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Management and Organizational Studies
Management and Organizational Studies 1023A/B
Maria Ferraro

Pages 198-210 How Firms Raise Capital To raise money, a firm can borrow, sell equity, or both. 15.1 BOOTSTRAPPING How New Businesses Get Started  Most businesses are started by an entrepreneur  Entrepreneurs regularly leave large companies to start businesses (often using technology developed by these firms)  Entrepreneur often holds an informal, low-budget discussion with people he trusts and usually talk about issues related to technology, manufacturing, personnel, marketing, and finance Initial Funding of the Firm  Bootstrapping – the process by which many entrepreneurs raise “seed” money to obtain other resources necessary to start their business  The initial seed money usually comes from the entrepreneur or other founders  Other cash comes from personal savings, the sale of assets (such as cars and boats), borrowing against the family home, loans from family members and friends, and loans obtained through credit cards  Entrepreneurs usually work regular full-time jobs until the business gets started  At this stage, banks or venture capitalists are not normally willing to fund the business  Seed money is usually spent on developing a prototype of the product or service and a business plan  The deliverables at this stage are whatever it takes to satisfy investors that the new business concept can become a viable business and deserves their financial support 15.2 VENTURE CAPITAL - The bootstrapping period usually lasts no more than one or two years; usually have developed a prototype and business plan already – critical time - Venture capitalists – individuals or firms that help new businesses get started and provide much of their early-stage financing; individuals or firms that invest by purchasing equity in new businesses and often provide entrepreneurs with business advice o Typically pool money from various sources to invest in new businesses:  Financial and insurance firms  Private and public pension funds  Wealthy individuals and families  Corporate investments not associate with employee pensions  Endowments and foundations - Angels (angel investors) – wealthy individuals who invest their own money in emerging businesses/ventures at the very early stages in small deals The Venture Capital Industry  Venture capital industry emerged in the late 1960s with the formation of the first venture capital limited partnership  Today, the venture capital industry consists of several thousand professionals at about one thousand venture capital firms (most in California and Massachusetts)  Modern venture capital firms tend to specialize in a specific line of business, such as hospitality, food manufacturing, or medical devices  A significant number focus on high-technology investments Why Venture Capital Funding is Different  Venture capital is important because entrepreneurs have only limited access to traditional sources of funding.  Why traditional sources of funding do not work for new or emerging businesses: 1. The high degree of risk involved – most new businesses fail so most suppliers of capital (banks, pension funds, insurance companies) do not want to make these high-risk investments 2. Types of productive assets – new firms whose primary assets are often intangible (patents, trade secrets) find it difficult to secure financing from traditional lending sources 3. Informational asymmetry problems – information asymmetry arises when one party to a transaction has knowledge that the other party does not. An entrepreneur knows more about his company’s prospects than a lender does. Most investors do not have the expertise to distinguish between competent and incompetent entrepreneurs so they don’t want to invest in these firms  For these reasons, many investors find it difficult to participate directly in the venture capital market. Instead they invest in venture capital funds that specialize in identifying attractive investments in new businesses, managing those investments and selling (exiting) them at the appropriate time The Venture Capital Funding Cycle Starting a New Business – The Tuscan Pizzeria  Developing a high-end pizzeria with an Italian ambiance and feel from the interior design, ingredients, wood oven, etc. The Business Plan  Business plan describes what you want the business to become, why consumers will find your pizzerias attractive (the value proposition), how you are going to accomplish your objected, and what resources you will need  Send business plan to a regional venture capital firm  Venture capital firms receive many unsolicited business plans, but respond to very few First-Stage Financing  After a number of meetings with you and your management team, the venture capital firm agrees to fund the project – but only in stages and for less than the full amount you requested  Will give you give you some money but you have to come up with the rest on your own How Venture Capitalists Reduce Their Risk  Staged Funding  Each stage gives the venture capitalist an opportunity to reassess the management team and the firm’s financial performance  If the performance does not meet expectations, the venture capitalists can bail out and cut their losses, or if they still have confidence in the project, they can help management make some midcourse corrections so that the project can proceed  Companies typically go through 3-7 funding stages – each stage passed is a vote of confidence for that project  The latter stages of financing sometimes called mezzanine financing because the investors did not get in on the ground floor  In the pizzeria example: the first/seed-stage is for funding the prototype, make it operational, and test the concept’s viability in the marketplace. In the later stages of financing will fund more new restaurants  The venture capitalists’ investments give them an equity interest in the company. Usually this is in the form of preferred stock that is convertible into common stock at the discretion of the venture capitalist  Preferred stock ensures that the venture capitalists have the most senior claim among the stockholders if the firm fails, while the conversion feature enables the venture capitalist to share in the gains if the business is successful  Personal Investment  Venture capitalists often require the entrepreneur to make a substantial personal investment in the business confirming that you are confident in the business and highly motivated to make it succeed  