Chapter 1 Introduction to Entrepreneurial Finance

Chapter 1 Introduction to Entrepreneurial Finance
Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Learning Objectives Understand how new venture finance is different from corporate finance. Understand the centrality to new venture finance of the objective of maximizing value for the entrepreneur. Briefly describe the evolution of thinking about the nature of entrepreneurship and how entrepreneurship relates to new venture finance. Describe the process of new venture formation from inception of the idea to harvesting of the investment. Recognize that studying new venture finance can contribute to better decision-making and increased potential for success. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

Intellectual Challenge
Diversification of risk affects investment value. Investment and financing decisions are interdependent. Outside investors may be actively involved in a venture. The parties have different information (and beliefs). The parties have different incentives from each other. New ventures are portfolios of real options. Value to the entrepreneur is different from value to shareholders. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

After This Course, You Should Be Able To:
Construct new venture financial models Assess the timing and amounts of financial needs Estimate risks and expected returns of financial claims Value financial claims in light of diversification Evaluate alternative new venture strategies Estimate the effects of complex options on value Design and negotiate “deals” Address information and incentive problems Understand the institutions of new venture finance Develop a business plan to attract outside funding ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

The Finance Paradigm More of a good is preferred to less.
Present wealth is preferred to future wealth. Safe assets are preferred to risky assets. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

Types of Financial Decisions
Investment Decisions Financing Decisions Mixed Decisions ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

New Business Formations & Terminations
Terminations with loss to creditors as a percent of start-ups Terminations as a percent of start-ups Source: Case, J., "The Dark Side" Inc. Magazine, 1997, based on The State of Small Business: A Report of the President, 1994, U.S. Government Printing Office, Washington, D.C., 1995.

Maximum Value for the Entrepreneur
The Objective Maximum Value for the Entrepreneur ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

Caveats Investment value is not the only factor an entrepreneur or investor can consider. The CAPM-based valuation models used in the book do not fully describe how investors view risk. Risk and expected return can be estimated, but not measured with precision. Not every new venture investment or financing decision should be carefully modeled and evaluated. Examples in the book are not intended to suggest that any party to a deal should try to capture all of the value for themselves. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

Chapter 2 Overview of New Venture Financing

Learning Objectives Learn new venture financing terminology.
Understand the value of tying financing to performance milestones. Recognize the distinguishing characteristics of the various stages of new venture development. Identify the financing sources available to a new venture and the factors favoring one financing source over another. Learn the basic structures and availability of various financing sources. Identify the key elements of deal structure and the functions they serve. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Some Milestones for New Venture Planning
Completion of Concept and Product Testing Completion of Prototype First Financing Completion of Initial Plant Tests Market Testing Production Start-up First Competitive Action First Redesign or Redirection First Significant Price Change Block and MacMillan (1992) ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Stages of New Venture Development
Development Stage Start-up Early Growth Rapid Growth Exit ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Stages of New Venture Development
Figure 2-1 Time Dollars Revenue Net Income Cash Flow Development Start-up Early Growth Rapid Growth Exit ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Sequence of New Venture Financing
Bootstrapping Seed Financing R&D Financing Start-up Financing First-stage Financing Second-stage Financing Third-stage Financing Mezzanine Financing Bridge Financing LBO, MBO, IPO ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Sources of New Venture Financing
Self, Friends, and Family Business Angels Venture Capital Investors Small Business Investment Companies (SBICs) Trade Credit and Factoring Asset-based Lending Mezzanine Capital Private Placements of Equity (Relational Investors) IPOs Public Debt ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Sources of New Venture Financing
©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Venture Capital Commitments by Source
Figure 2-3 Part I 1978 ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Venture Capital Commitments by Source
Figure 2-3 Part II ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Investment by Industry - 1997
Figure 2-4 Software/ Information 24.7% Communications 22.8% Healthcare 11.4% Biotechnology 6.7% Consumer 6.6% Medical Instruments 5.0% Business Services 4.7% Industrial 4.5% Electronics 3.6% Computers 3.2% Distribution/ Retailing 3.0% Semiconductors 0.8% Environmental 1.0% Pharmaceuticals 1.8% ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

