Entrepreneurial Finance

Strategy, Valuation, and Deal Structure

CONTENTS
List of Illustrations xvii
Abbreviations xxiii
Preface xxvii
Why Study Entrepreneurial Finance? xxviii
What Makes Entrepreneurial Finance Different from Corporate Finance? xxix
Interdependence between Investment and Financing Decisions
Diversifiable Risk and Investment Value
Managerial Involvement of Investors
Information Problems and Contract Design
Incentive Alignment and Contract Design
The Importance of Real Options
Harvesting the Investment
Value to the Entrepreneur
Whats New about This Book? xxxiv
Intended Audience xxxv
A Note about the Website and Internet Resources xxxvi
Simulation
Spreadsheets and Templates
Acknowledgments xxxix
About the Authors xli

PART 1 Getting Started

Chapter 1 Introduction 3
1.1

Entrepreneurship and the Entrepreneur 3

Survival and Failure Rates of New Businesses
Economic Downturns and Entrepreneurship

Globalization of Entrepreneurship
Types of Entrepreneurship
Corporate Venturing
Social Venturing
1.2

The Finance Paradigm 12

The Importance of Real Options
Objective: Maximum Value for the Entrepreneur

1.3

The Rocket Analogy 14

1.4

The Stages of New Venture Development 15

1.5

Measuring Progress with Milestones 17

1.6

Financial Performance and Stages of New Venture Development 19

1.7

The Sequence of New Venture Financing 21

1.8

The New Venture Business Plan 24

Business Plans of New Ventures Are Different
What Makes a Business Plan Convincing?

1.9

Organization of the Book 29

1.10 Summary 31
Review Questions 32
Notes 33
References and Additional Reading 34

Chapter 2 New Venture Financing: Considerations and Choices 37

2.1

Sources of New Venture Financing 37

Self, Friends, and Family
Angel Investors
Venture Capital
Asset Based Lenders
Venture Leasing
Corporate Venturing
Government Programs
Trade Credit
Factoring
Franchising

Mezzanine Capital
Nonpublic Debt
Public Debt
Private Placements of Equity and Debt
Initial Public Offering
Direct Public Offering
Later-Stage Financing Alternatives
2.2

Whats Different about Financing Social Ventures? 55

2.3

Considerations When Choosing Financing: The Organizational Form 57

2.4

Regulatory Considerations 60
What Is a Security?
Exemptions from Registration in the United States

2.5

The Deal 64
Information Problems Facing the Entrepreneur and Investors
Term Sheets and Investment Agreements
Deal Structures of Angel Investments

2.6

International Differences in Financing Options 71

2.7

Summary 73
Review Questions 74
Notes 75
References and Additional Reading 77

Chapter 3 Venture Capital 79

3.1

Development of the Venture Capital Market 80

The Investment Company Act and the SEC
The Prudent Investor Standard and the
Employee Retirement Income Security Act (ERISA)
Worldwide Growth of Venture Capital
The Changing Role of Venture Capital
Who Invests in Venture Capital Funds?
The Impact of Venture Capital on the Economy
Venture Capital and Private Equity Activity in Europe

3.2

The Organization of Venture Capital Firms 89

The Limited Partnership Structure

Waterfalls and Clawbacks
Returns to General Partners
Capital Commitments, Capital Calls, and Reputation
The Investment Process
Why Limited Partnership?
Geographic Clustering of Venture Capital Activity
3.3

How Venture Capitalists Add Value 99

Selecting Investments and Negotiating Deals
Selecting Entrepreneurs Who Are Likely to Be Successful
Changing the Management Team
Allocating Effort Efficiently
Monitoring and Advising Portfolio Companies
The Quest for Home Runs Can Result in Striking Out
Luck versus Skill: What Accounts for Venture Capital Success?
Syndication and Venture Capital

3.4

Investment Selection and Venture Capitalist Compensation 106

3.5

Venture Capital Contracts with Portfolio Companies 107

3.6

Venture Capital Contracts with Investors 109

3.7

The Role of Reputation in the Venture Capital Market 113

3.8

Reputation, Returns, and Market Volatility 114

3.9

Summary 115
Review Questions 116
Notes 117
References and Additional Reading 119

PART 2 Financial Aspects of Strategic Planning

Chapter 4 New Venture Strategy and Real Options 125
4.1

Product-Market, Financial, and Organizational Strategy 126

4.2

The Interdependence of Strategic Choices: An Example 128

4.3

What Makes a Plan or Decision Strategic? 130

4.4

Financial Strategy 131

4.5

Deciding on the Objective 132

4.6

Strategic Planning for New Ventures 134

4.7

Recognizing Real Options 137

Option Basics
Comparisons between Real and Financial Options
The Real Option Premium

