CHAPTER 12:

INFORMAL RISK CAPITAL, VENTURE

CAPITAL, AND GOING PUBLIC
 FINANCING THE BUSINESS
1. Early-stage financing is usually the most difficult and
costly to obtain.
• Seed capital is the most difficult financing to obtain
from outside funds and is usually a relatively small
amount of capital needed to prove concepts and finance
feasibility studies.
• Start-up financing is involved in developing and
selling some initial products to determine if commercial
sales are feasible.
2. Expansion or development financing is easier to
obtain, less costly, used as working capital to support
initial growth.
• In the third stage, the company is at breakeven or a
positive profit level and uses the funds for major sales
expansion.
• 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
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).
• There are three risk-capital markets that can be involved
in financing a firm’s growth:
the informal risk-capital market, the venture-capital
market, and the public-equity market.
Risk-capital markets- markets providing debt and
equity to non-secure financing situations
• Informal risk-capital market- area of risk-
capital markets consisting mainly of individuals
• Venture-capital market- one of the risk-capital
markets consisting of formal firms
• Public-equity market- one of the risk-capital
markets consisting of publicly owned stocks of
companies
PRIVATE EQUITY

• Called the enterprise capital market, provides capital

for privately held ventures.
• No formal identification and are often found by
referrals from accountants, bank officials, lawyers,
and university professors teaching in the
entrepreneurship/venture finance area.
INFORMAL RISK-CAPITAL MARKET

• Virtually invisible group of wealthy investors,

often called business angels, who are looking
for equity-type investment opportunities in a
wide variety of entrepreneurial ventures.
• Only about 20 percent of the angel investors
surveyed tended to specialize in a particular
industry
 CROWDFUNDING

• Allowed companies to be more vocal about their intent to raise

money
• Used to raise funds in exchange for private equity
VENTURE CAPITAL

• Nature of Venture Capital

• A professionally managed pool of equity capital formed
from the resources of wealthy individuals, pension funds,
endowment funds, and other institutions, including
foreign investors who are limited partners.
• Found in the creation of early-stage companies, the
expansion and revitalization of existing businesses, and
the financing of leveraged buyouts of existing divisions
of major corporations or privately owned businesses.
VENTURE CAPITAL INDUSTRY

• Ranking 53rd across the globe in 2020 and

advancing by 17 positions from its rank in 2017.
It is home to 400+ startups, 50+ angel investors,
40+ venture capitalists, and 35+ incubators and
accelerators and has seen an estimated 47 known
deals in 2019.
• Philippine Venture Capital Report 2020 (27 November
2020)
• This new report that covers the first half of 2020 records
USD $51.8 million in early-stage funding, higher than
full-year 2019 of USD $37.9 million, with Fintech, IT
and software, and transport and logistics as leading
sectors; the impact of covid-19 accelerates growth in
Fintech, with transaction values forecasted to increase by
24% at the end of 2020
VENTURE CAPITAL MARKET COMPOSITION

1. SBIC firms- Small business investment companies with

some government money that invest in other companies
2. private venture-capital firms- A type of venture capital
firm having general and limited partners
3. Venture capital division of major corporations
4. State-sponsored venture capital fund- A fund containing
state government money that invests primarily in
companies in the state
A VENTURE CAPITALIST EXPECTS A COMPANY
TO SATISFY THREE GENERAL CRITERIA

1. The company needs to have a strong management

team composed of individuals with solid experience
and backgrounds, a strong commitment to the
company, capabilities in their specific areas of
expertise, the ability to meet challenges, and the
flexibility to scramble wherever necessary.
2. The product and/or market opportunity must be unique,
having a differential advantage or three to five unique selling
propositions in a growing market.
3. The business opportunity must have significant capital
appreciation which is the increase in value of the organization
during a specific period of time.
Capital appreciation depends on factors as the size of
the deal, the stage of development of the company, the upside
potential, the downside risks, and the available exits.
FOUR PRIMARY STAGES OF VENTURE CAPITAL PROCESS

1. Preliminary screening begins with the receipt of the

business plan.
2. Agreement on general 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.
3. Due diligence, the longest stage, is the process of deal
evaluation.
Includes a thorough evaluation of the markets,
industry, finances, suppliers, customers, and management
4. Final approval, a comprehensive, internal investment
memorandum is prepared.
Reviews the venture capitalist’s findings and details
the investment terms and conditions of the
investment transaction
FACTORS IN VALUATION

