ENTREPRENEURSHIP
A PROCESS PERSPECTIVE
Robert A. Baron
Scott A. Shane
A. Rebecca Reuber
Slides Prepared by:
Sandra Malach, University of Calgary
Copyright © 2008 by Nelson, a division of Thomson Canada Limited
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6
FINANCING NEW VENTURES
Copyright © 2008 by Nelson, a division of Thomson Canada Limited
LEARNING OBJECTIVES
1.
2.
3.
4.
Explain why it is difficult for entrepreneurs to raise
money from external investors.
Identify specific solutions to venture finance
problems created by uncertainty and information
asymmetry, and explain why these solutions work.
Explain why entrepreneurs typically raise very little
start-up capital.
Create proforma financial statements and cash flow
statements and conduct breakeven analysis.
Copyright © 2008 by Nelson, a division of Thomson Canada Limited
LEARNING OBJECTIVES
5.
6.
7.
8.
Define debt and equity financing and explain how
they differ.
Describe the different sources of capital for new
ventures.
Describe the equity finance process from start to
finish.
Explain why equity financing in new ventures is
typically staged.
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LEARNING OBJECTIVES
9.
Describe how venture capitalists calculate the cost
of the capital that they provide to new ventures.
10. Explain why direct and indirect social ties are
important to raising money from external investors.
11. Identify the behaviours and actions that successful
entrepreneurs engage in to encourage investors to
back them, and explain why these behaviours and
actions are effective.
Copyright © 2008 by Nelson, a division of Thomson Canada Limited
INFORMATION ASYMMETRY
PROBLEMS

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Entrepreneurs have information about
their business that investors don’t have.
This creates three problems:
Investors must make decisions on
limited information
Entrepreneurs can take advantage of
investors
Adverse selection
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UNCERTAINTY PROBLEMS

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Investors must make judgments
based on little actual evidence
Entrepreneurs and investors
disagree on value of new
venture
Investors want collateral
Copyright © 2008 by Nelson, a division of Thomson Canada Limited
SOLUTIONS TO VENTURE
FINANCE PROBLEMS

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Self financing
Contract provisions
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Covenants
Convertible securities
Forfeiture and anti-dilution
Control rights
Vesting periods
Copyright © 2008 by Nelson, a division of Thomson Canada Limited
SOLUTIONS TO VENTURE
FINANCE PROBLEMS

Venture Capitalist Specialization
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By industry
Be development stage
Geographically localized investing
Syndication
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CAPITAL QUESTIONS



How much money do I
need?
Where should I get that
money?
What type of
arrangements do I need
to make to obtain that
capital?
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START-UP CAPITAL
How much do you need?


Average Canadian business requires
under $50,000 in startup capital.
Asset based start-ups require higher
start-up capital than hustle-based startups.
Copyright © 2008 by Nelson, a division of Thomson Canada Limited
FINANCIAL ANALYSIS TOOLS

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List of startup costs and use of proceeds
Proforma financial statements
Cash flow statements
Breakeven analysis
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STARTUP COSTS

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All costs incurred to get the business off
the ground
Capital costs for equipment & long-term
assets
Working capital
Determine the capital you need
Determine what you’ll do with the
capital once you get it
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PROFORMA FINANCIAL
STATEMENTS

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Project the financial condition of the new
venture
Estimate profit and loss (Income Statement)
Cash Flow Statement
Show financial structure of the business
(Balance Sheet)
Allow investors to conduct ratio analysis

Performance Plus
http://sme.ic.gc.ca/epic/internet/inpppp.nsf/en/Home
Copyright © 2008 by Nelson, a division of Thomson Canada Limited
INCOME STATEMENT

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
Revenue – Expenses = Gross Income
Revenue derived from accurate market
analysis
Expenses derived from costs


Natural tendency to underestimate
Industries have similar relationships
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BALANCE SHEET

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Equity = Debit + Equity
Illustrates the financial structure of the
relationship
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CIMITYM
Cash is more important
than your mother.
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CASH FLOW


Amount of cash on hand at a given
point in time.
Cash vs. accrual based accounting

Cash inflows and outflows don’t always
occur at the same time as revenue and
expenses are incurred.
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INCOME TO CASH FLOW
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Take your net profit and add back
depreciation
Subtract increases or add decreases in
accounts receivable
Subtract increases or add decreases in
inventory
Add increased or subtract decreases in
accounts payable
Subtract increases or add increases in
notes/loans payable
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IMPROVE THE FLOW
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Minimize accounts receivable
Reduce the raw material and finished
products inventory
Control your spending
Delay your accounts payable
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BREAKEVEN ANALYSIS



Calculate the amount of sales you need
to achieve to cover your costs
Determine the increase in sales volume
you need to have in order to increase
fixed costs
Total fixed costs________________
(unit sales price - unit variable costs)
Copyright © 2008 by Nelson, a division of Thomson Canada Limited
DEBT VS. EQUITY


Debt—financial obligation to return
capital provided plus a scheduled
amount of interest
Equity—The ownership of a company,
which takes the form of stock. It also
equals assets minus liabilities or net
worth.
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FINANCING WITH EQUITY
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New ventures tend to be financed by
equity because:
New ventures have no way to make
scheduled interest payments until they
have positive cash flow
Debt financing at a fixed rate
encourages people to take risky actions
to increase profitability
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DEBT FINANCING

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Debt guaranteed by the
entrepreneur’s personal assets or
earning power
Asset-based financing
Supplier credit
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SOURCES OF CAPITAL
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Savings
Friends and family
Business angels
Venture capitalists
Corporations
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Banks
Asset-based lenders
Factors
Government
programs
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SME FINANCING IN CANADA
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CRITERIA FOR VENTURE
CAPITALISTS
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Operate in high growth industry
Have proprietary advantage
Offer a product with a clear market
need
Be run by experienced management
team
Plan to go public
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EQUITY FINANCE PROCESS
1. Referral of Entrepreneur to Venture
Capitalist
2. Initial screening of Executive Summary
3. Review Business Plan
4. Due Diligence
5. Negotiate the Terms
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THE OPTIMAL TEAM

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An excellent venture team with
Motivation
Passion
Honesty
Experience
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THE OPTIMAL OPPORTUNITY

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An excellent business opportunity with
Large market
Appropriate strategy
Compelling product description
Externally observable competitive
advantage
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DUE DILIGENCE

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
Investigation of
The business
The legal entity
The financial records
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STAGING OF FINANCING
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Staging of financing allows investors to
Minimize their risk
Gather more information over time
Manage the uncertainty of investing
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RATE OF RETURN
The main factor that
determines the rate of
return for new
venture financing
The stage of
venture development
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RATES OF RETURN &
FINANCING ROUNDS
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VENTURE CAPITAL
COST OF CAPITAL
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ENCOURAGING INVESTORS
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
Use impression management
techniques
Create a good story

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Create a sense of urgency
Frame ideas to make them more appealing
Prepare a good business plan
Copyright © 2008 by Nelson, a division of Thomson Canada Limited
SOCIAL CAPITAL

Investors are more likely to invest in
entrepreneurs with whom they have a
direct or indirect business or social tie.

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Entrepreneur will be less likely to take
advantage of investor
Ability of investor to invoke sanctions
Efficient way to gather information
Create positive attributions
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