Financing the Entrepreneurial Venture: A Casebook

Financing the Entrepreneurial Venture

Financing the Entrepreneurial Venture

A Casebook

Paul A. Gompers

Anthem Press

An imprint of Wimbledon Publishing Company

www.anthempress.com

This edition first published in UK and USA 2024

by ANTHEM PRESS

75–76 Blackfriars Road, London SE1 8HA, UK

or PO Box 9779, London SW19 7ZG, UK

and

244 Madison Ave #116, New York, NY 10016, USA

© 2024 Paul A. Gompers

The author asserts the moral right to be identified as the author of this work.

All rights reserved. Without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored or introduced into a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of both the copyright owner and the above publisher of this book.

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library.

Library of Congress Cataloging-in-Publication Data: 2023923836

A catalog record for this book has been requested.

ISBN-13: 978-1-83999-148-6 (Hbk)

ISBN-10: 1-83999-148-8 (Hbk)

This title is also available as an e-book.

CONTENTS

Acknowledgments

Section 1: Introduction

1.1 Introduction to Entrepreneurial Finance – 2020: Course Overview Note

1.2 Entrepreneurial Finance Vignettes: 2022

Section 2: Defining the Entrepreneurial Business Model and Cash Flow Implications

2.1 Simplifyy

2.2 Evaluating Start Up Ventures

2.3 SRS and the Defense Innovation Unit: Rethinking Procurement

2.4 Loma Vista Medical

2.5 Vueling Airlines

2.6 Ginkgo Bioworks: The Cell as a Factory

Section 3: Valuation in Entrepreneurial Settings

3.1 Car Wash Partners, Inc.: Paul Gompers

3.2 Valuation in Entrepreneurial Settings

3.3 United Capital Partners (A)

3.4 Valuation in Emerging Markets

Section 4: Financing the Entrepreneurial Venture

4.1 Panoramic Power

4.2 Honest Tea

4.3 Tutor Time (B)

4.4 A Note on Franchising (Abridged)

4.5 Hudson Manufacturing Company

4.6 EyeControl: Inspiring Communication

4.7 WeWork - November 2018

Section 5: Gender and Diversity in Entrepreneurship

5.1 Aspect Ventures

5.2 CashDrop (A)

5.3 CashDrop (B1)

5.4 CashDrop (B2)

5.5 Ghia and Cleo Capital

5.6 Convertible Notes in Seed Financings

Section 6: Entrepreneurial Finance in Emerging Markets

6.1 Pakistan Rising: Bazaar’s Growth Story (A)

6.2 Nykaa.com: A Passion for Beauty

6.3 ICSGroup

6.4 New York Bagel: Hungary, April 1994

Section 7: Harvesting

7.1 Celtel International B.V.

7.2 Entrepreneurial Exits

7.3 Knoll Furniture: Going Public

7.4 Globant: Going Public

7.5 Luminar and the Rise of SPACs

Index

ACKNOWLEDGMENTS

Over the course of my academic career, entrepreneurial firms have been at the center of my research and teaching. During this period, I have written more than 100 case studies and more than 50 notes that knit together the insights of that career. This book represents the combination of my research and writings that I hope can provide foundational insights to entrepreneurs and investors.

The implications of this research are wide-ranging. For entrepreneurs, understanding the nuances of venture capital financing, governance mechanisms, and the broader financial landscape can be crucial for success. For venture capitalists and other investors, my findings offer strategies for investment and portfolio management, emphasizing the importance of active involvement in guiding portfolio companies. For policymakers, the insights highlight the significance of creating a favorable regulatory and economic environment that supports innovation, entrepreneurship, and the flow of venture capital.

The decade of the 2010s has been called an entrepreneurial decade because many new products and services were introduced by new and fast-growing companies. The number of start-ups exploded and entrepreneurial ecosystems sprang up around the world. And while it is true that employment growth in small firms fueled nearly all job creation over the past decade and a half, the real nature of entrepreneurship can only be understood within the context of the global opportunity that entrepreneurial firms will continue to drive.

This book would not have been possible without the advice and mentorship of colleagues, including Andrei Shleifer, Richard Ruback, and Bill Sahlman. More than 30 years ago, these three scholars guided me on this path. My many coauthors over the years have also been a constant source of inspiration and motivation. Josh Lerner, Andrew Metrick, Steve Kaplan, Alon Brav, Joy Ishii, David Scharfstein, Anna Kovner, Malcolm Baker, Henry Chen, Vladimir Mukharlyamov, Sophie Calder-Wang, Kevin Huang, Ilya Strebulaev, Will Gornall, Natee Amornsiripanitch, George Hu, and Will Levinson deserve special acknowledgment.

I also need to thank more than a dozen research associates who have helped in the writing of these cases, traveling everywhere to interview entrepreneurs and investors. Their names appear as coauthors on these case studies, and they all deserve tremendous credit. Additionally, more than 100 case protagonists were willing to share their life’s journey to educate the next generation of founders and venture capitalists. I have always been amazed at how open and candid these individuals are. They have formed the backbone of the lessons in this book.