How Changes in the Stock Market Affect New Equity Capital Raising
Figure 2-6 Percent Change from Prior Year ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Number of Debt Issues by Proceeds of Issues: 1990-94
Figure 2-7 Number of Issues Gross Issue Proceeds in Millions ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Deal Structure “The Deal” Term Sheet Pre-money Valuation
Post-money Valuation Investment Agreement Representations and Warranties Covenants and Undertakings Affirmative Covenants Negative Covenants Registration Rights Preemptive Rights Ratchets or Anti-dilution Provisions ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Chapter 3 The Business Plan

Learning Objectives Learn how and why business plans of new ventures are different. Know what to include and what to leave out. Understand the relationship to strategic planning. Use milestones and financial projections in the plan. Use the plan to signaling the entrepreneur’s beliefs, commitment, and capabilities. Understand how the plan can facilitate negotiation with outside investors. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

A set of hypotheses about an opportunity
What is a Business Plan? A written document Summarizes the purpose and overriding strategy of the venture Provides details on operation, financing, marketing, and management A set of hypotheses about an opportunity ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

What Makes the Business Plans of New Ventures Different?
Forecasts and projections usually are less precise. A greater investment in planning may be warranted. Deviations from plans are likely to be due to wrong assumptions. Not very useful for evaluating manager performance. More likely to be relied on externally. More likely to be used to attract investment capital. Often require greater breadth of coverage. Unconstrained by previous decisions. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

Do the Planning Before the Writing
Preparing a business plan is not the first step. The plan can commit the entrepreneur to an undesirable strategy. Consider aspects of strategy simultaneously, not sequentially. Do not lose sight of the objective. Analysis of strategic alternatives does not belong in the business plan. Be prepared to respond to alternative proposals. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

Alternative Product Market and Financing Choices

Contents of the Business Plan
Focus on the purpose(s) and uses of the plan. Include whatever information is relevant and material. Make certain the audience is neither overloaded nor left to speculate. Include only what is appropriate and necessary, given the use. Identify the key assumptions as assumptions. Include the support for key assumptions. Highlight the critical elements for success or failure. Delineate milestones. So users can evaluate success, modify assumptions, expectations, or strategy. Include financial projections. To test the plan, commit the entrepreneur, facilitate negotiation ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

Making the Business Plan Credible
Demonstrate understanding of the technology, market, risks, needs, and potential rewards. Provide evidence of the quality and capabilities of people involved, and that they can function effectively as a team. Provide evidence that key personnel are committed. Bonding Reputation Certification ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

The Issue of Confidentiality
Protecting intellectual property Preempting rivals and first-mover advantage Using non-disclosure agreements Relying on reputation ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

Financial Aspects of the Business Plan
Differing views on what to include Is the future too uncertain to warrant careful forecasting? Include in the plan, or as an appendix? The importance of supporting assumptions Relationship of projections to contract negotiation The value of quantifying risk Value as a diagnostic tool - to facilitate adaptation Updating the business plan ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

Chapter 4 New Venture Strategy

Learning Objectives Understand what makes a decision strategic.
Understand the interrelationships between financing decisions and other aspects of new venture strategy. Relate strategic decisions to the entrepreneur’s objective of value maximization. Describe strategic alternatives in terms of real options. Use decision trees to identify and evaluate real options. Use game trees when strategic choices depend on rival reactions. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

What Makes a Plan or Decision Strategic?
Strategic decisions are consequential. Strategic decisions are both active and reactive. Strategic decisions limit the range of possible future actions. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Interactive Financial Strategy
Figure 4-1 Rapid growth requires a larger organization. Economies-of-scope imply more product lines. Financial Strategy Product Market Strategy Organizational Strategy The more vertical and horizontal integration, the greater the financial needs. Outside investment is more likely the larger the firm. Rapid growth reduces financial flexibility and requires sacrificing control to attract outside financing. Outside v. entrepreneur Debt v. equity Loan covenants Options Staging Type of financing Financial contracts Price Margin Quality Differentiation Product Targeted sales growth Scale and scope Vertical boundaries Horizontal boundaries ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Financial Implications of Product-Market and Organizational Strategic Choices
Figure 4-2 ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

An Introduction to Options
Option - A right to make a decision in the future Elements of an option An underlying asset Exercise price (strike price) Expiration date European or American form Basic options Call option Put option Financial options Real options Complex options Contingencies - Option created by some earlier action Interdependencies - Options with interdependent values ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

