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Funding Innovation: Non-Traditional Risk Capital April 17, 2014 Mark Lauinger Director – Tulsa Advisory Services [email protected]

Feb 25, 2016

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Funding Innovation: Non-Traditional Risk Capital April 17, 2014 Mark Lauinger Director – Tulsa Advisory Services [email protected] Funding Innovation: Risk Capital Markets. Overview: Investment Landscape Sources & Trends – Angels & VC Funds Investment Pricing & Structuring - PowerPoint PPT Presentation

Oklahoma Seed Capital Fund i2E Investment Review Process

Funding Innovation: Non-Traditional Risk CapitalApril 17, 2014

Mark LauingerDirector Tulsa Advisory [email protected]

Introduce self & i2E.

Innovation funding requires risk capital. Normally innovation or high risk capital is associated with startups or early stage new businesses, but some of the same financial concepts are just as applicable to smaller existing companies looking to expand product/service offerings with new innovative offerings. 1Overview:Investment Landscape Sources & Trends Angels & VC FundsInvestment Pricing & StructuringSummary i2E Capital FundsFunding Innovation: Risk Capital Markets2

Idea or Business?

Were selling $100,000 shares in an idea we plan to have after raising enough capital to think about it.Unfortunately, many business executives or founders believe capital can be accessed at the idea stage. Innovation or early stage investors dont fund ideas, they FUND the execution of business principals or activities within a WELL DEFINED plan of action. Investors absolutely want to know how their money will be spent AND the targeted business performance outcomes, which need to successfully lower the risk associated with securing the next near-term round of risk capital financing. Again, risk capital investors fund execution not ideas. Its the plan wrapped around an innovative idea. Funding Innovation: Commercialization Stage ConceptBench scale/prototypePre-SeedPrototype/Beta customersSeedSales/Business InfrastructureEarlyExpanding Sales ChannelsGrowthProfitability/High growthMatureQuarter over Quarter ProfitabilityJust like the more traditional financial capital markets for existing businesses, which have a large variety of financial funding products with varying risk adjusted interest rates such as Accounts Receivable and Inventory revolving credit lines, term Equipment loans, long-term mortgages for buildings, etc., the high risk capital markets have a similar but smaller variety of financing structures however the cost of this capital varies much more substantially and is dependent upon the stage of commercialization. The earlier in the innovation cycle the higher the cost. While unfortunately there is some variance in names, general the various generic stages of commercialization can be categorized in this manner obviously from highest risk to lowest. The majority of the traditional capital market options are not available to a business until it reaches the Mature phase. 4Innovation Capital: The Valley of Death

AngelsSeed FundsVenture CapitalGRANTSAccel-eratorsSuper AngelsIronically, whether the innovation of a new product/service occurs in a new startup business or existing company, the funding risk and path is similar. Every new innovative product/service offering requires the product/service be fully developed first. You have to first complete the product/service research, build a bench scale prototype, test the innovative concept for BOTH performance AND customer fit or benefits, design ability to scale product/service, identify customers, identify sales channels, create the beginnings of a business infrastructure, etc. Therefore obviously the development of ANY new innovative product/service requires CAPITAL investment given cash expenditures precede even initial first revenues. In the risk capital markets, we refer to this as the Valley of Death. The larger these aggregate upfront expenditures are the deeper the Valley of Death goes and therefore the larger the capital requirements. This valley continues to decline until first revenues start, which ONLY serves to slow the decline. The new product/service must continue to raise capital until the new innovative offering reaches financial breakeven. It is only upon reaching this point that the curve begins to improve. The length of time to navigate across the Valley of Death can very substantially based upon the new innovative product/service offering. The deeper and the longer the Valley of Death the greater the financial risk and therefore the higher the capital costs. 5Yrs-Exit Typical Stage IRR Target ROI 6 Concept/Pre-Seed 66% 21.0 5 Seed 60% 10.5 4 Early 53% 5.5 3 Growth 47% 3.2 Source: Business Angels, Robert KeeleyInvestor: Expected Rates of ReturnBy traditional financial capital market costs, the costs of risk capital appears to be extremely high. The BIG difference is unfortunately the reality is most new innovative product/service offerings fail in the market. For example, typically for a Pre-Seed Venture Fund 4 to 6 out of every 10 investments will fail. Therefore, the few successful investments have to be significant in order to provide an adequate OVERALL portfolio return. While the IRR is listed for a reference basis, the various risk capital market investors traditional think or price capital in terms of an ROI multiple. This is just one published source, but the generalized magnitude or ROI representation is accurate, which at least provides you a data set for client discussions. While oriented towards a startup, this numbers are still indirectly applicable for an existing business electing to fund a new innovation product/service expansion as a means to internal evaluate the internal corporate risk adjusted allocation cost of capital. 6

