© 2007 Thomson South-Western Chapter 26 Entrepreneurial Finance And Venture Capital Professor XXXXX Course Name / Number

2 2 Entrepreneurial Finance Entrepreneurial growth companies Rapidly growing public or private firms Large external funding needs and imperfect access to public financial markets Often based on proprietary technology or unique service Challenges:  Need to fund rapid growth externally  Mostly intangible assets; Little ability to borrow  Extremely high risk, potentially high return companies  Must attract top people with minimum cash outlay Entrepreneurial growth companies very reliant on equity finance

3 3 Types of Venture Capital Funds  Institutional venture capitalists  SBICs  Financial and corporate venture capital  Corporate venture capital  Capital limited partnerships  “Angel” capitalists

4 4 Annual Venture Capital Investments in the United States, 1990 –2005 (in $ billion current dollars)

5 5 Geographic and Industrial Investment Patterns Venture capital investments are highly concentrated geographically.  California usually receives over half US total VC investment. Silicon Valley attracts 25-50% of total.  New England, NYC, Washington DC also major recipients Investments predominant in high-technology industries; Specific target industries change over time. Are venture capital investments profitable though?

6 6 U.S. Venture Capital Investment by Industry: 2004 and 2000

7 7 U.S. Venture Capital Investments by Stage of Company Development, Percent of Total Investment, 1997–2004 %

8 8 Economic Impact of 35 Years of U.S. Venture Capital Funding, 1970 –2004

9 9 How Investments Are Structured Venture capitalists almost always invest using convertible preferred stock. Venture capitalists typically make early and expansion stage investments.  The earlier the stage of investment, the more onerous the venture capitalists’ terms will be (price, control surrendered) Staged financing Preserves cancellation option for venture capitalist at each stage Same venture capitalists tend to remain throughout a firm’s development.

10 Distribution of Rights and Responsibilities  Venture capital contracts allocate risk, return, and ownership rights between the entrepreneur (and other existing owners of a portfolio company) and the fund, depending on  (1) the experience and reputation of the entrepreneur  (2) the attractiveness of the portfolio company as an investment opportunity  (3) the stage of the company’s development  (4) the negotiating skills of the contracting parties  (5) the overall state of the market

11 Typical VC Investment Contract Covenants Ownership right agreements: set voting rights, board seats Ratchet provisions: protect the venture capitalist in the event of new equity sales Demand registration rights, participation rights, repurchase rights: exit strategies for venture capitalist Stock option plans: designed to attract and motivate key managers

12 Convertible Securities  1. Because convertible debt or preferred stock is a distinct security class, contract terms and covenants specific to that issue are negotiable. F  2. Firms can create multiple classes of convertible debt or preferred stock, and use these securities to construct complex contracting arrangements with different investor groups.  2. Seniority places the VC ahead of the entrepreneur in the line of claimants on the firm’s assets should the firm not succeed.  3. Give VCs the right to participate in the upside when portfolio companies thrive.

13 The Pricing Of Venture Capital Investments  Based on company’s development stage, expected future firm value and entrepreneur prestige  Earlier the development stage, higher the return demanded  Expected future market value based on firm’s expected earnings (NI) and likely P/E ratio at exit date (IPO or merger).  Algebraically: Exp MV = Exp(NI) x P/E  Venture capital pricing inputs: Required return (r), years to exit via merger or IPO (n), and initial investment amount (A)  Looking for expected firm value in n years (FV)  From this determine fraction of equity (%Equity) VC receives An example.... Venture capitalist to provide $5 million IPO expected: n = 5 yrs; Exp(NI)= $4,000,000; P/E = 20 A = $5,000,000; r = 50%.

14 The Pricing Of VC Investments  Step 1: compute value of VC stake at exit date: FV = A (1+r) n = $5,000,000 x (1.50) 5 = $38,000,000  Step 2: compute expected firm market value at exit date:  Based on Exp(NI) and expected P/E ratio: Expected MV = Exp(NI) x P/E = $4,000,000 x 20 = $80,000,000  Step 3:compute fraction of firm’s equity VC will take today: %Equity = FV ÷ Exp MV = $38,000,000 ÷ $80,000,000 = So venture capitalist invests $5 million, receives 47.5% of firm. Very expensive financing!!

15 Venture Capital Exit Strategies  (1) IPO of shares to outside investors  (2) Sale of the portfolio company directly to another company  (3) Selling the company back to the entrepreneur/founders (the redemption option)

16 Venture Capital Exit Strategies Preferred exit vehicles: IPO, followed by mergers  On average, IPOs return about 4 times initial VC investment  Mergers less than half as profitable Third exit: forced sale (redemption) to entrepreneur Venture capitalists do not sell many shares at IPO Hold for 1-2 years after IPO, then distribute shares to limited partners

17 European Private Equity Investment, 1989–2004 (in € billions)

18 European Private Equity Investment, by Industry (2003 and 2000)

19 European Private Equity Raised by Type of Investor, Year 2003 (€ billion total investment)

20 Distribution of European Private Equity Investment by Stage of Company Development, 1997–2004

21 Investment Returns to Categories of European Private Equity Investment, 1984–2003

22 European Venture Capital  European venture capital (EVC) comparable to U.S. in size  Investment concentrated geographically and industrially  Technology accounts for increasing fraction of EVC

23 Key Requirements For A Strong Venture Capital Industry  A tradition of entrepreneurship and risk-taking  A well-established legal system, with good investor protection  A supportive, but non-interventionist, government  A stable regulatory system that doesn’t penalize start-ups  A free (and mobile) labor market, rich in engineering talent  A non-punitive taxation regime that allows use of stock options  A strong R&D culture, especially in universities or national labs  A vibrant IPO market, but could be a result, not a prerequisite  Funded pension system (independent funds) very helpful What economic, cultural and legal features will promote a strong venture capital industry?

24 Does a Nation’s Legal System Influence the Size of Its Venture Capital Industry?