The Structure of a Call Option
Value of Asset Value of Underlying Asset Underlying Asset E Expiration Call before ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Realized Returns on Options
Buy a Call Write a Call Gain Loss Gain Loss ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Valuing Options Put-Call Parity Financial Options Real Options
Option Pricing Models based on no-arbitrage Stock + Put = Call + PV(Exercise Price) Role of complete markets Financial Options Complete markets Incomplete markets Real Options Complex Real Options (Rainbow Options) Discrete scenarios Simulation ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Real Options - Some Examples
Defer - Investing now eliminates the option to defer (learning). Expand - An option to defer part of the scale of investment. Contract - The flexibility to reduce the rate of output. Abandon - Stop investing, and liquidate existing assets. Staging - Substitute a series of small investments for one large. Switching - Re-deploy resources or change inputs (terminate). Change Scope - Expand or contract scope. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Techniques for Reasoning Through Decision Trees
Focus on the most important decisions. Reason forward to construct the tree. Track certainties and uncertainties at each decision point. Calculate backwards to evaluate choices. Select the tree branch with the highest expected value. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Decision Tree - Restaurant Example
Demand may be high (30%), medium (50%), or low (20%). Cost of large restaurant is $750,000. Cost of small restaurant is $600,000. Entrepreneur will invest $400,000, outside investor provides the rest. Investor requires 1% of equity for each $10,000 invested. If demand is high - PV large is $1,500,000, PV small is $800,000. If demand is medium - PV large is $800,000, PV small is $800,000. If demand is low - PV large is $300,000, PV small is $400,000. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Accept/Reject Decision to Invest in Restaurant Business
Figure 4-3 High Demand (.3) Large restaurant Do not enter Small restaurant Intermediate Demand (.5) Low Demand (.2) -$400, x $1,500,000 = $575,000 -$400, x $800,000 = $120,000 -$400, x $300,000 = $-205,000 -$400, x $800,000 = $240,000 -$400, x $400,000 = -$80,000 $0 ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Evaluation of Accept/Reject Alternatives
Large-scale entry: NPV conditional on high demand = $575,000 NPV conditional on intermediate demand = $120,000 NPV conditional on low demand = ($205,000) NPV = .3 x $575, x $120, x $205,000 = $191,500 Small-scale entry: NPV conditional on high demand = $240,000 NPV conditional on intermediate demand = $240,000 NPV conditional on low demand = ($ 80,000) NPV = .3 x $240, x $240, x $80,000 = $176,000 Do not enter: NPV = $0 ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Restaurant Business Investment with an Option to Delay Investing
Figure 4-4 Large restaurant Wait Small restaurant High Demand (.3) Intermediate Demand (.5) Low Demand (.2) -$400, x $1,500,000 = $575,000 -$400, x $800,000 = $120,000 -$400, x $300,000 = $-205,000 -$400, x $800,000 = $240,000 -$400, x $400,000 = -$80,000 Determine market demand -$400, x $1,300,000 = $445,000 -$400, x $700,000 = $160,000 $0 ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Evaluation of Option to Delay
Large-scale entry strategy: NPV = $191,500 Delay until uncertainty is resolved: High demand Build large restaurant NPV conditional on high demand = $445,000 Intermediate demand Build small restaurant NPV conditional on intermediate demand = $160,000 Low demand Do not enter NPV conditional on low demand = $0 NPV of delay strategy: = .3 x $445, x $160, x $0 = $213,500 Value of Option to Delay = $213, ,500 = $22,000 ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Restaurant Business Investment with an Option to Expand Initial Investment
