Full Test Bank Ch10 Raising Money for Starting and Growing a

Chapter 10 Questions

True/False

1. It is very difficult for entrepreneurs to raise debt financing from conventional banks because they require as many as three years of actual—not projected—financial statements and assets that adequately cover the loan. (pg. 302)
2. Self-funding by entrepreneurs, along with funding from informal investors, is the lifeblood of an entrepreneurial society. (pg. 304)
3. The downside financial risk for an investor in the worst-case scenario is the same, whether they make a loan or an equity investment. (pg. 304)
4. Valuation of a small, privately held corporation is difficult. (pg. 304)
5. Angels invest in seed‐stage and very early‐stage companies that are not yet mature enough for formal venture. (pg. 306)
6. The term, “business angels,” strictly refers to just former entrepreneurs who invest some of their wealth in seed and early stage businesses. (pg. 307)
7. Corporate angels may be a headache for a small company. (pg. 307)
8. Professional angels are a category of investors primarily comprised of retired entrepreneurs. (pg. 307)
9. Placing a value on your startup is the first thing you should do when raising a round of angel investment. (pg. 308)
10. Business angels are generally satisfied with a lower return than venture capitalists. (pg. 308)
11. Most angel investors prefer common stock that can later be converted into preferred stock. (pg. 308)
12. According to the GEM Report, generally speaking, the amount needed to start a business is lowest in the consumer-oriented sector. (pg. 309)
13. The businesses that need the most startup capital are those created with the intent to grow and hire employees. (pg. 309)
14. Usually, businesses started by men require less capital than those started by women because they are more service-oriented. (pg. 309)
15. The majority of informal investors expect a negative or zero return. (pg. 309)
16. The median expected payback time of an investment is one year, and the median amount returned is two times the original investment. (pg. 309)
17. The expected internal rate of return or IRR (compound annual return on investment) is calculated from the expected payback time and the times return for formal investors and entrepreneurs who reported both. (pg. 310)
18. The SEC does not permit the offering and selling of securities through internet crowdfunding campaigns. (pg. 311)
19. In general, venture capital is invested in companies that are already in business. (pg. 312)
20. The formal venture capital industry was born in Massachusetts at the end of WWII when a group of investors were inspired by General Georges Doriot. (pg. 312)
21. The limited partners of venture capital funds raise money from the general partners. (pg. 312)
22. The general partners’ share of investment returns is called carried interest.

(pg. 313)

1. The highest return on a venture capital investment is produced when the company has a management buyout. (pg. 314)
2. In general, trade sales produce nearly as big a capital gain as IPOs. When a company executes a trade sale, it almost always has the option of an IPO, as well. (pg. 314)
3. The present value of a company is the present value of the past free cash flows, plus the residual (terminal) value of the firm. (pg. 318)
4. Market-comparable valuation is based on the net income and the startup’s capitalization rate. (pg. 318)
5. A rapidly growing, high-potential firm will generate a lot of free cash flow in its first few years. (pg. 318)
6. The modified-book value method of valuation’s main weakness is that it reflects the past rather than the future. (pg. 319)
7. Modified-book value is applicable to small, fast-growing, firms. (pg. 319)
8. The liquidation value of a company is a strict valuation placed on an insolvent company by the courts during a bankruptcy proceeding. (pg. 319)
9. The difference between a seed-stage company and a startup is that the latter, unlike the former, is already in business. (pg. 320)
10. Venture capital investors expect a higher rate of return for mezzanine stage investments than for bridge financing. (pg. 320)
11. A company’s growth rate vis-à-vis its industry is not considered when using the Asset-Based valuation method. (pg. 321)
12. After the IPO, the company has to file a registration statement with the SEC. (pg. 324)
13. The company planning a public offering must first select an investment bank. (pg. 325)
14. Selling the company is the most common way of harvesting an investment. (pg. 326)