Innovation Valuation/Total Investment Compatibility Analysis

Given this generalization of the risk market cost of capital, we strongly recommend the simple above back of the envelope approach to quickly assess the financial viability of the overall startup or innovation project. Leveraging the previous targeted risk capital market investor targeted ROI, rounded for calculation simplicity, you can quickly sum the aggregate risk capital investors targeted return expectations across the entire financially forecasted capital path. The above theoretical business will require a total of $1.6 million in three sequentially staged investment rounds over the next three years. The first $100 thousand expect a 25X, which requires a $2.5 million aggregate return, the next round of Angel investors invest $500 thousand and expect a 20X gain, or $10 million, and the last Seed Venture Capital investor invests $1.0 million and expects a 5X, or needs to receive $10 million. Therefore, the new innovative business MUST at least be able to create a total of $22.5 million in market value creation in order to attract the necessary risk capital in order to embark on the business opportunity. As their financial advisor this provides you a methodology to quickly assess the risk of attracting the necessary capital, as you can assess the probability of the business to exceed this minimally required value. In this example, based upon the startup companys or projects financial modeling can the value exceed this requirement. This is analogous to a more sophisticated Net Present Value computation, but is faster and easier to understand. If the business opportunity passes this back of the envelope test, then you have to find the appropriate risk capital source for the stage of the commercialization.

7US$ 17.60 billion~57,000 deals35% seed/startup47% early stage15% expansion capitalApprox. 259,500 individualsAngel Investors 2009US$ 17.69 billion~2,800 deals9% seed/startup26% early stage65% later/expansion capitalTotal 794 firms (not all active)Venture Capital 2009Investment StageUS$ MillionsEarly Stage Funding ProfileMost business executives and even financial professionals are surprised that in aggregate Angel investors invest the same amount of capital as the entire Venture Capital industry. While the above data is slightly dated, it is still representative of the risk capital markets. Note, that Angels and Venture Capitalist BOTH invested $17 billion in capital, but that is where the resemblances end. The average Angel investment is $309 thousand whereas the average VC deal is $6.3 million. There are 327 Angels per every VC. At the above SEED stage, Angels invested the $6.16 million in 20,029 investment whereas the VCs invested in only 309 deals. Obviously, Angels tend to invest much earlier than Venture Capitalist. Therefore, advise your clients that are seeking early stage capital, typically in amounts less than $2 million, to aggressively concentrate on Angel investors not Venture Capitalist. The stage of commercialization greatly influences the SOURCE of risk capital. 8Mission: Support the growth, financial stability, and investment success of its member angel groups and their investors

325+ angel groups10,000+ investors20 affiliates49 states/provinces

Angel Capital AssociationJust over ten years ago, there were less than 50 organized Angel Capital groups and today there are over 325 groups operating a national trade association, the Angel Capital Association. Ironically, and to everyones surprise the ACA is based not on the east or west coast, but is located in Kansas City. The typical Angel group has 40 to 50 members. Over this last decade, the Angel capital markets have begun to organize, adopt more standardized best practices, and now even syndicate investment transaction in order to dramatically increase potential investment round amounts. This resulting market sophistication and even consolidation is GOOD for entrepreneurs which allows need capital. Relatively larger numbers of Angel investors can be accessed in a single meeting saving valuable time. Investment terms are more consistent enabling regional syndication enabling larger investment rounds and lowering subsequent follow-on risk. Therefore, a great referral source for your clients is the ACA website, which is www.angelcapitalassociation.com. The site contains a