4.8

Strategic Planning and Decision Trees 141

Building and Pruning Decision Trees
An Illustration
Evaluating the Venture as an Accept/Reject Decision
The Learning Option
The Expansion Option
The Abandonment Option

4.9

Rival Reactions and Game Trees 151

An Illustration
Nash Equilibrium
Games Entrepreneurs Play

4.10 Strategic Flexibility versus Strategic Commitment 155

4.11 Strategic Planning and the Business Plan 156
4.12 Summary 157
Review Questions 157
Notes 158
References and Additional Reading 160

Chapter 5 Developing Business Strategy Using Simulation 162

5.1

Use of Simulation in Business Planning: An Example 163

5.2

Who Relies on Simulation? 165

5.3

Simulation in New Venture Finance 166

5.4

Simulation: An Illustration 167

5.5

Simulating the Value of an Option 171

5.6

Describing Risk 173

5.7

Using Simulation to Evaluate a Strategy 176

Step 1: Identifying Strategic Alternatives

Step 2: Choosing Evaluation Criteria

Step 3: Modeling the Problem
Step 4: Specifying the Assumptions and Describing the Uncertainty
Step 5: Running the Simulation
Step 6: Analyzing the Results
5.8

Comparing Strategic Choices 187

The Option to Abandon
The Learning Option
The Expansion Option

5.9

Summary 198
Review Questions 198
Notes 199
References and Additional Reading 200

PART 3 Financial Forecasting and Assessing Financial Needs

Chapter 6 Methods of Financial Forecasting: Revenue 205
6.1

Principles of Financial Forecasting 206

6.2

Forecasting Revenue 207

Forecasting the Revenue of an Established Business
Forecasting Revenue of a New Venture
Demand and Supply Considerations

6.3

Estimating Uncertainty 222

Assessing Risk Using Historical Data
Sensitivity Analysis
Developing Alternative Scenarios
Incorporating Uncertainty with Simulation

6.4

Building a New Venture Revenue Forecast: An Illustration 225

6.5

Introducing Uncertainty to the Forecast: Continuing the Illustration 228

Sensitivity Analysis
Scenario Analysis
Simulation

6.6

Calibrating the Development Timing Assumption:

An Example 236
6.7

Summary 239
Review Questions 240
Notes 241
References and Additional Reading 242

Chapter 7 Methods of Financial Forecasting: Integrated Financial Modeling 243

7.1

An Overview of Financial Statements 244

7.2

The Cash Conversion Cycle 248

7.3

Working Capital, Growth, and Financial Needs 251

Working Capital Financing
Working Capital Policy

7.4

Developing Assumptions for the Financial Model 256

Information Sources
Using Industry Data and SEC Filings to Develop Assumptions
Developing Assumptions Based on Fundamental Analysis

7.5

Building a Financial Model of the Venture 266

The Cash Flow Statement
An Illustration of Financial Statement Integration

7.6

Adding Uncertainty to the Model 277

7.7

NewCompany: Building an Integrated Financial Model 281

Modeling the Development Stage
Modeling the Start of Sales
Modeling External Funding
Achieving Profitability
Operating Cash Flow and Stable Growth
Forecasting Financing Needs
Uncertainty in the NewCompany Model
Linking Assumptions to the Financial Model
Results of the Simulation

7.8

Summary 292
Review Questions 294
Notes 295

References and Additional Reading 296

Chapter 8 Assessing Financial Needs 297

8.1

Sustainable Growth as a Starting Point 299

8.2

Assessing Financial Needs When the Desired Growth Rate

Exceeds the Sustainable Growth Rate 304

8.3

Planning for Product-Market Uncertainty 306

Planning for Success
Planning for Failure
High-Tech, High-Growth Innovation

8.4

Cash Flow Breakeven Analysis 310

An Illustration
Using Breakeven Analysis to Project Financial Needs
Present Value Breakeven Analysis

