is critical to the Venture Capitalist because it will tell if this
fits the firms meet the long term policy and short term need to balance a portfolio.

Agreement on Principle Terms

 The venture capitalist wants a basic understanding of the terms with the entrepreneur.
 They want this prior to the time commitment it will take to complete “due diligence”.

Detailed Review & Due Diligence

 This is the longest stage and can last from 1-3 months.
 The upside and risk potential are assessed.
 Complete background of all management members is completed.
 Thorough evaluation of the markets.

Final Approval
 A confidential internal investment memorandum is prepared.
 Details the investment terms and conditions of the transaction.
 This information is required to prepare the formal legal documents that will need to be
signed for a binding contract.

VALUING YOUR COMPANY

 The problem confronting the entrepreneur in obtaining any investment is determining
value of the company.

Factors in Valuation
1. The nature and history of the business. Provides strength and diversity from the
outset.
2. Examination of the financial data of the venture compared with that of other
companies in the industry. Included are the outlook of the economy and the outlook of
that particular industry.
3. The book value is the owner’s equity which is the acquisition cost (less depreciation)
minus liabilities. This is built over time.
4. The future earning capacity of the company is the most important factor in valuation.
5. The dividend paying capacity of the venture.
6. The assessment of goodwill and other tangibles of the venture.
7. Assessing any previous sale of stock.
8. The market prices of the stocks of companies engaged in similar lines of business.

Ratio Analysis
 Control mechanisms to test the financial strength of the new venture.
 Liquidity ratios measure assets v liabilities. (page 391)
 Acid Test Ratio is short term liquidity because it eliminates inventory which is the
least liquid asset.
 Activity ratios show the average number of days it takes to convert accounts
receivable into cash.
  Inventory Turnover measures the efficiency of the venture in managing and selling its
inventory.
 Leverage Ratios assess the debt ratio to reveal the firm’s ability to meet all its
obligations.
 Debt to Equity assesses the firm’s capital structure.
 Net Profit Margin translates the firm’s ability to translate sales into profit.
 Return on Investment measures the firm’s ability to manage its total investment in
assets.

General Valuation Approaches

1. Methods to determine the worth of the company.
2. Present value of future cash flow is based on future sales and profits.
3. Replacement Value is the cost of replacing all assets of the company.
4. Book value is the indicated worth of the assets of the company.
5. Earnings Approach determines value by looking at present and future earnings.
6. Factor approach uses the major aspects of the company to determine its worth.
7. Liquidation value is the worth of the company based selling everything today.