Finally, my family has been a constant source of support, always willing to engage in discussions of ideas that affect the world. Jody Dushay, my wife, and my three daughters—Sivan, Annika, and Zoe—have always been there and encouraged me to dig deeper. I could not have completed this book without their constant presence in my life.

Section 1

Introduction

Chapter 1.1

Introduction to Entrepreneurial Finance – 2020: Course Overview Note

Paul Gompers

This note presents an overview of the structure and material that will be covered in Entrepreneurial Finance. In addition to presenting the outline and themes of the course, this note provides resources from the academic literature to use as reference material. The listing of articles, while not exhaustive, covers a broad range of topics in entrepreneurial finance at various technical levels.

When looking through the course description, many of you may have asked, What is entrepreneurial finance? The best way to understand it is to define the individual terms. Finance is easier to define. Finance is the study of value and resource allocation. Cash is central to any working definition of finance. The value of any cash stream is influenced by its magnitude, timing, and riskiness. Finance is also concerned with the cost of capital and determining the least expensive source of funds for an investment project. This issue is especially important for start-up and growing firms that may face internal financial constraints and have different costs of debt and equity capital.

Entrepreneurship has had many definitions over the past two and one half centuries since Richard Cantillon first used the term in the early 18th century. Some have focused on the risk-bearing nature of entrepreneurship, while others have focused on the innovations that entrepreneurs create. Both are important elements of what entrepreneurs do, but neither is entrepreneurship. Entrepreneurship focuses on a way of thinking, managing a career, business, or anything else. While most of us associate entrepreneurship with small, startup companies, large firms can also be entrepreneurial. The important element of entrepreneurship is the relentless pursuit of opportunity without regard to resources currently controlled.¹

Entrepreneurial Finance will focus on financial management within entrepreneurial firms. Most of these will be young firms, although some are more established. The course will examine these firms at all phases of their life cycle, from the initial idea generation to the ultimate harvesting of the venture. The course will cover firms in a diverse set of industries including high technology, low technology, and services. A significant fraction of the cases will focus on non-U.S. ventures.

Financial management in entrepreneurial firms entails understanding both sides of the balance sheet. Consequently, we will look at issues related to both sides as well. The first section of the course will explore how to evaluate entrepreneurial business opportunities, i.e., the asset side of the balance sheet. The skills necessary to make good investment decisions include developing a framework of analysis for business opportunities. The process also entails reinforcing and enhancing valuation skills. With these tools, you will be able to qualitatively and quantitatively assess markets and opportunities.

The second section of the course examines how entrepreneurial investments are financed. An emphasis will be placed on understanding financial institutions and deal terms. We then examine how entrepreneurial firms which have succeeded need to continually finance the scaling of their operations. What are the financial issues that affect this types of firms? How do the sources and terms of financing change? This transition to the second product or opportunity is often the most difficult time for the entrepreneurial enterprise. The course then concludes with an examination of harvesting. Unless an entrepreneur plans for the future realization on investment, he or she could get left holding the bag with little value having been created.

Finally, we will make use of notes throughout the course. These notes provide background information about industry facts and figures. They are meant to be references that you can use often, both during the course and as you start your venture.

Module 1: Identification of Opportunity

The first module explores the structural model of entrepreneurship. We will use it as a framework for evaluation. The behavioral model defines entrepreneurship as the pursuit of opportunity without regard to resources currently controlled.² The four stages of entrepreneurship include: identifying opportunities; acquiring the financial, professional, and productive resources to exploit the opportunity; implementing a plan of action; and harvesting the rewards.³ Entrepreneurship should not, however, be seen as a linear process. True entrepreneurship involves any or all the elements at any one particular time and should be viewed as a constantly repeating cycle.

William Sahlman had developed a framework that identifies four critical success factors for entrepreneurial ventures: people, opportunity, deal, and context.⁴ The cases in this course are selected to highlight how these various factors influence success and failure for firms in various industries. Each element is dynamic and can change over time, and the entrepreneur must constantly reevaluate the four factors that are critical to entrepreneurial value creation. Three questions can help center your analysis as you go forward:

What can go right?

What can go wrong?

What actions can be taken to increase the probability that things will go right or minimize the chances that things will go wrong?

People

An important task in each case is to identify the key players. What is their experience? How does this experience prepare or not prepare them for the opportunity that exists? What are the strengths and weaknesses of the people involved on all sides of the transaction? Are there key individuals that the company should add or replace?

Opportunity

The opportunity that arises may be a new product or service, a new method of delivery, or a new production technique that provides a cost advantage. The entrepreneur must answer many questions before he or she commits to the venture. What is the nature of the opportunity? Is there a sustainable competitive advantage or is the idea easily replicated? Must the opportunity be exploited immediately or is there the possibility of delaying investment until further information is available? Are there intermediate milestones that can be used to assess the success of the project?