Figure 4-5 Large restaurant Do not enter Small restaurant High Demand (.3) Intermediate Demand (.5) Low Demand (.2) -$400, x $1,500,000 = $575,000 -$400, x $800,000 = $120,000 -$400, x $300,000 = $-205,000 -$400, x $800,000 = $240,000 -$400, x $400,000 = -$80,000 $0 Expand Do not expand -$400, x $1,400,000 = $580,000 -$400, x $800,000 = $240,000 ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Evaluation of Option to Expand
Large-scale entry strategy: NPV = $191,500 Delay until uncertainty is resolved: NPV = $213,500 Build small, with Option to Expand: Conditional on High demand: NPV if Expand = $580,000 NPV if Remain Small = $240,000 Conclusion: Expand if demand is high Conditional on Intermediate demand: NPV of Remaining Small = $240,000 Conditional on Low demand: NPV of Remaining Small = ($80,000) NPV of Small-scale entry with Option to Expand = .3 x $580, x $240, x $80,000 = $278,000 Value of Expansion Option = $86,500 Incremental value over Delay Option = $64,500 The Options are Mutually Exclusive ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Evaluation of Option to Abandon
Large-scale entry strategy: NPV = $191,500 Large-scale entry with Abandonment option: Convert to office with $600,000 value NPV of converting for entrepreneur = ($10,000) NPV with Abandonment Option: = .3 x $575, x $120, x $10,000 = $230,500 Would pay up to $39,000 extra for location that is convertible Small-scale entry with Expansion and Abandonment Options: Convert to office with $300,000 value NPV of converting for entrepreneur = ($160,000) = .3 x $580, x $240, x $160,000 = $262,000 Abandonment has negative value for the small restaurant A result of discreteness of the analysis Conclusion: Build small with Expansion Option NPV = $278,000 ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Game Trees The Basics Strategic interaction Nash equilibrium
Players Order of play Information set Available actions Payoff schedules Strategic interaction Cooperative and Non-cooperative games Sequential-move game - Game tree Simultaneous-move game - Payoff matrix Nash equilibrium Sub-game perfection ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Evaluating Strategic Games
Develop the tree Prune branches involving dominated strategies Specify assumptions about rival actions and reactions ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Entry Decision Game Tree
Figure 4-6 $380, ($100,000) Kelly’s Bar Erin’s Pub Enter Stay Out Large Small Wait Kelly’s Payoff Erin’s Payoff $425, $0 $250, $200,000 $400, $0 $300, $100,000 $190, $210,000 $ $300,000 $370, $0 $350, $0 $ $0 ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Examples of Real Options
Defer Expand or contract Abandon Switch inputs or outputs Grow To wait before taking an action until more is known or timing is expected to be more favorable To increase or decrease the scale of a operation in response to demand To discontinue an operation and liquidate the assets To commit investment in stages giving rise to a series of valuations and abandonment options To alter the mix of inputs or outputs of a production process in response to market prices Stage investment To expand the scope of activities to capitalize on new perceived opportunities Examples Description Option Adding or subtracting to the daily flights on an airline route or adding memory to a computer When to harvest a stand of trees, introduce a new product, or replace an existing piece of equipment Discontinuing a research project, closing a store, or resigning from current employment Staging of research and development projects or financial commitments to a new venture The output mix of refined crude oil products or substituting coal for natural gas to produce electricity Extending brand names to new products or marketing through existing distribution channels ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Chapter 5 Financial Forecasting