Multiple Choice

1. Almost every new business raises its initial money from the founders themselves and what we call informal investors, including: (pg. 303)
   1. Venture capitalists.
   2. Family members.
   3. Private equity firms.
   4. Institutional investors.
   5. All of the above.
2. Who comprises the “4Fs”? (pg. 303)
   1. Founders, Family, Friends, and Financial advisors.
   2. Founders, Family, Financial advisors, and Foolhardy investors.
   3. Founders, Financial advisors, Friends, and Foolhardy investors.
   4. Financial advisors, Family, Friends, and Foolhardy investors.
   5. Founders, Family, Friends, and Foolhardy investors.
3. According to the GEM study, entrepreneurs contribute about ______ of the capital needed to launch their ventures. (pg. 304)
   1. one-third
   2. two-thirds
   3. one hundred percent
   4. half
   5. none of the initial capital needed
4. According to the GEM study, half of all informal investors are expecting their money to be returned within how many years? (pg. 304)
5. 1 year
6. 2 years
7. 3 years
8. 4 years
9. 5 years
10. Approximately how many business angels are there in the US as of 2016? (pg. 306)
11. 10 million
12. 12 million
13. 14 million
14. 16 million
15. 18 million
16. What subset of informal investor is relatively sophisticated and invests primarily in glamorous companies? (pg. 306)
    1. Friends
    2. Family
    3. Founders
    4. Financial advisors
    5. Business angels
17. Which of the following types of angels is usually a passive investor? (pg. 307)
18. Professional
19. Entrepreneurial
20. Corporate
21. Micromanagement
22. Enthusiast
23. Which of the following types of angels have started their own businesses and are looking to invest in new businesses? (pg. 307)
24. Professional
25. Entrepreneurial
26. Corporate
27. Micromanagement
28. Enthusiast
29. Which of the following types of angels are managers of larger corporations who invest from their savings and current income? (pg. 307)
30. Professional
31. Entrepreneurial
32. Corporate
33. Micromanagement
34. Enthusiast
35. Which of the following types of angels are doctors, dentists, lawyers, accountants, consultants, and even professors who have substantial savings and incomes and invest some of their money in start‐ups? (pg. 307)
36. Professional
37. Entrepreneurial
38. Corporate
39. Micromanagement
40. Enthusiast
41. Which of the following types of angels are retired or semiretired entrepreneurs and executives who are wealthy enough to invest in start‐ups as a hobby? (pg. 307)
42. Professional
43. Entrepreneurial
44. Corporate
45. Micromanagement
46. Enthusiast
47. Which of the following types of angels are entrepreneurs who have been successful with their own companies and have strong views on how the companies they invest in should be run? (pg. 307)
48. Professional
49. Entrepreneurial
50. Corporate
51. Micromanagement
52. Enthusiast
53. The amount of capital that entrepreneurs need to start their ventures depends mainly on______. (pg. 309)
    1. the type of business
    2. the ambitions of the entrepreneur
    3. the location of the business
    4. the country of origin
    5. all of the above
54. For informal investment, the amount invested by _______ is the highest, and the median return expected is ____ times the original investment. (pg. 309)
    1. Strangers; 1.5
    2. Friends; 2.0
    3. Venture Capitalists; 1.0
    4. Relatives; 1.0
    5. Work Colleagues; 1.5
55. Approximately what percent of informal investment is directed to businesses founded by the investor’s close family? (pg. 309)
56. 25%
57. 35%
58. 40%
59. 50%
60. 65%
61. Which of the following categories of informal investors expects the highest return on his or her investment, since it is made in a more detached manner? (pg. 309)
    1. Founders.
    2. Family.
    3. Friends.
    4. Foolhardy investors.
    5. All of the above expect the same returns.
62. The split of the percent of entrepreneurs who expect to profit from their ventures and the percent of those that do not is almost ________ of the split among informal investors. (pg. 310)
    1. the same
    2. the reverse
    3. positively correlative
    4. in-correlative
    5. None of the above.
63. The rarest source of capital for nascent entrepreneurs is______. (pg. 311)
    1. friends
    2. family
    3. venture capital
    4. financial advisors
    5. foolhardy investors
64. While classic venture capitalists finance very few companies, some of the ones that they do finance play a crucial role in the development of ______industries. (pg. 312)
    1. knowledge-based
    2. return-based
    3. risk-based
    4. core economy-based
    5. none of the above
65. The companies are often up and running before ____ is raised. (pg. 312)
    1. the first investment from venture capital
    2. the second investment from venture capital
    3. trade credit
    4. the investment from family and friends
    5. the investments from IPO
66. Venture capital funds are limited partnerships that typically begin with how long of a term? (pg. 312)
    1. Two years.
    2. Four years.
    3. Six years.
    4. Eight years.
    5. Ten years.
67. The capital gain on the harvest is shared with ____% for the limited partners and ____% for the general partners, once the limited partners have received their entire original principal. (pg. 313)
    1. 80% - 20%
    2. 20%-80%
    3. 40%-60%
    4. 60%-40%
    5. 50%-50%
68. What category of venture capital participant employs gatekeepers to advise it on what projects to invest in and to monitor the investment afterwards? (pg. 313)
    1. General partners.
    2. Limited partners.
    3. Investment advisors.
    4. All of the above.
    5. None of the above.
69. If a venture capital fund is successful, as measured by the financial return to the limited partners, the general partners usually raise another fund ______ years later. (pg. 314)
    1. 1 - 3 years
    2. 4 - 6 years
    3. 7 - 9 years
    4. 10 - 12 years
    5. 13 - 16 years
70. In general, a venture capitalist should not sit on more than what number of portfolio company boards? (pg. 316)
71. 2
72. 6
73. 8
74. 10
75. 12
76. What will a VC usually receive in exchange for the money invested? (pg. 316)
77. Common stock
78. Stock options
79. Promissory notes
80. Letter of deposit
81. Convertible preferred stock
82. The equation for the value of a company with the earnings capitalization method is: (pg. 318)
83. Company Value = Gross Revenue ÷ Book Value
84. Company Value = Net Income ÷ Capitalization Rate
85. Company Value = Net Income × Market price of stocks
86. Company Value = Sum of Cash Flow for the past five years
87. Company Value = Price of one share × number of shares
88. Which of the following must be added to Operating Income when calculating Free Cash Flow? (pg. 318)
89. Depreciation
90. Principal Payments
91. Interest Payments
92. Capital Expenditures
93. Tax Payments
94. Replacement Value is a variation of: (pg. 319)
95. Market-Comparable Valuation Method
96. Earning Capitalization Method
97. Present Value of Future Cash Flows Method
98. Market Capitalization Method
99. Asset-based Valuation Method
100. The least desirable way for venture capitalist to harvest an investment is: (pg. 322)
101. IPO
102. Acquisition
103. Buyback
104. Stock swap
105. They are equally attractive
106. What is the term for the event by which the investor realizes his or her investments? (pg. 322)
107. Crop
108. Gain
109. Exit
110. Yield
111. Cream
112. In recent years, approximately how many venture-backed companies went public? (pg. 323)
113. 220
114. 340
115. 270
116. 100
117. 140
118. The period when the prior shareholders are not permitted to sell any of their stock is called: (pg. 323)
119. Lockup period
120. Blocking period
121. Limited period
122. Banning period
123. None of the above
124. For the entrepreneur advancing through the IPO process, what is the step that immediately follows the SEC’s approval of the preliminary prospectus? (pg. 325)
125. The “road-show”
126. Filing the registration form with the SEC
127. Agreeing upon the price of stocks
128. Meeting with all key players
129. Start seeking an underwriter for the IPO