Deal

Once the people and opportunity pass some litmus test, a proper deal just be structured. Throwing money at good projects and good people will not guarantee success. Incentives and contingencies are important considerations. The proper deal structure can minimize moral hazard and adverse selection problems. From whom should the firm raise money: wealthy individuals (angels), banks, venture capitalists? What is the proper financing instrument: debt, equity, convertible securities, or a combination? Is a no-compete clause important? Can the deal create stakeholders that increase the probability of success? Who bears the downside (upside) risk?

Context

Often the most difficult part of the analysis is identifying contextual issues that are relevant to the success or failure of the project. Potential competitors may not be easily identified, but will always be waiting to enter potentially profitable markets. The government is important because regulations and restrictions can aid or harm the firm’s profitability. The entrepreneur must attempt to forecast what policies the government might pursue in response to political pressure. The opening of markets and the collapse of foreign regimes may be important in creating a favorable environment for new ideas. Economic conditions and trends will also influence a particular market and should be analyzed and understood.

The Concept of FIT

While most of the analysis may be divided into the four areas discussed above, it is important to understand the big picture. In other words, how do the four elements relate to each other? Do the people have the requisite skills and experience to exploit the opportunity? Does the deal provide the proper incentive to all players given the necessity of their input and the level of their skills? Will the context change the nature of the opportunity?

Module 2: Valuation

The second module of the course will address valuation techniques. Value is one of the fundamental concepts of finance and should be familiar to you from your first year. To make proper investment decisions, it is always necessary to undertake a valuation. Stating that the uncertainty is too great to value a given project or company misses the point. Uncertainty affects the distribution of possible values, not the ability to undertake a valuation. Valuation in finance is a way to ask the right questions and understand what important assumptions determine the ultimate value. In fact, if the range of potential outcomes is quite high, i.e., there is high uncertainty, a thorough valuation can give information about when to invest, when to discontinue a project, or when to investigate further. The sole purpose of valuation is not the production of a single number.

The first set of valuation problems are discounted cash flow valuation models. While we discuss various discounted cash flow models, under the right assumptions, they should all give similar answers. The most important lesson is to fully understand the assumptions made in the process. We analyze discounted cash flow models in the case of both mature leveraged buyout situations as well as young, startup ventures. The analysis emphasizes both the strengths and weaknesses of such models. In fact, for many young firms, simple discounted cash flow models can give misleading values.

We will explore issues of valuation that are specific to entrepreneurial firms. First, our common models of valuation assume that the person performing the valuation is a diversified investor, i.e., they hold the market portfolio. In that setting, they only care about systematic risk because idiosyncratic risk is diversified away. That is almost universally not true for an entrepreneur. Their entire wealth is likely tied up in their company. This lack of diversification means that traditional cost of capital approaches used for assessing discount rates are wholly inappropriate. Entrepreneurial finance will explore how we need to adjust those approaches to deal with the reality of entrepreneurs whose entire wealth may be tied up in their ventures.

Entrepreneurial finance will also explore other sources of risk that may need to be considered in valuing a company. Emerging markets have become hot beds of entrepreneurship. Country-specific sources of risk need to be examined and, in specific circumstances, included in the calculation of discount rates. We will explore the foundations for adjustments to discount rates that stem from an entrepreneurial firm operating in an emerging market.

Those of you have worked in the venture capital world know that few venture capitalists use typical discounted cash flow analysis. The relationship between the DCF methods that you learn in finance and the hurdle rate approaches used by venture capital practitioners is important to understand. We will draw a connection between both methods to assess value and how such industry rules of thumb are employed.

The shortcomings of standard discounted cash flow models often stem the inability to account real option value. Many projects have embedded optionality. A project that requires a small investment today to allow for information gathering and a possible future investment is like a financial option. The ability to delay investment until the acquisition of more information is a real option. The ability to halt a project creates an option to abandon. The payoff curve is similar to a call option where the only downside is the price of the option, but the upside is substantial. If the entrepreneur does not understand the value of these options, he or she may make improper investment decisions.

Entrepreneurial Finance will also examine real options in entrepreneurial firms. We will discuss their importance in the decisions of young, emerging companies. The course will develop tractable methods to deal with real option value and use it in the planning and structuring of investments.

Module 3: Financing the Entrepreneurial Firm

Once the entrepreneur identifies an investment opportunity, a financing strategy needs to be outlined. The opportunity may be a new firm, a new project, an expansion of a plant, or even the hiring of new employees. Any of these types of investments present particular financing problems. An entrepreneur who cannot raise the required resources will not succeed. A firm needs cash to survive.

Discussion will identify financial institutions and players that actively provide resources to entrepreneurial firms. We will also examine the nature of contracting between investors and entrepreneurial firms. Understanding the terms and conditions of financing is important for all entrepreneurs to determine payoffs and incentives. Similarly, terms and conditions determine who controls the firm under various circumstances. Control rights such as board membership, information rights, covenants and restrictions are often employed in the financing of entrepreneurial firms. Careful crafting of the financing document often increases the likelihood of success. Various factors drive firms to seek capital from a multitude of capital providers. Four primary factors that influence the source of funds can be identified.