Learning Objectives Learn the elements of the cash flow cycle.
Understand the four critical determinants of a firms financial needs: minimum efficient scale, profitability, cash flow, and sales growth. Learn how to prepare a sales forecast for an established firm. Learn how to prepare a sales forecast for a new venture. Develop a financial model of a venture using pro forma analysis to integrate income statement, balance sheet, and cash flow items. Identify publicly available data sources to provide an objective basis for underlying assumptions of the financial model. © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Benefits of Financial Forecasting
A disciplined means to evaluate the cash needs of a venture An aid to determine whether a proposed venture deserves the entrepreneur’s investment of capital and effort A means to compare the expected values of strategic alternatives A way to demonstrate project merits to investors and to use in negotiating ownership A way to identify appropriate benchmarks for assessing project development © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

The Firm as a Cash Conversion Process
Future Cash Firm Cash © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

The Cash Flow of a Business Venture
Capital (equity and debt) Infusions Beginning cash Reinvestment (to retained earnings) Expenditures Employees Materials Fixed Assets Production Inventory Credit Sales Cash sales Accounts Receivable Collections Ending Cash Equity Returns Debt Service Taxes © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Key Determinants of Financial Needs
1) Minimum efficient scale and capital intensity 2) Profitability 3) Cash flow 4) Sales growth © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Manufacturer’s Long Run Average Cost (LRAC)
Figure 6-2 Quantity Dollars Q Q* © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Factors that Increase a Firm’s Cash Needs
Competition in markets where the minimum efficient scale (MES) of an enterprise is large Low profit margins High rates of sales growth Increased reliance on depreciation of assets and less on expensing of assets Expectation of low cash flow levels Increased trade credit offered (accounts receivable as a fraction of assets is high) Decreased trade credit used (accounts payable as a fraction of assets is low) © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Introduction to Pro Forma Analysis
Assumptions for a simple asset-driven business model: Sales = 2 x Beginning Assets Net Income = Sales x 0.1 Retained Earnings = Beginning Assets x 0.06 Dividends = Net Income - Retained Earnings Ending Assets = Beginning Assets + Retained Earnings © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Asset-driven Pro Forma Model
Assets S/A Sales Retained Earnings ROS Retention Net Income Dividends © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Five Year Pro Forma Analysis for a Simple Business Venture
Figure 6-3 Assumptions: Sales = 2 x Beginning Assets Net Income = Sales x 0.1 Retained Earnings = Beginning Assets x 0.06 Dividends = Net Income - Retained Earnings Ending Assets = Beginning Assets + Retained Earnings © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Integrating Pro Forma Financial Statements
Basic Pro Forma Financial Statements (and some others) Sales Forecast Income Statement Cash Flow Statement Balance Sheet The statements are interdependent Income Statement changes affect Balance Sheet and Cash Flow (e.g., higher profit may lead to increased cash balances). Balance Sheet changes affect Income Statement and Cash Flow (e.g., borrowing leads to interest expense and reduces taxes). A financial model should integrate the statements © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Integration of Financial Statements: The Circular Flow
Figure 6-4 Assumptions Ending Balance Sheet Cash Flow Statement Income Statement Beginning Balance Sheet Sales Forecast © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Key Questions to be Answered in a Sales Forecast
1) When will the venture begin to generate revenue? 2) How rapidly will revenue grow? 3) Over what span of time (3 years, 5 years, 10 years, etc.) should the forecast be made? 4) What is an appropriate forecasting interval (weekly, monthly, annually, etc.)? © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Forecasting the Sales of an Existing Business
The forecast can be based on the existing track record of the business Some considerations Forecasting in levels or changes Forecasting in real or nominal terms Weighting of historical data Forecasting based on underlying factors for which forecasts exist © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Combining Growth Rates and Current Sales Levels to Forecast the Sales of an Existing Business
Average Sales Growth = 8.06% Range = -3.7% to 20% © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Forecasting in Real Terms
Average Real Sales Growth = 3.66% Range = -10.7% to 17% © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Using Weighting to Improve a Forecast
Weighted Average Real Sales Growth = 1.96% © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Using Regression Analysis to Forecast
Regression Model: Expected Real Sales Growth = 3.34% x Change in Real GDP © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Forecasting for a New Venture
No track record on which to rely Yardstick approach Comparable firms in relevant dimensions IPO prospectuses Other data sources Fundamental analysis Market and market share Engineering cost estimates Demand-side approach - How much customers would buy Supply-side approach - How fast the venture can grow Credibility and support for assumptions Mixed approach © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

General Rules of Financial Forecasting
Part 1 Build and support a schedule of assumptions. Begin with a forecast of sales. If sales growth is expected to track inflation, consider forecasting sales in real terms. When using historical data to forecast, consider a weighting scheme that focuses on the firm’s most recent experiences. For new ventures, choose several “yardstick” firms to use in developing underlying assumptions regarding expected performance. Integrate the pro forma balance sheet and income statement variables through a financial model. © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

General Rules of Financial Forecasting
Part 2 Consider time span. To assess financial need, project at least until the firm expects follow-on financing. To determine venture value, extrapolate to the point of harvest. Determine the planning horizon of the venture to establish forecasting intervals. Test the model’s rationality by tracing line items across financial statements. Apply sample scenarios and compare outcomes to estimates. Try a basic sensitivity analysis to ensure that the model yields reasonable results when magnitudes and growth rates of key variables change. © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

New Company Assumptions
Figure 6-5: Part I 1) Development will require 18 months, during which no sales will be made. 2) Initial sales of $10,000 in the 19th month. 3) Sales will grow 8% per month in real terms for three years and at the inflation rate thereafter. 4) Cash operating expenses during the development period of $15,000 per month, plus inflation. 5) Inflation at 9 percent per year. 6) A $200,000 production facility will come on line at the end of month 18. The facility is to be leased by the company for the first 5 years of operation, with monthly payments of $3,000. 7) Gross profit of 60% of sales revenue on materials costs with trade discounts. 8) Selling expenses of 15% of sales. 9) Administrative expenses of $2,000 per month beginning in month 19, growing at the inflation rate, plus 15 percent of sales (Included in development period operating expense total). © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

