Start-Up Businesses and Venture Capital: Corporate Financial Strategy

Chapter 7
Start-up businesses and venture capital
Corporate Financial Strategy

Start-up businesses and venture capital: contents
 Learning objectives
 Financial strategy for a start-up business
 Stages in a start-up
 Two ways of accounting for the risk
 Real options
 Venture capital and business angels
 Example of corporate venturing
 Deal terms will include…
 Pre- and post-money
 Pre- and post-money example
 Anti-dilution clauses, used in a ‘down’ round
 Liquidation preference reduces risk and boosts return
Corporate Financial Strategy 2

Learning objectives
1. Explain how the life cycle model is applied to the start-up stage of a
business.
2. Contrast the different ways that companies use to account for high
business risk.
3. Prepare or appraise a venture capital term sheet, and explain the
potential impact of some common investor protection clauses.
4. Distinguish the various different forms of early-stage financing and
comment on their strengths and weaknesses.

Financial strategy for a start-up business
Business risk Very high
Financial risk Very low
Source of outside Venture capital
funding
Dividend policy Nil pay-out ratio
Future growth prospects Very high
Price/earnings multiple Very high
Current profitability (eps) Nominal or negative
Share price Rapidly growing but highly volatile

Stages in a start-up
Business making R&D spend
market testing
Prototype and
Product
rcializat
comme
ion &
Chance to become
ion
valuable
Time
The length of each stage depends on the industry and business model
The number of successful entities decreases at each stage

Two ways of accounting for the risk
Probability-adjust cash flows Use a higher discount rate

 Probability-adjust the cash flows  A high discount rate is applied to
to allow for the changes in the whole project to allow for the
probability of success as each overall risk taken on
stage is reached
 This is more complex  This is more commonly used,

mathematically, but has the because it is simpler, but can be
advantage that certain cash misleading
outflows are not discounted at a
high rate
 It is theoretically more
appropriate

Real options
 Multi-stage projects
 Timing flexibility
 Alternative uses
 Growth potential
 Exit options
Real options take account of the

value inherent in flexibility

Venture capital investors and business angels
Venture Capital Business Angels

 Professional investment firms,  Individuals, often investing their
generally investing funds they own money
have raised as intermediaries  Often more informal than
rather than their own money professional firms
 Have a portfolio of high-risk  Investment criteria include:
investments, often specializing in favourable impression of the
a particular sector or a specific management team, familiarity
technology with the sector, geographical
proximity, synergy with own skills
Both venture capital firms and
business angels are investing with
the aim of a high financial return

Example of corporate venturing
http://www.altassets.net/private-equity-news/by-
news-type/deal-news/corporate-vc-bmw-i-
Corporate Financial Strategy
ventures-inks-fifth-strategic-investment.html
9
Deal terms will include
1. Company’s constitution
2. Shareholders’ agreement
a. Details of the investment and the terms attached to each of the securities – e.g.
votes, vetoes, covenants, rights on exit, conversion terms …
b. Drag along and tag along rights
c. Pre-emption rights
d. Board representation rights
3. Fees
4. Representations and warranties
5. Service contracts
6. Banking agreements

Pre- and post-money
Pre- = Post-
money + Investment money
value value

Pre- and post-money example
 Entrepreneur seeks £100,000 in exchange for 10% of the business.

 This implies that the business as it stands is worth £900,000 (pre-money)
 And after the investment, it will be worth £1,000,000 (post-money)
£100,000 = 10% (Pre-money value + £100,000)

£100,000 = (10% x Pre-money value) + £10,000
10% x Pre-money value = £90,000
Pre-money value = £900,000
Post-money value = £900,000 + £100,000 = £1,000,000

Anti-dilution clauses, used in a ‘down’ round
If someone else buys more cheaply, you get a refund.
Example
 Original VC investors bought ‘A’ shares at £100 per share. The ‘A’
shares will convert into ordinary shares on a disposal, on a 1:1 basis
 Next stage investors will buy ‘B’ shares at £50 each
 Because the ‘A‘ shares are being diluted, the holders of the ‘A’ shares
are issued with new free(ish) shares, to bring their overall cost down to
£50 per share. This dilutes the founder’s stake. Or, conversion terms
may alter to achieve same effect.

Liquidation preference reduces risk and boosts return
PE company makes sure that on a disposal it gets its money back, or a

multiple of its money. Surplus proceeds are then split between parties
Example, where VC has put in £200,000 for 50% of the equity. Sales
proceeds for equity of £100k, £300k and £1m.
£100,000 £300,000 £1 million
proceeds proceeds proceeds
No liquid’n pref £50,000 £150,000 £500,000
1x LP £100,000 £250,000 £600,000
(£200k plus half of (£200k plus half of
£100k) £800k)
2x LP £100,000 £300,000 £700,000

(£400k plus half of
£600k)
OR – the other shareholders may be credited with their own amounts paid for their
shares, in a catch-up exercise before the net proceeds are divided

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Chapter 7

Start-up businesses and venture capital

Corporate Financial Strategy

Corporate Financial Strategy 2

Corporate Financial Strategy 3

Business risk Very high

Financial risk Very low

Source of outside Venture capital

Dividend policy Nil pay-out ratio

Future growth prospects Very high

Price/earnings multiple Very high

Current profitability (eps) Nominal or negative

Share price Rapidly growing but highly volatile

Business making R&D spend

Corporate Financial Strategy 5

Probability-adjust cash flows Use a higher discount rate

 This is more complex  This is more commonly used,

Corporate Financial Strategy 6

Real options take account of the

Corporate Financial Strategy 7

Venture Capital Business Angels

Corporate Financial Strategy 8

Corporate Financial Strategy 10

Corporate Financial Strategy 11

 Entrepreneur seeks £100,000 in exchange for 10% of the business.

£100,000 = 10% (Pre-money value + £100,000)

Corporate Financial Strategy 12

If someone else buys more cheaply, you get a refund.

Corporate Financial Strategy 13

PE company makes sure that on a disposal it gets its money back, or a

2x LP £100,000 £300,000 £700,000

Corporate Financial Strategy 14

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