The Four Factors

Uncertainty is a measure of the array of potential outcomes for a company or project. The greater the uncertainty, the wider the dispersion of potential outcomes. By their very nature, young companies are associated with significant levels of uncertainty. Uncertainty may exist about whether the research program or new product will succeed. Uncertainty may also exist about the response of rival firms to the introduction of a new product. High uncertainty means that investors and entrepreneurs cannot confidently predict how the firm will perform, what investment opportunities the company will identify, or what resources the firm will require.

Uncertainty affects the willingness of investors to contribute capital, the desire of suppliers to extend credit, and the decisions of a firm’s manager. If managers are risk averse, it may be difficult to induce them to make the right decisions. Conversely, if entrepreneurs are overoptimistic, then investors want to curtail various actions. Uncertainty and the revelation of new information also affect the timing of investment. Should an investor contribute all the capital at the beginning or should he stage the investment through time? Investors need to know how information-gathering activities can address these concerns and when to undertake them.

Asymmetric information is distinct from uncertainty. Due to her day-to-day involvement with the firm, an entrepreneur knows more about her company’s prospects than investors, suppliers, or strategic partners. Similarly, investors may know more about their resources or ability to add value than the entrepreneur. Various problems develop in settings where asymmetric information is prevalent. Moral hazard can result when the entrepreneur takes potentially detrimental actions that investors cannot observe. For example, the entrepreneur may undertake a riskier strategy than initially suggested or may not work as hard as the investor expects. The entrepreneur might also invest in projects that build up her reputation at the investors’ expense.

Asymmetric information can also lead to adverse selection problems when the entrepreneur knows more about the project or his abilities than investors do. Investors may find it difficult to distinguish between competent entrepreneurs and incompetent ones. Without the ability to screen out unacceptable projects and entrepreneurs, investors are unable to make efficient and appropriate decisions.

The third factor dynamically affecting a firm’s corporate and financial strategy is the nature of its assets. Firms that have tangible assets—e.g., machines, buildings, land, or physical inventory—may find financing easier to obtain or may be able to obtain more favorable terms. The ability to abscond with the firm’s source of value is more difficult when it relies on physical assets. When the most important assets are intangible, such as trade secrets, raising outside financing is often more challenging.

Market conditions also play a key role in shaping a firm’s evolution. The supply of capital from public and private investors and the price at which this capital is available may vary dramatically. These changes may be a response to regulatory edicts or shifts in investors’ perceptions of future profitability. Similarly, the nature of product markets may vary dramatically due to shifts in the intensity of competition or in the nature of the customers.

The ability of young companies to grow rapidly and respond swiftly to the changing competitive environment is a key source of competitive advantage, but also a major problem for those who provide resources to these firms. The key characteristics of the firm—uncertainty, asymmetric information, the nature of its assets, and market conditions—will change dramatically over time. Because the firm may be different in the future, investors and entrepreneurs need to be able to anticipate change.

The combination of case studies and notes in this course develops recommendations for optimal capital raising and ownership structures in entrepreneurial firms. The materials demonstrate that careful crafting of financing strategies and contracts can alleviate many potential roadblocks. For instance, the best source of capital is not always obvious. Each source may be appropriate for a firm at different points in its life. The various factors identified above play a critical role in determining the optimal decision.

In addition, the form of financing (e.g., debt, equity, or convertible security) plays a critical role in reducing potential conflicts. Financing can be simple debt or equity, or involve hybrid securities like convertible preferred equity or convertible debt. These financial structures can potentially screen out overconfident or under-qualified entrepreneurs because they have very different payoffs for the entrepreneur in good and bad outcomes. The structure and timing of financing can also reduce the impact of uncertainty on future returns.

Another important element is the division of the profits between entrepreneurs and investors. Compensation contracts can be written that align the incentives of managers and investors. Incentive compensation can be in the form of cash, stock, or options. Performance can be tied to several measures and compared to various benchmarks. Carefully designed incentive schemes can avert destructive behavior.

Firms can also alter the nature of their assets and thus obtain greater financial flexibility. Patents, trademarks, and copyrights are all mechanisms to protect firm assets. Understanding the advantages and limitations of various forms of intellectual property protection, and coordinating financial and intellectual property strategies are essential to ensuring a young firm’s growth. Firms can also affect the nature of their assets through strategic decisions, such as encouraging the creation of a set of locked-in users who rely on its products.

Monitoring and evaluation are also critical elements of the relationship between entrepreneurs and investors. Both parties must ensure that proper actions are taken and that appropriate progress is being made. Critical control mechanisms--e.g., active and qualified boards of directors, the right to approve important decisions, and the ability to fire and recruit key managers--need to be effectively allocated in any relationship between an entrepreneur and investors. By examining theory and evidence, this course makes both descriptive and prescriptive comments on the effective use of monitoring, evaluation, and control.