New Company Assumptions
Figure 6-5 Part II 10) Entrepreneur’s salary of $3,000 per month through the first full year of sales (included in initial operating expenses), increasing thereafter by $500 per month. 11) Corporate tax rate of 45%. No loss carry forward. 12) All sales are for credit. The average collection period is 45 days. No discount for prompt payment. 13) The inventory turnover rate is 5 times per year, measured against ending inventory. 14) The company desires to maintain the greater of 30 days’ sales in cash or $10,000. 15) All materials are purchased on credit, with terms of 2/10 net 30. The company anticipates paying in time to receive the discount. The payables period is 10 days. 16) The entrepreneur will borrow any funds necessary at a rate of 1% per month. 17) Initial investment by the entrepreneur of $200,000. Additional financing as needed by borrowing on a line of credit. © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

New Company Sales Forecast
Figure 6-6 (Forecast generated monthly, selected months shown) Go to the Excel file next. © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

The Framework of New Venture Valuation
Chapter 6 The Framework of New Venture Valuation Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Learning Objectives Know the difference between a “hurdle rate” and a realized rate of return. Know why hurdle rates for new ventures usually are higher than realized rates of return. Know the difference between a hurdle rate and the opportunity cost of capital. Know how to use the Capital Asset Pricing Model to estimate cost of capital. Know how to use the risk-adjusted discount rate and certainty equivalent forms of the CAPM. © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Learning Objectives (continued)
Know the limitations of the CAPM for new venture valuation Know the differences between the CAPM and the Option Pricing Model and be able to reconcile their use. Know how diversifiable risk affects expected returns. Know why the valuation of the entrepreneur is likely to be different from that of the investor, and how to use the information in deal negotiation. © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

The Many Uses of Valuation
Strategic Planning Estate Planning Partnership formation and dissolution Initial public offering (IPO) Stock options and Employee stock ownership plans (ESOPs) Mezzanine financing Negotiating a merger or sale of a venture © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Valuation Myths Beauty is in the eye of the beholder.
The future is anybody’s guess. Investors in new ventures demand very high expected rates of return to compensate for the risks. The outside investor determines what the venture is worth. © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Hurdle Rates For Venture Capital
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Venture Capital Realized Rates of Return (based on various studies)
14% - 92 firms in ‘60s and ‘70s. 23% - before fees, 100 firms in the ‘60s 16% - public fund stock returns from 1959 to 1985. 27% - 11 firms from 1974 to 1979. 13.5% - from 1974 to 1989. 20.7% - from 1987 to 1996. How are the hurdle rates reconciled with realized rates? © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Valuation Methods Value = Present value of future cash flows
Two conceptually equivalent approaches RADR - Risk-Adjusted Discount Rate CEQ - Certainty Equivalent Cash Flow The choice of method depends on information availability. © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Issues for RADR Valuation
What cash flows should be valued? What discount rate should be used? © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Factors Affecting the Discount Rate for RADR Valuation
Compensation for deferring consumption (time value) Compensation for bearing risk (risk premium) A measure of risk - the standard deviation of holding period returns. The discount rate is not a matter of personal risk tolerance. It is market determined It is based on opportunity cost The discount rate depends on the ability of an investor to diversify. © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Estimating the Discount Rate
Opportunity cost of capital What discount rate should be used? CAPM All measures are based on holding period returns. © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

The Feasible Set and the Efficient Set of Risky Portfolios
Figure 8-2 Return Risk (Standard Deviation) Preferred portfolio of highly risk-averse investor Preferred portfolio of risk-tolerant investor Efficient Set Feasible Set © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

The Efficient Set, the Market Portfolio, and the Capital Market Line
Figure 8-3 Return Risk New preferred portfolio of highly risk-averse investor New preferred portfolio of risk-tolerant investor Capital Market Line Market Portfolio Efficient Set r F M M © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

How Portfolio Risk Depends on the Number of Assets in the Portfolio
Figure 8-4 Risk Number of Assets in Portfolio Portfolio Diversifiable Risk Non-diversifiable M © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