Syndication  It is common practice to seed- and early-stage venture capital investments  Syndication occurs when the originating venture capitalist sells a percentage of a deal to other venture capitalists  Reduces risk: o Increases the diversification of the originating venture capitalist’s investment portfolio o The willingness of other venture capitalists to share in the investment provides independent corroboration that the investment is a reasonable decision  In-Depth Knowledge  The venture capitalist’s in-depth knowledge of the industry and technology also reduces risk The Exit Strategy  Venture capitalists are not long-term investors in the companies they back  They stay with a new firm until it is successful with usually take 3-7 years then they exit by selling their equity position  Every venture capital agreement includes provisions identifying who has the authority to make critical decisions concerning the exit process  Usually includes: timing, the method of exit, and what price is acceptable  3 ways in which venture capital firms exit venture-backed companies: selling to a strategic buyer in the private market, selling to a financial buyer, and offering stock to the public  most exit though strategic and financial sales rather than public sales  Strategic Buyer  The strategic buyer is looking to create value through synergies between the acquisition and the firm’s existing productive assets  Financial Buyer  This type of sale occurs when a financial group – often a private equity (leveraged buyout) firm – buys the new firm with the intention of holding it for a period of time, usually 3-5 years, and then selling it for a higher price  Financial buyer not expecting to gain from operating or marketing synergies  The firm operates independently and the buyer focuses on creating value by improving operations. If firm is performing poorly, the buyer will bring in new management  Initial Public Offering (IPO)  To obtain the highest price possible in the IPO, a venture capitalist will not typically sell all of the shares he or she holds at the time of the IPO o Selling everything would send a bad signal to investors  Once firm’s shares are publicly traded, he can sell the remaining shares in the public market Venture Capitalists Provide More Than Financing  One of the most important roles of venture capitalists is to provide advice to entrepreneurs  At the early stages of a business’ operations, the people managing often have technical skills but not the skills necessary to successfully manage growth  The extent of the venture capitalists’ involvement in the management of the firm depends on the experience and depth of the management team  Venture capitalists may want a seat on the board of directors  Want an agreement that gives them unrestricted access to information about the firm’s operations and financial performance and the right to attend and observe any board meeting  Insist on a mechanism giving them authority to assume control of the firm if the firm’s performance is poor, as well as the authority to hire a new management team if necessary The Cost of Venture Capital Funding  The cost of venture capital funding is very high but the high rates of return earned by venture capitalists are not unreasonable  For every 10 businesses backed by venture capitalists, only 1 or 2 will succeed – the winners have to cover the losses on the businesses that fail  If a business is successful, the venture capitalists have made a substantial contribution to creating value for the other owners 15.3 INITIAL PUBLIC OFFERING - If a business is really successful, it will outgrow the ability of private sources of equity - It will need more money for investments in plant and equipment, working capital, and research and development (R&D) than these sources of capital will provide - One way to raise larger sums of cash or to facilitate the exit of a venture capitalist is through an initial public offering (IPO) of the company’s common stock - And IPO is a company’s first sale of common stock in the public market - A seasoned public offering is a sale of securities (either stocks or bonds) by a firm that already has similar publicly traded securities outstanding - Public offering means that the securities being sold are registered with the Securities and Exchange Commission so it can be legally sold to the public at large o Only these can be sold to the public Advantages and Disadvantages of Going Public  The decision to go public depends on an assessment of the advantages and disadvantages of going public Advantages of Going Public  The amount of equity capital that can be raised in the public equity markets is typically larger than the amount that can be raised through private sources  Millions of investors in public stock markets and easier to reach them  After an IPO, additional equity capital can usually be raised through follow- on seasoned public offerings at low cost – public markets are highly liquid and investors are willing to pay higher prices for more liquid shares of public firms than for illiquid shares of private firms  Going public can enable an entrepreneur to fund a growing business without giving up control – only needs to sell what is needed to raise the necessary funds  Once public, there’s an active secondary market where stockholders can buy and sell its shares  Motivate and attract top management talent Disadvantages of Going Public  The high cost of the IPO itself – because stock is not seasoned  A seasoned stock allows investors to observe how many shares trade on a regular basis and the prices. The stock sold in IPO is less well known and its value is more uncertain. Investors less comfortable buying a stock sold in an IPO and won’t pay as high for it as for a similar seasoned stock  The costs of complying with ongoing SEC disclosure requirements. Once a firm goes public it must meet a myriad of filing and other requirements by the SEC – the costs are high for smaller firms  The requirement that firms provide the public with detailed financial statements puts the firm at a competitive disadvantage  The SEC’s requirement of quarterly earnings estimates and financial statements encourages managers to focus on short-term profits Investment Banking Services  To complete an IPO, a firm needs the services of investment bankers who are experts in bringing new securities to the market  Investment bankers provide: origination (giving the firm financial advice and getting the issue rea
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