Module 4: Financing the Scaling Venture

In the fourth module of the course, we discuss the financing issues that scaling ventures face. The issues that these firms face differ from those that early stage ventures must deal with. First, the ecosystem of late stage investors has rapidly changed in recent years. These investors are often driven by the desire to deploy capital that can affect the late stage valuations. Such cycles in late stage financing can affect the underlying discipline and strategy of the firms raising that capital. For example, the time to exit has increased markedly as the availability of late stage financing has expanded. Similarly, the focus on achieving profitability may be adversely affected by firms that are flush with cash.

We will examine the types of investors approached and types of strategies followed by late scaling ventures. Industry and geographic considerations will be a key element of this module. Finally, we will assess the value implications of terms in this late stage rounds for the implied valuations of scaling companies. Terms like preferences and ratchets can dramatically affect that total implied enterprise value in late stage rounds. We will develop methods to analytically (and intuitively) adjust the post-money valuations for the myriad terms in late stage financing rounds.

Module 5: Harvesting the Entrepreneurial Venture

Every entrepreneur needs to consider harvesting at some point. Harvesting can take many forms. Successfully planning for harvesting of the entrepreneurial venture is critical to maximizing the value of your input. We will explore various modes of harvesting like initial public offerings (IPOs) and acquisitions. The emphasis is on assessing whether the entrepreneurial firm is ready for harvesting. In addition, we will emphasize the structural, legal, and dynamic issues of various modes of harvest.

The public markets are a significant source of capital for emerging companies. For many firms, accessing the public market is just the next phase of their dynamic capital process. For others, it represents the beginning of the ability to receive the fruits of their labors. We explore the various motivations for going public and the advantages and disadvantages of being a public company. Structural and legal issues will be discussed. In addition, we explore the impact that the cyclical nature of the initial public offering market has on firms’ access to capital. The role of various intermediaries will be examined and the motivations of various parties discussed.

The course then covers acquisitions. Most firms will never be large enough for the public market and will therefore need to find one specific buyer. The ability to find the best buyer and negotiate the best deal terms of the deal for the entrepreneur is critical. We emphasize the role of bargaining and auctions in the context of acquisitions. The motivations of buyers and sellers must be understood to ensure the conclusion of a successful deal.

Finally, we will explore how to shut down a venture that has not met milestones and will run out of cash. Liquidating failing ventures is a common occurrence, even for venture capital-financed firms. At least 50% of venture capital-backed companies fail. Failure rates for angel-backed and boot-strapped are even higher. The process of liquidation is critical to maintaining ones reputation in the face of company failure.

Conclusion

Entrepreneurial Finance is a course that examines the issues confronting entrepreneurial firms at all stages of their existence. The course presents various frameworks and builds new skills needed to identify important business ideas, raise and structure financing, and ultimately harvest the project. The knowledge and skills learned are invaluable for all students, whether they find a job in an entrepreneurial enterprise, a fund that finances entrepreneurial companies, work in a traditional firm, or start a company of their own.

Notes

1 Howard H. Stevenson and William A. Sahlman, The Importance of Entrepreneurship, Entrepreneurship, Intrapreneurship, and Venture Capital, (Robert D. Hisrich, ed.), Lexington books; Lexington, MA (1986). 2 Ibid. 3 William A. Sahlman, Entrepreneurial Finance, Harvard Business School Case No. 288-004 (1987). 4 Ibid.

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Chapter 1.2

Entrepreneurial Finance Vignettes: 2022

Paul Gompers

Brooklyn Bagel: Hungary April 2014¹

Gathered in the vaulted cellar office of Brooklyn Bagel (BB) shop in Budapest, Taylor and his staff were jubilant, having posted another day of record revenue. His partner, Sara Cohen, was meanwhile meeting with contractors at the site of BB’s upcoming 3,000 square foot shop. Taylor, Co-founder and Co-CEO of BB, stepped over to his fax machine and read line by line the incoming term sheet. This was the last round of a long-negotiated deal with Spartan-Hungary Ventures (SHV), that Taylor and Cohen hoped would finally help them realize their dream of a multi-unit chain of bagel shops. The terms from the venture capital fund were much worse than he had expected.

Taylor had to once again remind himself where the business stood. Their first shop, despite its out of the way location, experienced a growing base of regular customers, not to mention a flurry of local and international press intrigued by the reintroduction of bagels to Hungary after centuries of absence. He and his partner realized that the fixed costs of pioneering the market could not be recouped in a single store, so they prepared for expansion, which included installing multi-unit retail systems, building a real estate development team, and securing a lease on a prime urban location. These measures were complete; all the partners needed was capital to finance the expansion.

However, cash was a serious problem. Until the new store opened, the business would continue to post operating losses. Taylor had not paid himself a salary for the past three months, and funds trickling in from the US, thanks to the fund raising efforts of their third partner, Tomas Szabo, would not last long. Taylor and Cohen would have to raise institutional money if they wanted to survive.