8.5

Assessing Financial Needs with Scenario Analysis 315

8.6

Assessing Financial Needs with Simulation 319

Interpreting the Simulation Results
Gauging Uncertainty and Avoiding Undue Complexity

8.7

How Much Money Does the Venture Need? 324

Using Simulation to Examine Alternative Financing Arrangements
Determining the Initial Investment

8.8

Assessing Financial Needs with Staged Investment 331

8.9

Summary 334
Review Questions 335
Notes 336
References and Additional Reading 336

PART 4 Valuation
Chapter 9 Foundations of New Venture Valuation 341
9.1

Perspectives on the Valuation of New Ventures 342

9.2

Myths about New Venture Valuation 343

Myth 1: Beauty Is in the Eye of the Beholder

Myth 2: The Future Is Anybodys Guess

Myth 3: Investors Demand Very High Rates of Return to Compensate for Risk
Myth 4: The Investor Determines the Value of the Venture
9.3

An Overview of Valuation Methods 347

The Discounted Cash Flow Method
The Relative Value Method
The Venture Capital Method
The First Chicago Method

9.4

Discounted Cash Flow Valuation 352

The Risk-Adjusted Discount Rate Approach
The Certainty Equivalent Approach

9.5

The Relative Value Method 363

An Illustration: Valuing Residential Real Estate
Relative Valuation and New Ventures

9.6

Valuation by the Venture Capital Method 367

9.7

Valuation by the First Chicago Method 369

9.8

Reconciliation with the Pricing of Options 370

9.9

Required Rates of Return for Investing in New Ventures 372

9.10 Matching Cash Flows and Discount Rates 374

Cash Flow Definitions
Consistent Discount Rates
Consistency in the Use of Continuing Value
9.11 Summary 378
Review Questions 379
Notes 380
References and Additional Reading 382

Chapter 10 Valuation in Practice 386

10.1 Criteria for Selecting a New Venture Valuation Model 386
10.2 Implementing the Continuing Value Concept 388
10.3 Implementing DCF Valuation Methods 396
Estimating the Risk-Free Rate of Interest
Estimating the Market Risk Premium

Estimating the New Venture Beta

Estimating the Components of Beta Separately
Shortcuts for Estimating Opportunity Cost of Capital
Shortcuts in the Application of DCF
Testing the Consistency of Assumptions
A Caveat
10.4 New Venture Valuation: An Illustration 412
Using the RADR Form of the CAPM
Using the CEQ Form of the CAPM
Comparing CEQ and RADR Approaches
Using the Relative Value Method
Using the Venture Capital Method
Using the First Chicago Method
10.5 The Cost of Capital for NonUS Investors 427
10.6 Summary 428
Review Questions 429
Notes 429
References and Additional Reading 430

Chapter 11 T he Entrepreneurs Perspective on Value 432

11.1 Opportunity Cost and Choosing Entrepreneurship 434
11.2 The Entrepreneur as an Underdiversified Investor 437
How Ability to Diversify Affects Cost of Capital
Factors That Offset the Entrepreneurs Cost-of-Capital Disadvantage
Defining the Entrepreneurs Commitment to a Venture
A Shortcut for Estimating Wealth and Investment
11.3 Valuing Partial-Commitment Investments 430
Using RADR to Estimate Value
Using CEQ to Estimate Value
11.4 Implementation: Partial Commitment 452
Using Simulation to Forecast Expected Cash Flow and Risk
Valuing the Venture as a Partial Commitment
Wealth, Diversification, and Venture Value

11.5 Shortcuts and Extensions 457

Shortcuts to Valuing Partial-Commitment Investments
Using Data for Public Firms to Estimate the Entrepreneurs Cost of Capital
Shortcuts for Estimating the Entrepreneurs Cost of Capital from Market Data
Valuing Ventures That Have Cash Flows in Multiple Periods
11.6 Benefits of Diversification 464
Achieving the Right Balance
11.7 A Sanity Check: The Art and Science of Investment Decisions 466
Assessing Sensitivity to Assumptions
Using and Misusing Simulation
Treatment of Sunk Costs in the Valuation
11.8 Summary 469
Review Questions 470
Notes 471
References and Additional Reading 472