1. Nature and history of the business- provides

information on the strength and diversity of the company’s
operations, the risks involved, and the company’s ability to
withstand adverse conditions.
2. Economic and industrial outlook- comparative financial
evaluation of the company in relation to the industry
3. Book value (net value) of the stock of the company and
the overall financial condition of the business
4. Future earning capacity of the company- Special
attention should be paid to depreciation, nonrecurring
expense, officers’ salaries, rental expense, and historical
trends.
5. Dividend-paying capacity of the venture
6. Assessment of goodwill and other intangibles
7. Assessment of any previous sale of equity
8. Market price of equity of companies engaged in the
same or similar lines of business.
LIQUIDITY RATIOS
1. Current Ratio- used to measure the short-term
solvency of the venture or its ability to meet its short-
term debts

2. Acid Test Ratio

ACTIVITY RATIOS
1. Average Collection Period- average number of days it
takes to convert accounts receivable into cash.

2. Inventory Turnover- measures the efficiency of the

venture in managing and selling its inventory
LEVERAGE RATIOS
1. Debt Ratio- assess the firm’s ability to meet all its
obligations (short and long term)

2. Debt to Equity- provides a measure of risk to creditors

by considering the funds invested by creditors (debt)
and investors (equity).
PROFITABILITY RATIOS
1. Net Profit Margin- ability to translate sales into profits

2. Return on Investment- ability of the venture to manage

its total investment in assets
GENERAL VALUATION APPROACHES
1. Search for a similar company- assesses
comparable publicly held companies and the prices
of these companies’ securities.
2. Present value of future cash flow- adjusts the
value of the cash flow of the business for the time
value of money and the business and economic
risks;
• valuing a company based on its future sales
3. Replacement value- The cost of replacing all assets of a
company; valuation of the 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.
4. Book value- The indicated worth of the assets of a
company; uses the adjusted book value, or net tangible
asset value, to determine the firm’s worth.
5. Earnings approach- determining the worth of a
company by looking at its present and future
earnings
6. Factor approach- using the major aspects of a
company to determine its worth: earnings,
dividend-paying capacity, and book value
7. Liquidation value- worth of a company if
everything was sold today
GENERAL VALUATION METHOD
• According to the following calculations, the company
would have to give up 32 percent ownership to obtain the
needed funds:
DEAL STRUCTURE
The form of the transaction when money is obtained by a
company; the terms of the transaction between the
entrepreneur and the funding source.
• Needs of the funding sources include
1. the rate of return required
2. the timing and form of return
3. the amount of control desired
4. the perception of the risks involved in the
particular funding opportunity
GOING PUBLIC
Selling some part of the company by registering with the
SEC
• Advantages
1. Obtaining new equity capital
2. Realizing an enhanced valuation due to the greater
liquidity of an equity investment in the company
3. Enhancing the company’s ability to obtain future
funds
• Disadvantages
1. Increased reporting
2. The potential loss of control that can occur in a
publicly traded company; resulting loss of autonomy
as well as increased duties to public stockholders and
administrative burdens
• lose control of decision making, which can even
result in the venture being acquired through an
unfriendly tender offer.
MAJOR EXPENSES OF GOING PUBLIC
• Accounting fees depend in part on the size of the company, the
availability of previously audited financial statements, and the
complexity of the company’s operations
• Legal fees cover preparation of corporate documents, preparation
and clearing of the registration statement, negotiation of the final
underwriting agreement, and closing of the sale of the securities
to these underwriters
• Underwriter’s fees- compensation, warrants to purchase stock,
reimbursement for expenses, and the right of first refusal on any
future offerings
TIMING OF GOING PUBLIC AND UNDERWRITER SELECTION

TIMING
1. Is the company large enough?
2. What is the amount of the company’s earnings, and
how strong is its financial performance?
3. Are the market conditions favorable for an initial
public offering?
4. How urgently is the money needed?
5. What are the needs and desires of the present owners?
AFTER GOING PUBLIC
1. Aftermarket support- actions of underwriters to
help support the price of stock following the
public offering
2. Relationship with the financial community
3. Reporting requirements