Project Bagel

John Taylor and Sara Cohen became friends as students in the Class of 1999 at Swarthmore College. Taylor, with a degree in Economics, went into investment banking where he was initially an analyst, then moved to a marketing and operations function. Cohen, after a year at a boutique M&A firm, decided to go to law school, where he met Tomas Szabo, a second generation Hungarian-American who had worked for an investment bank in Budapest.

When the allure of corporate life lost its glow in 2012, the three decided to explore opportunities in Eastern Europe. The bagel business was chosen for several reasons. The partners figured that the bagel’s reputation for healthiness and freshness would set it apart from the other fast food concepts and traditional Hungarian cuisine, which often called for fat-laden goose lard. They also had a sense of bringing the bagel home. Folklore suggests that the bagel was developed in the Austro-Hungarian Empire in 1683 to celebrate the banishment of the despised Turks. The round-shaped bread with the hole in the middle was named after the stirrups of the victorious cavalry; the German word for stirrup is bugel. Fortunately, the word had dropped out of the Hungarian language, enabling the partners to trademark the word bagel in Hungary. The large captive market of American expatriates in the Hungarian capital, longing for the tastes of home, would also provide an initial customer base.

The decision to open a bagel store in Budapest - Project Bagel - had come about quickly. Taylor, Cohen, and Szabo had already collected some money into a fund to search for opportunities in Hungary. In order to reach the initial starting capital of $200,000 projected for opening a bagel shop, the partners raised capital from individuals in the United States, mostly family and friends. Recognizing the comfort for investors of investing in a U.S. company, the partners set up a Delaware-based holding company, Brooklyn Brookside Ventures, Inc., which would own 100% of Brooklyn Bagel Corp. in Hungary. This way, investors would be protected by U.S. laws.

Driven to acquire hands-on experience of the bagel business, Taylor took several part-time jobs at bagel stores in the Boston area while still at Lehman Brothers. His new employers were suspicious, noticing that Taylor showed up to work in a suit and tie before changing to perform the nightly cleanup. On weekends, his responsibilities alternated between tending the bagel boiler, cleaning, and serving customers. Once Taylor announced his departure plans, though, his boss was supportive and even invested personally in the bagel venture.

What’s a Bagel?

The first store was launched in June 2013. Taylor and Cohen considered this first store their beta-test! Everything was brand new to the Hungarian employees, customers, and the American owners. To create a concept we had to jump through eighteen regulatory hoops and spent extensive time training staff to adopt a ‘customer first’ attitude. Even with Taylor’s bagel experience, the partners felt that they needed an expert at the helm, at least in the start-up stage of the store. Stuart Kaplan, whose family had been making bagels in New Jersey for three generations, went to Hungary to help start the company. His services entitled him to buy shares in BB at a discounted price.

Revenues for the first store were between $13,000 and $20,000 per month. (see Exhibits 1-2) Despite the enthusiasm which greeted the bagel enterprise, operational losses for the first six months were approximately $10-20,000 per month. A number of factors contributed to the losses. For one, BB employed a full-time purchasing manager and two people responsible for new store development. The partners figured that they needed a core group of employees willing to work long hours to get the business off the ground. Fortunately, the BB team coalesced well, resulting in a store opening in less than six months, but the partners were well aware of the cash drain of the core team, not to mention the partners’ salaries, plus the expense of installing retail management systems. If financing would not be forthcoming, Taylor and Cohen considered a no expansion scenario whereby the core team would be dismantled and Taylor and Cohen would return to the U.S.; even then the shop would have a hard time making money due to the large fixed costs of producing bagels. On the other end of the spectrum, the partners felt they had the capability and could generate sizeable returns for investors by developing a bagel production commissary serving up to 20 stores. This would lower costs by spreading the fixed costs out among as many stores as possible.

BB’s Second Store

BB started to look for second store within three months of opening the first. In September 2013 they found a location in the city’s prime office district and right across the street from a subway station packed full with commuters. In the auction for the property, BB submitted a bid of $200,000 in December 1993. Although they did not have enough capital at the time of the auction, they felt that they could not forgo the opportunity of the location. They only had $150,000 of the $400,000 they estimated was needed to pay for the rental right and refurbish the store. They also wanted to have adequate funds available to set up more stores after the second store was up and running. (see Exhibits 3-4 for store projections)

The BB bid won the auction on December 17, 2013, but the partners still did not have adequate funds to refurbish the store. Even with possession of the rental right, they could not use it as collateral for a bank loan. They wondered if they should risk investors’ money on a second store. The location of the store was critical to the success of the future chain and it would take another three to six months to find a similarly situated property, by which time the business would probably run out of cash. They did not want any further delay in opening the second store.

Financing Decisions

Taylor and Cohen looked at their options for raising more capital. They could continue to get funds from individual investors, go to institutional investors, or approach venture capital firms. They had raised $200,000 between December 2, 2013 and mid-January 2014 from several individual investors. The two partners wondered about raising institutional venture capital. The advantages of obtaining funds from venture capital firms were obvious. The partners of BB would no longer have to raise funds from individual investors, allowing them to spend more time running the company.

