Chapter 2 Solutions

Chapter 2 Solutions - 2-1 Examples of bootstrap ...

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Unformatted text preview: 2-1 Examples of bootstrap financing include credit cards, loans from family and friends, or a mortgage on the entrepreneur's home. This type of financing is widely used in start - up ventures because it is based on the entrepreneur's personal characteris?cs and financial strength rather than the venture's likelihood of success or value. Because of this, bootstrap financing can usually be raised quickly and with liCle due diligence on the venture. 2-2 Venture capital firms invest at various stages of development, including some early- stage and some late- stage investments. Generally venture capital firms seed to invest in ventures that are beyond seed stage. The ventures tend to require significant amounts of capital and to have rela>vely well- established management teams. The VC is looking for opportuni>es that do not require too much of their >me. Organized business angel groups tend to seek very early- stage investments, including some seed stage opportuni>es. They usuall seek to invest fairly small amounts of capital. In come cases, angel groups co- invest with VC firms that target early- stage ventures. Note that these dis>nc>ons are not always clear and may change over >me, depending on the level of VC ac>vity. When the market is slow, VC firms are more likely to invest at earlier stages. 2-3 Factors an entrepreneur should consider when seeking venture capital include the following: 1. The :ming of the venture. VC funding will be most valuable if the venture is at a stage where the VC can add value to the firm beyond just the financial infusion. 2. The venture should be in an industry sector that is aCrac:ve to VC firms, which usually focus on high- technology, risky ventures with the poten:al for rapid growth. 3. VC funds usually invest in a specific geographic region and an entrepreneur might consider loca:ng in a region with a large number of firms if he believes VC funding and exper:se will be important to the venture's success. 4. VCs usually look for investments that will produce returns in a 3- 7 year :me horizon. They are not typically intrested in shorter- term opportuni:es, even if they promise an earlier return of cash. 2-4 Google strives to hire smart and crea2ve people and then offering them an environment that encourages innova2on and risk taking. They are expected to invest 2me and energy into new opportuni2es and markets for the company and are encouraged to spend one day per week working on anything they want. This ini2a2ve appears to have been successful, as Google has developed numerous new products and services beyond its core search engine technology, e.g., Gmail, Chrome, Google Calendar, etc. 2-5 a. If you pay on day 10 you will get the 1% discount meaning you owe $9,900, or $10,000 less the 1% discount. However, you would be ill- advised to pay in on day 10 since you could wait unAl day 15 and sAll get the discount. b. By forgoing the discount and paying in 45 days, the implicit interest rate for the 30 days is 12.9%. (1 + discount percent)(365/credit period) − 1 Implicit interest rate Discount percent Credit period 12.9% 1.0% 30 days 2-6 If the company borrows $85,000 from the bank today, in 60 days it will owe interest of $1,693,08, meaning it will have $98,306.92 aCer collecDng the receivable. If the company factors the receivable, it will receive $85,000 immediately and $12,500 in 60 days (the $15,000 minus a $2,500 fee), for a total of $97,500. Conclusion: It is beKer to use the short- term secured bank loan. Receivable Loan A/R days Interest rate Interest Total $ $ $ $ 100,000 85,000 60 0.12 1,693.08 98,306.92 2-7 1. Avoids the -me and cost required to complete a public offering. 2. Limits the number of people who gain access to strategic informa-on about the venture. 4. Fewer requirements for ongoing financial disclosure. 3. A small number of sophis-cated investors facilitates monitoring, and if needed, renego-a-on. 2-8 Not- for- profit organiza/on means that the enterprise does not pay income tax. There are no shareholders, per se. However, par/es can invest in not- for- profit ventures in a variety of ways, such as by providing assets in exchange for lease or royalty payments. If a not- for- profit earns a surplus, the surplus gets reinvested in the enterprise (as opposed to being distributed to shareholders). Not- for- profit organiza/ons s/ll need to consider strategy and to operate efficiently and profitably (i.e., cover their opera/ng costs). Success enables the venture to grow more rapidly and provides funds to support this growth. In choosing between for- profit and not- for- profit status, the entrepreneur needs to consider such things as the different opportuni/es for raising funds that may be available to either, the need to grow rapidly, the value of a structure that includes equity, and the value of not paying taxes. 