Open Ended

1. What are other sources of funding besides Venture Capital? (pg. 303)

• Services at reduced rates (some accounting and laws firms offer reduced fees to startup companies as a way of getting new clients)
• Vendor financing (getting favorable payment terms from suppliers)
• Customer financing (getting down payments in advance of delivering goods or services)
• Reduced rent from a landlord
• An incubator that offers rent and services below market rates
• Government programs such as the Small Business Innovation Research awards for technology companies

1. Who are informal investors and what are the benefits of attracting investments from them? (pg. 304)
   • Informal investors are family and friends.
   • You may not need a formal loan agreement when you’re dealing with your family and friends.
   • They often treat this lending more as help to you than an investment and will not sue if the investment is not fully repaid.
   • Informal investing is often much easier for a startup to access, than other sources of funding.
2. What are the key characteristics of the various types of angel investors? (pg. 307)
   1. Entrepreneurial angels have the experience and track record to be both business advisors and mentors.
   2. Corporate angels, with their experience in large organization, are looking to invest their money and experience in a startup.
   3. Professional angels such as doctors, lawyers and professors may each have their own deep expertise in a particular industry, but they are largely silent investors.
   4. Enthusiast angels are wealthy and retired (or semiretired) and are investing in startups as a hobby.
   5. Micromanagement angels are entrepreneurs with strong views on how to manage the companies they are investing in, and they want to be involved and informed.
3. What is convertible debt? What stages of funding are convertible debt usually raised for? (pg. 308)