J2 and Oura Ring

Alex Harstrick and Jon Bronson, co-founders of J2 Ventures, an early stage venture capital firm with a focus on companies with applications in the military, looked at their investment recommendation memo for a potential investment in the series C round for Oura Ring, a fitness wearable company with a revolutionary ring capable of measuring heart rate, body temperature, resting heart rate, heart rate variability, respiratory rate, duration and timing of physical activity, calories burned, inactivity, and metabolic equivalents (METs). (See Exhibit 5 for an image of the Oura Ring wearable and Exhibit 6 for bios of Harstrick and Bronson.) The size and sophistication of the device was intriguing to Harstrick and Bronson.

Moreover, the product was attracting attention from a highly unusual confluence of users: the quantified-self community liked fidelity of data resulting from the long battery life and convenient form-factor; celebrities such as the Kardashians and Jennifer Aniston liked the aesthetic enough to provide unpaid endorsements; communities looking for patient monitoring, ranging from couples trying to conceive to the NBA to the US military, liked the medically rigorous approach the company was taking to help users monitor sleep, fertility, fitness to operate heavy machinery and, most importantly, early COVID detection. The decision they were about to make for their young venture capital firm would surely set the tone for future opportunities.

Investment Decision

Harstrick and Bronson were considering investing in Oura’s $800M series C secondary offering ($800 million post-money valuation). The company had recently raised an $80M series C led by Bedford Ridge Capital and based upon Harstrick’s relationship with the company, J2 was offered the opportunity to invest in an extension of the Series C, at the same terms as the primary offering. The investment would be part of a secondary offering of a $100M to cash out early employees and early angel investors and better position the company for growth minded investors who could help the company expand. (See Exhibit 7 for an overview of the Series C term sheet.)

Oura was founded in 2013 in Oulu Finland and had 2020 gross revenue of approximately $80 million USD. In 2020, the company employed 225 people. Oura sold a combination wearable and software application that measured human biometrics information and translated insights related to the user's sleep, activity, readiness and predictions of disease onset. Historically, the biometrics wearables space had focused on the wrist, but the company believed its patented ring form factor was clinically proven to provide superior detection through infrared LED’s. The multiple biometric markers were processed in the ring’s software application allowing for measurement and processing of information related to recovery, sleep stages and activity recommendations. The smaller size also allowed the ring to be charged in 40-80 minutes with an average battery life of five to seven days. This increased user adherence and the reliability of trending information collected. Most impressively, the average consumer satisfaction score was 91.2. Of note, the technology had been used in a number of peer-reviewed publications, including the prestigious scientific journal Nature.

Notable healthcare clients included University of California San Francisco (UCSF) with whom Oura partnered for a national COVID-19 prediction study and West Virginia Rockefeller Neuroscience Institute. Oura had also successfully reached initial deployments across the Army, Navy, Air Force and Marine Corps in a joint study sponsored by the Defense Threat Reduction Agency (DTRA) named Rapid Analysis of Threat Exposure (RATE). J2 believed there was significant interest from the DOD to expand their contracts with Oura. The company had successfully won a US Air Force Direct to Phase II SBIR and was in negotiations to provide an additional 10,000 rings to the Air Force as part of a COVID-19 response effort. Harstrick was actively guiding management through military and health insurance procurement conversations even prior to the proposed investment.

Harstrick and Bronson’s investment thesis was based upon several important considerations. First, the company had more than doubled revenue every year since 2017. (See Exhibit 8 for historical revenues.) The company had raised over $140 million across four rounds of financing (See Exhibit 9 for historical financing information.) Wearables were a $27 billion industry in 2020 and growing, with some estimates suggesting 15% growth per year through 2027². (See Exhibit 10 for an overview on the wearables market leaders.) Oura had entered into several high-profile partnerships including with the NBA, UFC, NASCAR and Redbull Racing. The company was seeing growth from diversified channels, most notably consumer, healthcare, and defense. Oura had also recently decided to move from a hardware-only revenue model to hardware + SaaS, where publicly-traded comps traded at higher multiples. With approximately $80 million USD in gross revenue last year, the post-money valuation of roughly 10x revenue LTM revenue was believed to be attractive for a company at this stage.

Conclusion

Hastrick and Bronson looked at each other and pondered the implications of their choice. They both had dreamed of establishing their own venture capital firm and now the rubber was hitting the road. Was Oura an attractive investment? Could Hastrick and Bronson add value? Were the terms reasonable? Bronson noticed his heart rate had just spiked to over 100 beats per minute. Okay, Alex, what is your vote?