2-9 An S corpora*on is a corpora*on that is taxed as a partnership, which means the corporate earnings flow through to investors (in propor*on to their investment). This can be advantageous if the business is losing money, as the investors may be able to use the S corpora*on losses to offset other income. S corpora*ons are limited to 100 shareholders (at this wri*ng) which limits the ability to rapidly raise large amounts of equity. A C corpora*on pays tax on corporate income, and has no easy way to take advantage of losses (except through net opera*ng loss carryforwards). Howerver, a C corpora*on is not limited in the number of investors (domes*c or foreign) and can therefore raise large sums from equity sales, oHen on public exchanges. 2-10 Limited liability means that the liability of equity investors is limited to the amount of their investments. In general, limited liability does not mean that the business risks of the venture are reduced. Because the liability of the stockholders is limited, others involved in the business are subject to greater risk of loss. Purchasers of products who are dissa@sfied do not have recourse to the stockholders' other assets. If the venture defaults on loans, the lenders can only look to the value of the firm's assets for repayment - not to the other assets of the firm's stockholders. Employees owed earnings cannot aEempt to collect from the firm's stockholders. 2-11 The following types of transac3ons/securites are exempt: 1. Small offerings: less than $1 million in any 12- month period. 2. Offerings to "accredited investors" or a limited number of investors: up to $5 million in any 12- month period to any number of accredited investor or up to 35 other "nonaccredited" investors. 3. Private placements: unlimited amount, but without general solicita3on and only to sophis3cated (accredited) investors. If there are nonaccredited investors involved, the maximum that can be raised is $5 million. 2-12 Milestones are associated with changes in risk or the resolu3on of uncertainty. When a milestone is reached it is easier to forecast the probability of success of the venture more accurately. For ventures with posi3ve outcomes, this means the entrepreneur will end up owning more of the venture. There are several poten3al problems with milestones The par3es may not agree on whether a par3cular milestone has been achieved. The entrepreneur may be able to manipulate performance in a way that achieves a milestone, but harms the long- term value of the venture. Each investment round requires an assessment and poten3al valua3on, which can make managing numerous milestones cumbersome. Finally, event the achievement of a par3cular milestone does not guarantee subsequent funding will be easy or available. 2-13 The term sheet is the informal understanding of the financing arrangement being nego5ated between the entrepreneur and investors. It reflects their basic understanding of key provisions in of the rela5onship. The investment agreement is the legal formaliza5on of the term sheet provisions and includes a more comprehensive discussion fo the representa5ons, warran5es, commitments, and undertakings of each party. 2-14 The investor's per share price is $3 ($60,000/20,000 shares). A;er the investment there will be 120,000 total shares. Thus the post- money valuaDon is 120,000 shares Dmes $3/share, or $360,000. By subtracDng the amount invested, we get a pre- money valuaDon of $360,000 - $60,000 = $300,000. 2-15 The entrepreneur will sell 80,000 new shares at an implied share price of $6.25 (25% higher than the last round) in order to raise $500,000. The new pre- and post- money valuaCons are $2.5 million and $3.0 million respecCvely. Old shares Value 25% increase New share price $ raised New shares Total shares Post-money Pre-money 400,000 $2,000,000 $2,500,000 $6.25 $500,000 80,000 480,000 $3,000,000 $2,500,000 2-16 a) WIthout a ratchet agreement, the post- money value of the venture is $5.5 million and the entrepreneurs stake is worth $3.5 million. b) With a ratchet, the angel investor has to be given 692,308 free shares , for a total of 1,292,308 shares. Because of the diluHon, the new invstor will demand 269,231 shares for the $500,000, meaning the new share price is $1.86. The entrepreneur's 47% stake is worth $2.6 million. Problem Prior Round 2,000,000 Value: New Investor Investment $8,000,000 $0 $2,400,000 $5,600,000.00 Value per Total New share Investor Shares Angel Shares Entreprenuer Shares Entrepreneur's Percentage Total Shares $ 600,000 1,400,000 70% 4.00 Postmoney Value Value: Angel Value: Entrepreneur No Ratchet $2.50 200,000 600,000 1,400,000 64% 2,200,000 $5,500,000 $500,000 $1,500,000 $3,500,000.00 Ratchet $1.86 269,231 1,292,308 1,400,000 47% 2,961,538 $5,500,000 $500,000 $2,400,000 $2,600,000.00 Note: You can find the ratchet-adjusted price by finding the price (cell C19) that makes Postmoney value ((I19) equal $5,500,000. Alternatively, Price (C19) = (Postmoney value (I17) - New Investment (J17) - Old Investment (K15))/Shares Held by Entrepreneur (F19) 2-17 Anti-dilution Provision Total New Investor Shares Prior Round Value per share $2.00 Total Old Investor Shares 1,000,000 a $0.80 1,250,000 1,000,000 b $0.20 5,000,000 c $0.60 1,666,667 Problem Postmoney Value Value: New Investor Investment Value: Old Investor Investment $ 2,000,000 Entreprenuer Shares Entrepreneur's Percentage Total Shares Value: Entrepreneur 2,000,000 67% 3,000,000 $6,000,000 2,000,000 47% 4,250,000 $3,400,000 $1,000,000 $800,000 10,000,000 2,000,000 12% 17,000,000 $3,400,000 $1,000,000 $2,000,000 $400,000 2,000,000 2,000,000 35% 5,666,667 $3,400,000 $1,000,000 $1,200,000 $1,200,000 Full Ratchet (part b) Note: You can find the ratchet-adjusted price by finding the price (cell C11) that makes Postmoney value ((I11) equal $5,500,000. Alternatively, Price (C11) = (Postmoney value (I9) - New Investment (J9) - Old Investment (K7))/Shares Held by Entrepreneur (F11) Partial Ratchet (part c) Given that the share price falls below $1 in part (a), the old investor's shares reach their minimum average value of $1, making the shares 2,000,000. You can then use Solver to find the solution. Alternatively, Price (C13) = (Postmoney value (I13) - New Investment (J13))/( Max Shares Held by Old Investor (E13) +Shares Held by Entrepreneur (F13)) $4,000,000 $1,600,000 2-18 Post and Pre Money Valuation There are three different scenarios. The entrepreneur has 2.5 million shares of common stock each scenario Scenario 1: $5 million for 2 million shares of common stock Price Per Share = Cash Paid / Number of shares issued $5,000,000 2,000,000 = $2.50 = Total Number of Shares Issued = New Shares + Original Shares = 2,000,000 + 2,500,000 = 4,500,000 Post- Money Valuation = Price Per Share * Total Number of Shares Issued = ($2.5) * ( 4,500,000) = $11,250,000 Pre- Money Value = Post- Money Valuation – Investment = $11,250,000 − $5,000,000 = $6,250,000 Scenario 2: $5 million for 1.8 million of preferred stock convertible to common stock for the ratio of 1:1 Price Per Share = Cash Paid / Number of shares issued $5,000,000 1,800,000 = $2.78 = Total Number of Shares Issued = New Shares + Original Shares = 1,800,000 + 2,500,000 = 4,300,000 Post- Money Valuation = Price Per Share * Total Number of Shares Issued = ($2.78) * ( 4,300,000) = $11,954,000 Pre- Money Value = Post- Money Valuation – Investment = $11,954,000 − $5,000,000 = $6,954,000 Scenario 3: $5 million for 1.5 million shares of preferred stock convertible to common stock and a warrant for 1.5 million shares of common stock Price Per Share = Cash Paid / Number of shares issued $5,000,000 1,500,000 = $3.33 = Total Number of Shares Issued = New Shares + Original Shares = 1,500,000 + 2,500,000 = 4,000,000 Post- Money Valuation = Price Per Share * Total Number of Shares Issued = ($3.33) * ( 4,000,000) = $13,333,000 Pre- Money Value = Post- Money Valuation – Investment = $13,333,000 − $5,000,000 = $8,333,000 Note: This valuation can also be computed on a fully diluted basis, with 3 million new shares issued. 2-19 Under a full ratchet provision, if subsequent rounds are at a lower valua7on per share, the investor would receive enough addi7onal shares to lower the investor's cost basis per share to the same as that of the investors in the subsequent round. For example, if the investor's cost per shire is $1.00, and the next round is at $0.40 per share, the original investor would get $1.00/$0.40 - 1 = 1.5 new shares for each exis7ng shares. The problem with an7- dilu7on rights is that the new investors must take those rights into account when deciding on the valua7on they will use. If the rights are too strong, there may be no way for the investors to invest unless the provision is renego7ated. This possibility can be avoided by using some form of par7al ratchet. For example, exis7ng investors might receive no more new shares than would lower their average cost basis to $0.80, even if subsequent rounds had valua7ons below $0.80. ...
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