Lecture 9

Financing the Business

Mahbubur Rahman
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+8801841084583 (WhatsApp)
 Outline of lecture-9

Financing
the Private Company
Venture
Business: Equity Valuation: Going Public:
Capital:
Stages of Market Factors, Advantages &
Types, Ration Disadvantages
Business
Process Analysis
Developme
nt Funding
 Stages of Funding
In evaluating the
appropriateness of financing
alternatives, particularly angel
versus venture- capital
financing,
 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
difficult 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.
 Stages of Funding

Early Stage Financing

Seed Capital
- Most difficult financing to obtain
- Small amount of capital needed to
prove concepts and finance
feasibility studies.
- Venture capitalists rarely involved
in this type of funding except in high-
technology ventures
Startup Cap
-Involved in developing and
selling some initial products to
determine if commercial sales are
feasible.

Angel investors are very active in these two types of financing.

 Stages of Funding
2. Development financing :
I. Expansion or development financing (the second basic financing type) is easier to obtain than
early-stage financing.
II. Venture capitalists play an active role in providing funds at this stage.
III. As the firm develops, the funds for expansion are less costly.
IV. Generally, funds in the second stage are used as working capital to support initial growth.
V. In the third stage, the company is at breakeven or a positive profit level and uses the funds for
major sales expansion.
VI. Funds in the fourth stage are usually used as bridge financing in the interim period as the
company prepares to go public.
3. Acquisition financing or leveraged buyout financing (the third type)
I. This is more specific in nature.
II. It is issued for such activities as traditional acquisitions, leveraged buyouts (management buying
out the present owners), and going private (a publicly held firm buying out existing stockholders,
thereby becoming a private company).
 Private Equity Market
PRIVATE EQUITY The private equity market,
which is better called the enterprise
capital market, provides capital for
privately held ventures.
The market is composed of three verticals
as indicated in Figure 12.1—individuals,
venture capital firms, and private equity
funds.
While the size of the investment
increases from individuals to private
equity funds, the number of deals done
decreases.
 Private Equity Market
INFORMAL RISK-CAPITAL MARKET :
I. It consist of wealthy investors, often called “business angels”
II. These angels provide the funds needed in all stages of financing, particularly in
start-up (first stage financing)
III. who are looking for equity-type investment opportunities in a wide variety of
entrepreneurial ventures.
IV. The total amount invested in smaller amounts by angels is about equal to the
total amount invested by the venture capital industry.
V. Sometimes, this individual gets other individuals involved so that the amount of
capital per individual is reduced as well as the risk.
VI. These individuals have no formal identification and are often found by referrals
from accountants, bank officials, lawyers, and university professors teaching in
the entrepreneurship/venture finance area.
Private Equity Market
 Crowdfunding
Crowdfunding is
practice of funding a
project or venture by
raising money from a
large number of people,
typically via internet. It is
source of crowdsourcing
and alternative
financing.
• Risk is diversified
• Demand and supply
side alignment is
ensured
• Innovation is
encouraged
 Venture Capital - Nature
 Professionally managed pool of equity capital.
 Equity pool is formed from the resources of wealthy individuals or institutions who are limited
partners.
 Other principal investors in venture-capital limited partnerships are pension funds, endowment
funds, and other institutions, including foreign investors.
 The pool is managed by a general partner—that is, the venture-capital firm—in exchange for a
percentage of the gain realized on the investment and a fee.
 The investments are in early-stage deals as well as second- and third-stage deals and leveraged
buyouts.
 Long-term investment discipline, usually occurring over a five-year period.

 In each investment, the venture capitalist takes an equity participation through stock, warrants,
and/or convertible securities and has an active involvement in the monitoring of each portfolio
company, bringing investment, financing planning, and business skills to the firm. The venture
capitalist will often provide debt along with the equity portion of the financing.
Venture Capital - Types
 Venture Capital - Objective
 To generate long-term capital
appreciation through debt and equity
investments.
 A typical portfolio objective of venture-
capital firms in terms of return (risk
based return) criteria and risk involved
is shown in Figure 12.5.
 The venture capitalist does not
necessarily seek control of a company
and actually would prefer to have the
firm and the entrepreneur at the most
risk. The venture capitalist will require at
least one seat on the board of directors.
Once the decision to invest is made to
make sure the business succeeds.
 Venture Capital – Supply Side
A venture capitalist expects a company to satisfy three general criteria before he or she will commit to
the venture.
1. Management Team with Commitment:
 Strong management team composed of individuals with solid experience and backgrounds, a strong commitment
(needs to be reflected in dollars invested in the company) to the company, capabilities in their specific areas of expertise,
the ability to meet challenges, and the flexibility to scramble wherever necessary.
 A venture capitalist prefers to invest in a first-rate management team.
 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 the entrepreneur and team members to spend
additional time necessary to start and grow the company.