Car Wash Partners³

Tom Curtis had already been a successful entrepreneur in the service industry when he proposed the investment in Car Wash Partners to Bill Burgin and Cabot Brown. Curtis received his undergraduate degree from the University of North Carolina as well as his J.D. from the University of Pennsylvania Law School and his MBA from Harvard Business School. In 1969, Curtis founded Executive Air Fleet Corporation which provided comprehensive management services for corporate aircraft around the world. In 1982 he sold Executive Air Fleet to PHH, Inc. Curtis had built the firm from no revenues in 1969 to over $50 million in sales in 1982. After the sale of his firm, Curtis taught Entrepreneurship at a well-known business school. After retiring from teaching in 1987, Curtis became an advisor to several venture capital firms and startup companies.

By 1995, however, Curtis was beginning to feel the entrepreneurial itch. He researched several ideas within the service industry before finding the opportunity to consolidate within the car wash market. As he surveyed the market, he became more convinced that the idea made sense. Over the course of 1996, Curtis visited over fifty car wash units and had started acquisition discussions with several leading car wash chains.

Car Wash Partners’ Strategy

Curtis had outlined a strategy with which he hoped to build the leading provider of car wash and related services in the U.S. Car Wash Partners would focus on the conveyor segment of the market. Curtis felt that a reputation for service excellence would be most effective in the full-service and exterior-only segments of the industry. Self-service and hand-wash units generally did not attract sufficient volumes to allow for scale economies or premium pricing.

Car Wash Partners would also focus on growth via acquisition. The construction and opening of a new exterior-only center generally took from 18 to 24 months, of which the first nine to twelve months were required to obtain the necessary governmental approvals. As such, growth through new sites would require not only large amounts of capital and real estate expertise, but it would dramatically slow the rate at which Car Wash Partners could expand.

Financial Projections

Curtis had already identified two acquisition candidates that he wished to finance using the proceeds from the offering, one in Bakersfield, CA and the other in Boise, ID. The Bakersfield company had three sites, all with detailing, merchandise, lubrication, and gas. The operations were well run and highly profitable. Similarly, the Boise, ID operations were operating smoothly, although none of the sites in Boise offered lubrication services and only one offered gasoline.

Car Wash Partners would start from modest beginnings. In 1996, Curtis projected to have only two cities in operation. (See Exhibit 11 for detailed plan on the number of planned cities and sites. Exhibits 11-14 have financial projections.) By 2000, Curtis expected Car Wash Partners to be the nation’s leading provider of car washing services with operations in 13 cities, 115 units in operation, and more than twelve millions cars washed. Curtis was convinced that these numbers were reasonable given the large and fragmented market. After all, this was less than 1% of the car wash units across the country. (See Exhibit 15 for data on public comparables and Exhibit 16 for macroeconomic data.)

With these modest assumptions, however, Car Wash Partners would grow into a substantial company. (See Exhibits 11-14 for financial projections.) If projections were met, the firm would generate more than $330 million in revenue in 2000 and earn more than $18 million after tax. Curtis’s plan, however, called for substantial investment in acquisitions as well as capital expenditure building new sites and renovating existing ones. While the company would be profitable by 1998 according to his projections, the required investments would create extremely large funding needs. (See Exhibit 14 for detailed financing plan.) Curtis’s estimate placed the required need for outside capital at $283 million. Because of the large amount of real estate and fixed assets, he believed that Car Wash Partners could take on substantial amounts of debt. He conservatively felt that the company could obtain at least half of this financing from debt, with the remaining coming from private equity.

According to his business plan, Curtis would use the small initial equity financing to acquire the properties in Bakersfield and Boise. These cities were to serve as beta sites for the firm. Once he proved the Car Wash Partners value proposition, he felt that he could attract substantial amounts of capital for the roll-up of existing operators. It was not unheard of for large private equity organizations to provide $50 to $100 million to acquire small retail and service providers. Once these small players were rolled up into a larger entity, Curtis felt the company could access the public markets to finance the remaining acquisitions. Having a public company might also allow him to provide stock instead of cash to do the acquisitions. In the interim, however, Curtis felt that he would need to finance most of the acquisition in cash. Current car wash operators had little interest holding the equity of an illiquid private company. Curtis worried, however, how he might provide the right incentives for the local partners. After all, he would be in Boston and needed local management to run the properties. Structuring the acquisitions would take some careful crafting.

Notes

1 Based upon Paul A. Gompers and Catherine Coneely, New York Bagel Harvard Business School Case 297-078. 2 Grand View Research, Wearable Technology Market Size, Share & Trends Analysis Report By Product (Wrist-Wear, Eye-Wear & Head-Wear, Foot-Wear, Neck-Wear, Body-wear), By Application, By Region, And Segment Forecasts, 2021 – 2028, October 21, 2021, https://www.grandviewresearch.com/industry-analysis/wearable-technology-market, accessed December 2021. 3 Excerpted from Gompers, Paul A. Car Wash Partners, Inc. Harvard Business School Case 299-034, February 1999.

EXHIBIT 1 Detailed Income Statement Brooklyn Bagel, Q1 2014

EXHIBIT 2 Cash Flow Statement for Brooklyn Bagel 2013-2014 (Thousands of US Dollars)