• Convertible debt is a bridge loan that converts to equity at the next round of investment, assuming that it is an equity round. Convertible debt securities allow the next-round investors, who are usually venture capitalists, to set the value of the company and provide the first-round angel investors with a discount. Business angels would like to get a 30% discount, but actual discounts range from 10% to 30%. Convertible debt has the advantage over convertible preferred stock because it reduces or eliminates squabbling over the valuation between venture capitalists and the entrepreneur on behalf of the angels.
• Convertible debt is raised by seed-stage companies that expect to get venture capital investment in later rounds of financing

1. How much startup capital does an entrepreneur need to start a business? (pg. 309)

• The amount of capital that entrepreneurs need to start their ventures depends, among other things, on the type of business, the ambitions of the entrepreneur, the location of the business, and the country where it is started.
• According to the GEM Report the median level of funding required to start a business is $17,500, with entrepreneurs providing 57% of the funding.
• The amount needed to start a business is highest in extractive industry at $347,000, because of the large investment in capital equipment necessary for extracting raw materials such as oil and gas. Meanwhile, startups in the business services sector required an average of $20,000 and the lowest amount of funding was required by consumer-oriented businesses which needed only $11,216. The businesses that need the most startup capital are those created with the intent to grow and hire employees. For example, nascent businesses that expect to create 6 or more jobs in five years require an average of $50,000 in startup money.

1. What is the expectation of return on investment for informal investors? How does it differ based on the relationship to the entrepreneur? (pg. 309)
   • The median expected payback time, as you can see in Figure 10.1, is two years, and the median amount returned is one times the original investment. In other words, there is a negative or zero return on investment for half the informal investments.
   • It seems that altruism is involved to some extent in an informal investment in a relative’s or a friend’s new business. Put differently, investments in close family are often made more for love, not money.
   • The amount invested by strangers is the highest. What’s more, the median return expected by strangers is 1.5 times the original investment, compared with just 1 for relatives and friends. The most likely reason is that investments by strangers are made in a more detached and businesslike manner than are investments by relatives and friends.
2. Describe venture capital investing from the perspective of the firm’s general partners. (pgs. 312-313)

• At the center of the process are general partners of venture capital funds, which are limited partnerships with a ten-year life that is sometimes extended. The general partners of venture capital funds raise money from limited partners. In return for managing the partnership, the general partners receive an annual fee of 2% to 3% of the principal that has been paid into the fund.
• The general partners then invest money in portfolio companies in exchange for equity. If all goes well, the investment in the portfolio companies grows and the equity is eventually harvested, usually with an initial public offering (IPO) or a trade sale to a bigger company.
• The capital gain on the harvest is shared 80% - 20% between the limited partners and the general partners once the limited partners have received back all the principal they put into the limited partnership.
• Sometimes gatekeepers are employed by limited partners to advise them on what venture capital funds they should invest in and to watch over an investment once it has been made. The fee for gatekeepers is approximately 1% of the capital invested.

1. What are the advantages of having a venture capital backed company? (pgs. 315-316)
   • IPOs of such companies are generally very successful
   • VCs help with recruiting key members of management, strategic advice, industry contacts, and professional contacts
   • VCs have deep pockets and can in most cases raise new funds for additional venture financing
   • Being a VC-backed company adds to your credibility and reputation
2. Name the ways of valuing a business and explain why none of them can be called ideal. (pg. 317)
   • Earning-capitalization valuation
   • Present value of future cash flows
   • Market-comparable valuation
   • Asset-based valuation
   • No single method is ideal, because the value of a business also depends on opportunity, risk, purchaser’s financial resources, future strategies for the company, time horizon of the analysis, alternative investments, and future harvest. Also, while each method is appropriate for valuing some businesses, none fit for every business.
3. What are the three ways for an investor to exit an investment? Which is the most lucrative? (pgs. 322-323)

• There are three ways to exit an investment: an initial public offering, an acquisition, and a buyback of the investor’s stock by the company itself. Most investors prefer an IPO because it produces the highest valuation in most cases— but not in every case. An acquisition is the second choice. And a buyback is a distant third because in almost every instance it produces a mediocre return.
• IPOs generally yield the biggest returns for the pre-IPO investors, but in the long run, they’re not always satisfactory for the entrepreneurs and the management team.
• Buybacks are rare because a successful and rapidly growing company needs all the cash it can get just to keep on its growth trajectory. It has no free cash to buy out its external investors. A firm doing a buyback is more likely to be one of the living dead for which an IPO or acquisition is not feasible, but somehow the company arranges a refinancing in which it buys back the stock owned by the original investors.