PART 5 Information, Incentives, and Financial Contracting

Chapter 12 Deal Structure: Addressing Information and Incentive Problems 477
12.1 Some Preliminaries 478
12.2 Proportional Sharing of Risk and Return 479
Choosing the Scale of the Venture
Sharing Ownership in Proportion to Investment
12.3 Asymmetric Sharing of Risk and Return 481
How Shifting Risk Affects the Entrepreneur
The Investors Perspective
Risk-Allocation Contracting in Practice
12.4 Contract Choices That Allocate Expected Returns 483
The Entrepreneurs Gain from Contracting with a Well-Diversified Investor
How Much of the Entrepreneurs Wealth Should Be Invested in the Venture?
Reconciling Theory and Practice
12.5 Contract Choices That Alter Venture Returns 489
Evaluating Investment by Subsidized Investors

Evaluating Investment by Active Investors

12.6 Implementation and Negotiation 490
12.7 A Recap of Contracting with Asymmetric Attitudes toward Risk 493
12.8 Information Problems, Incentive Problems, and Financial Contracting 494
12.9 A Taxonomy of Information and Incentive Problems 495
Financial Contracting with Known Symmetrical Beliefs
Precontractual Information Problems
An Example: Adverse Selection in Capital Raising
Postcontractual Incentive Problems
An Example: Moral Hazard in Organizations
The Agency Cost of Debt Distorting the Investment Decision
12.10 Essentials of Contract Design 508
Discrete Contracting
Relational Contracting and Flexibility
Incomplete Contracts and Mechanisms for Resolving
Information and Incentive Problems
12.11 Organizational Choice 516
12.12 Summary 520
Review Questions 522
Notes 522
References and Additional Reading 525

Chapter 13 Value Creation and Contract Design 529

13.1 Staged Investment: The Venture Capital Method 530
Single-Stage Investment
Multistage Investment
Why Does Staging Reduce the Outside Ownership Share?
Determining the Required Ownership Percentage
When Follow-On Investment Is Expected
How the Capitalization of a Venture Relates to the Stage of Financing
Limitations of the Venture Capital Method
13.2 Staged Investment: CAPM Valuation with Discrete Scenarios 536
Single-Stage Venture Capital Method Valuation

Identifying the Real and Financial Options

Specifying Key Assumptions
CAPM-Based Valuation with Irrevocable Commitment to Invest
Valuing the Staged Venture at Each Investment Round
Determining the Investors Required Ownership Share
Concerns about Ownership Dilution
13.3 Valuation-Based Contracting Model 545
Designing the Investment Agreement
Dealing with Ownership Dilution
Dealing with Parties Differing Beliefs
Valuing the Entrepreneurs Claim
13.4 Negotiating to Increase Value, Signal Beliefs, and Align Interests 549
13.5 Using Simulation to Design Financial Contracts 550
Developing the Financial Model of the Venture and Specifying the Assumptions
Using Simulation to Estimate Expected Cash Flows and Risk
The Value of the Second-Stage Investment to the Investor
How the Investors Decision Affects Value to the Entrepreneur
The Value of the Investors Interest in the Venture
The Value of the Entrepreneurs Interest in the Venture
13.6 Information, Incentives, and Contract Choice 560
Valuing Different Types of Financial Claims
Increasing the Number of Contracting Parties
Contracting to Resolve Information and Incentive Problems
13.7 Summary 567
Review Questions 568
Notes 568
References and Additional Reading 569

Chapter 14 Choice of Financing 571

14.1 Financing Alternatives 571
14.2 The Objective and Basic Principles of the Financing Decision 573
Basic Considerations That Affect Financing Choices
Other Considerations That Affect Financing Choices

14.3 An Overview of the Financing Decision Process 575

14.4 First Step: Assess the Current Stage and Condition of the Venture 577
The Stage of Development
Development Stage and the Financing Option for High-Risk Ventures
The Value of Outside Advice
The Asset Base
14.5 Second Step: Assess the Nature of the Ventures Financial Needs 584
The Influence of Immediate Financing Needs
The Influence of Near-Term Financing Needs
The Influence of Cumulative Financing Needs
14.6 Financing Choices and Organizational Structure 589
The Relationship between Financing and Strategic Partnering
The Relationship between Financing and Franchising
14.7 How Financial Distress Affects Financing Choices 591
Why Turnaround Financing Is Different
The Influence of Financial Distress Costs on Choice of Financing
14.8 How Reputations and Relationships Affect Financing Choices 594
14.9 Avoiding Missteps and Dealing with Market Downturns 596
The Investors Perspective on Timing
Financing after a Marketwide Downturn in Valuations
Going Private as a Response to Declining Market Valuations
14.10 Summary 599
Review Questions 600
Notes 601
References and Additional Reading 605