2. The Business Idea or the Opportunity:

 The product and/or market opportunity must be unique.
 Having a differential advantage or 3-5 unique selling propositions (USPs) in a growing market.
 Securing a unique market niche is essential since the product or service must be able to compete and grow during the
investment period.
3. Capital Appreciation or Return on investment:
 The final criterion for investment is that the business opportunity must have significant capital appreciation.
 The venture capitalist typically expects a significant percent return on investment in most investment situations.
Venture Capital – Supply Side (Stage of investment preference)
 Guidelines to Deal VCs***
The entrepreneur should approach only those venture capitalists (VCs tend to specialize
geographically and by industry, by size and stage of investment) that may have an interest in their
investment opportunity based on these criteria.
Where to find these VC:
 An entrepreneur should carefully research the names and addresses of prospective venture-capital
firms that might have an interest in their particular investment opportunity.
 Via investment bankers.
 Other sources include bankers, accountants, lawyers, and professors.
Venture Capital – Demand Side
Venture Capital – Demand Side
 Valuation of Business / Venture: Factors to Consider
There are eight factors that vary by situation the entrepreneur should consider when valuing the
venture.
i. Nature and history of the business:
 The characteristics of the venture and the industry in which it operates are fundamental
aspects in every evaluation process.
 The history of the 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 adverse
conditions.
ii. Outlook of the economy and particular industry:
 This involves an examination of the financial 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 or services. Will these markets grow, decline, or stabilize, and in what
economic conditions?
iii. Book value (net value) of the stock of the company and the overall financial condition of
the business:
 The book value (often called owner’s equity) is the acquisition cost (less accumulated
depreciation) minus liabilities.
 Valuation of Business / Venture: Factors to Consider
iv. Future earning capacity of the company:
 Previous years’ earnings are averaged and weighted, with the most recent earnings receiving
the highest weighting.
v. Dividend-paying capacity of the venture:
 The future capacity to pay dividends rather than actual dividend payments made that is
important.
vi. Assessment of goodwill and other intangibles:
 Intangible assets usually cannot be valued without reference to the tangible assets of the
venture.
vii. Assessing any previous sale of equity:
 Previous equity transactions and their valuations accurately represent future sales particularly if
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.
viii.Market price of equity of companies engaged in the same or similar lines of business:
 The critical issue is the degree of similarity between the publicly traded company and the
company being valued.
 Valuation of Business / Venture: Ratio Analysis
A) Liquidity Ratio:
i) Current Ratio: 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 obligations.

The higher, the better

ii) Acid Test Ratio: Rigorous test of the short-term liquidity of the venture because it eliminates inventory,
which is the least liquid current asset.

Usually a 1:1 ratio is considered favorable in most industries

 Valuation of Business / Venture: Ratio Analysis
B) Activity Ratio:
i) Average Collection Period: This ratio indicates the average number of days it takes to convert accounts
receivable into cash. This ratio helps the entrepreneur gauge the liquidity of accounts receivable or the ability
of the venture to collect from its customers.

This particular result needs to be compared with industry standards since collection will vary considerably.
The shorter, the better
ii) Inventory Turnover: This ratio measures the efficiency of the venture in managing and selling its inventory. A
high turnover 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 profitability of a new venture.

This would appear to be a good turnover as long as the entrepreneur feels that he or she is not losing sales
because of understocking inventory.
The higher, the better
 Valuation of Business / Venture: Ratio Analysis
C) Leverage Ratio:
i) Debt Ratio: Many new ventures will use debt to finance the venture. The debt ratio helps the entrepreneur
to assess 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 fixed commitment in the form of interest and principal repayments.

This result indicates that the venture has financed 8.9 percent of its assets with debt. On paper this looks very
good, but it also needs to be compared with industry data.
The lower, the better
ii) 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 of debt, the greater the degree of risk to any of the creditors.
 Valuation of Business / Venture: Ratio Analysis
D) Profitability Ratio:
i) Net Profit Margin: This ratio represents the venture’s ability to translate sales into profits. Gross profit
instead of net profit may be used 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 ratios over time.

The higher the better

ii) Return on Investment: The return on investment measures the ability of the venture to manage its total
investment in assets. Return on equity can also be measured, which substitutes stockholders’ equity for total
assets in the following formula and indicates the ability of the venture in generating a return to the
stockholders.

The result of this calculation will also need to be compared with industry data.
The higher the better
 Going Public
Going public occurs when the entrepreneur and other equity owners of the venture offer and sell some part of
the company to the public through a registration statement filed with the securities commission of the country.
In the United States(and also in Bangladesh), this is the Securities and Exchange Commission (SEC) pursuant to
the Securities Act. 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.
 Thank You
See you in last class