Chapter 2 Finance Module

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

Chapter 7- How Firms Raise Capital Bootstrapping How New Businesses Get Started most businesses are started by an entrepreneur who has a vision for a new business or product and a passionate belief in the concepts viability new businesses are seldom started in large corporations the entrepreneur often fleshes out his or her ideas and makes them operational through informal discussions with people whom the entrepreneur respects and trusts Initial Funding of the Firm the process by which many entrepreneurs raise seed money and obtain other resources necessary to start their businesses is often called bootstrapping initial seed money usually comes from the entrepreneur or other founders other cash may come from personal savings, the sale of assets such as cars and boats, borrowing against the family home, loans from family members and friends it is spent on developing a prototype of the product or service and a business plan Venture Capital bootstrapping period usually lasts no more than one or two years the founders will have developed a prototype, which they can take on the road to seek venture capital funding to growth the business venture capitalists are individuals or firms that help new businesses get started and provide much of their early-stage financing individual venture capitalists, so-called angels (or angel investors), are typically wealthy individuals who invest their own money in emerging businesses at the very early stages in small deals venture capital firms typically pool money from various sources to invest it in new businesses The Venture Capital Industry venture capital industry as we know it today emerged in the late 1960s with the formation of the first venture capital limited partnerships approximately $25 billion was invested in venture capital funds in both 2005 and 2006 biggest concentrations of firms in California and Massachusetts modern venture capital firms tend to specialize in a specific line of business Why Venture Capital Funding is Different three reasons why traditional sources of funding do not work for new or emerging businesses: 1. The high degree of risk involved- most new businesses fail, and it is difficult to identify which firms will be successful, most suppliers of capital are averse to undertaking high-risk investments 2. Types of productive assets- new firms who primary assets are often intangibles, such as patents or 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 or her companys prospects than a lender does. Most investors do not have the expertise to distinguish between competent and incompetent entrepreneurs for these reasons, many investors find it difficult to participate directly in the venture capital market The Venture Capital Lending Cycle THE BUSINESS PLAN the business plan describes what you want the business to become, why consumers will find your business attractive (the value proposition), how you are going to accomplish your objectives and what resources you will need venture capital firms receive many unsolicited business plans and respond to very few FIRST-STAGE FINANCING HOW VENTURE CAPITALISTS REDUCE THEIR RISK Staged Funding each funding stage gives the venture capitalist an opportunity to reassess the management team and the firms 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 corrections so that the project can proceed companies typically go through three to seven funding stages latter stages of financing are sometimes called mezzanine financing the venture capitalists investments give them an equity interest in the company typically, this is in the form of preferred stock that is convertible into common stock at the discretion of the venture capitalists preferred stock ensures that the venture capitalists have the most senior claim among the stockholders if the firm fails and the conversion feature enables the venture capitalists to share in the gains if the business is successful Personal Investment venture capitalists often require an entrepreneur to make a substantial personal investment in the business it is also unlikely that the venture capitalists will allow you to pay yourself a large salary as manager of the business Syndication syndication occurs when the originating venture capitalist sells a percentage of a deal to other venture capitalists syndication reduces risk in two ways first, it increases the diversification of the originating venture capitalists investment portfolio, since other venture capitalists now own a portion of the deal second, the willingness of other venture capitalists to share in the investment provides independent corroboration that the investment is a reasonable decision In-Depth Knowledge a high degree of specialization gives the venture capitalist a comparative advantage over other investors or lenders that are generalists THE EXIT STRATEGY venture capitalists are not long-term investors in the companies they back they stay with a new firm until it is a successful gong concern, which usually takes three to seven 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 include the following: (1) timing, (2) the method of exit, and (3) what price is acceptable exit strategies can be controversial Strategic Buyer a common way for venture capitalists to exit is to sell the firms equity to a strategic buyer in the private market the strategic buyer is looking to create value through synergies between the acquisition and the firms 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 three to five years, and then selling it for a higher price difference between a strategic and a financial buyout is that a financial buyer does not expect to gain from operating or marketing synergies in a financial buyout, the firm operates independently and the buyer focuses on creating value by improving operations as much as possible Initial Public Offering a venture capitalist may also exit an investment by taking the company public through an initial public offering (IPO)
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