PART 6 Harvesting and Beyond

Chapter 15 Harvesting 611
15.1 Going Public 612
The IPO Process
Underwriter and Venture Capitalist Certification and Issue Pricing
An Illustration Underwriter Selection, Issue Pricing, and Distribution

OpenIPO A Test of Efficiency of Current Practice

Harvesting in the IPO
Harvesting After the IPO
15.2 Acquisition 625
Purchasing the Equity of the Venture for Cash
Purchasing the Assets of the Venture for Cash
Exchanging Equity or Assets of the Venture for Equity of the Acquirer
After the Acquisition
Agreeing to Disagree
Valuing Private Transactions
Illustration: Estimating the Cost of Private Transactions
Going Public by Reverse Merger
Examples of Reverse Mergers with Public Shells
15.3 Management Buyout 633
Valuing MBO Transactions
15.4 Employee Stock Ownership Plans 634
The ESOP Process
Valuation Considerations
15.5 Roll-Up IPO 638
Valuation Considerations
15.6 The Harvesting Decision 640
Company Size
The Value of a Public Market for the Shares
Synergies
Track Record and Ease of Valuation
Timing
Ownership and Control
Taxes
Transactions Costs
15.7 Venture Capital Harvesting and the Internet Bubble 643
Investor Irrationality
Public Market Valuation and Harvesting Choices
15.8 Summary 648

Review Questions 649

Notes 650
References and Additional Reading 654

Chapter 16 T he Future of Entrepreneurial Finance: A Global Perspective 658

16.1 Completing the Circle 659
Entrepreneurial Investment and Financing Decisions are Interdependent
Investment Value Depends on the Entrepreneurs Ability to Diversify
Investors Supply More than Money to the Ventures in Which They Invest
Financial Contracts and Other Devices Can Address Information Problems
New Venture Financial Contracts Can Align Incentives
Real Options Are an Important Source of Value for New Ventures
Harvesting is Critical to the Investment Decision
Organizational and Financing Choices Can Be Compared
Based on Their Effects on Value
16.2 Breaking New Ground 664
How Can Portfolio Theory Best Be Adapted to Evaluate
High-Risk Opportunities with Significant Probabilities of Failure?
What Is the Opportunity Cost of Capital for High-Risk, Long-Term Investments?
What Is the Best Way to Value Investment Opportunities Involving Portfolios
of Complex and Interdependent Real Options?
What Is the Best Way to Estimate the Uncertain Cash Flows of a New Venture
and the Correlation of Those Cash Flows with the Market?
What Is the Best Approach for Valuing Multiple-Period Cash Flows
for an Underdiversified Investor?
What Kinds of Investment Opportunities Are Most Effectively Pursued
by Individual Entrepreneurs and What Kinds Are Most Effectively Pursued
by Corporations?
Is VC Firm Success a Result of Persistence or Luck?
How Do Financial Wealth and the Opportunity Cost of Human Capital Affect
an Individuals Decision to Undertake a High-Risk Entrepreneurial Venture?
What Social and Economic Institutions Foster Entrepreneurial Activity and
Can Communities Proactively Develop Such Institutions?

How Will a Decrease in the Rate of Innovation Affect the Allocation of

Resources Devoted to Entrepreneurial Activity?
16.3 Public Policy and Entrepreneurial Activity: An International Comparison 669
Caveats about the Objectives of Public Policy
The Role of Institutional Structure in Stimulating Entrepreneurial Activity
16.4 The Future of Entrepreneurial Finance 683
Methods of Selecting New Venture Investment Opportunities Will Improve
Changes in the Set of Investment Opportunities Threaten Existing Institutions
Changes in the Competitive Climate Are a Threat to Existing Institutions
What Will Be the Drivers of Success?
Notes 689
References and Additional Reading 691

Index 695