Entrepreneurial Finance Strategy, , and Deal Structure

CONTENTS

List of Illustrations xvii Abbreviations xxiii Preface xxvii Why Study Entrepreneurial Finance? xxviii What Makes Entrepreneurial Finance Different from ? xxix Interdependence between Investment and Financing Decisions Diversifiable Risk and Investment Value Managerial Involvement of Information Problems and Contract Design Incentive Alignment and Contract Design The Importance of Real Options Harvesting the Investment Value to the Entrepreneur What’s 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 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 Asset –Based Lenders Venture Leasing Corporate Venturing Government Programs Trade Credit Factoring Franchising Nonpublic Public Debt Private Placements of Equity and Debt Initial Direct Public Offering Later-Stage Financing Alternatives 2.2 What’s Different about Financing Social Ventures? 55 2.3 Considerations When Choosing Financing: The Organizational Form 57 2.4 Regulatory Considerations 60 What Is a ? 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 80 The Investment Company Act and the SEC The Prudent 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 Activity in Europe 3.2 The Organization of Venture Capital Firms 89 The 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 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 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 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 Anybody’s 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 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 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 Non–US Investors 427 10.6 Summary 428 Review Questions 429 Notes 429 References and Additional Reading 430

Chapter 11 T he Entrepreneur’s 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 Entrepreneur’s Cost-of-Capital Disadvantage Defining the Entrepreneur’s 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 Entrepreneur’s Cost of Capital Shortcuts for Estimating the Entrepreneur’s 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 Investor’s Perspective Risk-Allocation Contracting in Practice 12.4 Contract Choices That Allocate Expected Returns 483 The Entrepreneur’s Gain from Contracting with a Well-Diversified Investor How Much of the Entrepreneur’s 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 ? 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 Investor’s 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 Entrepreneur’s 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 Investor’s Decision Affects Value to the Entrepreneur The Value of the Investor’s Interest in the Venture The Value of the Entrepreneur’s 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 Venture’s 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 Investor’s 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 633 Valuing MBO Transactions 15.4 Employee 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 Entrepreneur’s 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 Individual’s 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