1. Explain three positive reasons to go public and three negative reasons not to IPO: (pgs. 323-324)
   • Positives:
     1. Financing. The principal reason for a public offering is to raise a substantial amount of money that does not have to be repaid. For example, the average amount of money raised by the 338 venture-capital-backed companies that floated IPOs during the period 2013 – 2017 was $111 million. In 2017, 1,624 companies went public globally, up 49% versus 2016. The total money raised was nearly $249 billion globally, resulting in average $200 million for each company. The year 2014 was atypical, as it included Alibaba’s blockbuster offering of almost $25 billion.
     2. Follow-On Financing. A public company can raise more capital by issuing additional stock in a secondary offering.
     3. Realizing Prior Investments. Once a company is public, shareholders prior to the IPO know the value of their investment. What’s more, their stock is liquid and can be sold on the stock market after the lockup period is over. The lockup period is a length of time after the IPO date (usually 180 days) when the prior shareholders are not permitted to sell any of their stock.
     4. Prestige and Visibility. A public company is more visible and has more prestige. This sometimes helps the company with marketing and selling its products, outsourcing, hiring employees, and banking.
     5. Compensation for Employees. Stock options presently held by employees or granted in the future have a known value.
     6. Acquiring Other Companies. A public company can use its shares to acquire other companies.
   • Negatives:
     1. High Expenses. Expenses associated with going public are substantial. They include legal and accounting fees, printing costs, and registration fees. On average, companies spend anywhere from $7.3 million for IPOs less than $100 million to $27million for IPOs from $250 to $500 million. Those expenses are not recoverable if the company does not actually go public, which happens to about half the companies that embark on the IPO process and fail to complete it. If the company does go public, the underwriter’s commission takes between 4% and 7% of the money raised.
     2. Public Fishbowl. When a company goes public, SEC regulations require that it disclose a great deal of information about itself that until then has been private and known only to insiders. That information includes compensation of officers and directors, employee stock option plans, significant contracts such as lease and consulting agreements, details about operations including business strategies, sales, cost of sales, gross profits, net income, debt, and future plans. The IPO prospectus and other documents that have to be filed with the SEC are in the public domain; they are a gold mine for competitors and others that want to pry into the company’s affairs.
     3. Short-Term Time Horizon. After an IPO, shareholders and financial researchers expect ever-increasing performance quarter by quarter. This expectation forces management to focus on maximizing short-term performance rather than on achieving long-term goals.
     4. Post-IPO Compliance Costs. To meet SEC regulations, a public company incurs accounting costs it never had when it was private. Those can amount to $100,000 or more annually.
     5. Management’s Time. After an IPO, the CEO and the CFO have to spend time on public relations with the research analysts, financial journalists, institutional investors, other stockholders, and market makers— so named because they make a market for the company’s stock. This is a distraction from their main job, which is running the company for optimal performance.
     6. Takeover Target. A public company sometimes becomes the target of an unwelcome takeover by another company.
     7. Employee Disenchantment. A rising stock price boosts the morale of employees with stock or stock options, but when it is sinking, it can be demoralizing— especially when an employee’s options go “underwater” (the stock price falls below the options price). Underwater options can make it difficult to motivate and retain key employees.
2. Explain why the underwriter of an IPO often tries to lower the price of the stocks in the offering. (pg. 325)
   • The worst thing that can happen to an underwriter during an IPO that the underwriter cannot sell all of the stock.
   • Following a simple demand/supply rule, the higher the price of a stock, the fewer shares investors are willing to buy.
   • Therefore, if underwriters see that the market is not ready to buy all the stock at a set price before the IPO, they may try to lower the price.
3. Why would a company want to be acquired? (pgs. 326-327)
   • Managers can focus on building the company
   • Easy access to additional capital
   • Fast realization of investments
   • The entrepreneurs and employees get cash immediately
   • The expenses and investment banker’s commission are substantially lower for an acquisition than for an IPO.
4. What may be some drawback in getting acquired? (pgs. 326-327)
   • Management may prefer to move on to a new venture instead of working through an earn-out period.
   • The culture of your venture may clash with, or be impacted adversely by, the acquirer.
   • You company may be valued less in an acquisition than in an IPO
   • The strategic flexibility of your company may be impacted by its role in a parent companies portfolio.
   • Your cash could be harvested by the acquirer to support other ventures.
   • Employees may have different views on how the venture should be harvested and an acquisition may cause turn-over.