The Capital Asset Pricing Model
Figure 8-5 Beta 1.0 Return Security Market Line Market Portfolio r F M © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Measures of Cash Flow Expected Actual Cash Flow
Operating Cash Flow Operating Cash Flow = EBIT + Depreciation Expense - Capital Expenditures - Increase in NWC Cash Flow to All Investors (both stockholders and creditors) Total Capital Cash Flow + EBIAT = Operating Cash Flow - Actual Taxes Cash Flow to Creditors (expected in light of default risk, potential prepayment, potential additional borrowing) Debt Cash Flow = Expected Interest Payments + Expected Net Debt Service Cash Flow to Stockholders (expected in light of expected cash flows to creditors) Equity Cash Flow = Operating Cash Flow - Expected Interest Payments - Expected Net Debt Service - Expected Actual Taxes Other Measures of Cash Flow Contractual Cash Flow to Creditors (assuming no default or prepayment) Contractual Cash Flows to Creditors = Contractual Interest Payments + Contractual Net Debt Service Unlevered Free Cash Flow (expected if no debt financing) Unlevered Free Cash Flow - Operating Cash Flow - Theoretical Taxes as Unlevered

Matching Cash Flows to Discount Rates for Various Financial Claims
Figure 8-6 © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Issues for CEQ Valuation
What cash flows should be valued? How are risky cash flows adjusted to their certainty equivalents? What is the discount rate for valuing certain future cash flows? © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

The CEQ Form of the CAPM CAPM
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Chapter 7 Financial Contracting

Learning Objectives Understand how and why staging and other real options affect the values of new venture financial claims. Value the financial claims of a new venture using either discrete scenario analysis or simulation. Use financing modeling and valuation techniques to study game theoretic issues that arise for the parties to a new venture. Construct financial contracts to signal information and align incentives. Evaluate the effects of alternate financial contracts on the values of the financial interests of the entrepreneur and outside investor. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13
Figure 13-1 Objective Determine the fraction of equity an outside investor would require if the entire investment is made at time zero. Assumptions New venture needs $700, 000 of cash per year. Projected negative earning initially, then rapid growth. Earnings reach $2.5 million by year 5. No free cash flow during first 5 years. Typical earnings multiple of comparable firms is 15. Resulting projected continuing value is $37.5 million in year 5. Hurdle rates consistent with Venture Capital Method. Risk-free rate is 4% per year. All investment is made at time zero. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Figure 13-2 Objective Determine the fraction of equity an outside investor would require if the investment is made in stages (compared to single-stage). The spreadsheet shows how the required investment is determined at each stage, based on the Venture Capital Method. Assumptions New venture needs $700, 000 of cash per year. Projected negative earning initially, then rapid growth. Earnings reach $2.5 million by year 5. No free cash flow during first 5 years. Typical earnings multiple of comparable firms is 15. Resulting projected continuing value is $37.5 million in year 5. Hurdle rates consistent with Venture Capital Method. Risk-free rate is 4% per year. Investment is made at times zero, two and four. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Determining the Required Shares of Staged Investment
Equation (1) shows how the required fraction of equity can be determined when future rounds of financing are anticipated. Fraction of Equity Required = Ending Fraction of Equity Required x (1 - Sum of Fractions Required by Investors in Future Rounds) (1) Using this equation, the required share of the investor in the second round is percent. 10.30 % = % / (100 % %) Similarly, the the required share for the investor in the first round is percent. 31.77 % = % / (100 % % %) ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Staging and Market Capitalization
Investors are disappointed if capitalization does not increase from one round of financing to the next. Figure 13-2 shows why. Investment Round First Stage Second State Third Stage Investment Share of Equity Received Capitalization $1,373,077 $700,000 31.77% 10.30% 2.43% $4,321,992 $13,330,844 $28,806,584 ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Evaluating the Entrepreneur’s Investment Based on Expected Returns
Step 1: Estimate the expected cash return and total risk (standard deviation of cash flows) of the entrepreneur’s financial interest in the venture. Step 2: Estimate the expect cash return and risk of the entrepreneur’s investment in the market portfolio. Step 3: Use the above results and the correlation between the venture and the market to estimate the expected cash return and total risk of the entrepreneur’s total portfolio. Step 4: Value the portfolio by the CEQ method (based on its total risk). Step 5: Infer the value of the entrepreneur’s investment in the venture by subtracting the market value of the entrepreneur’s investment in the market index portfolio. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Single-Stage Investment with Discrete Scenarios
Figure 13-3 Objective Valuation is based on sharing of returns and risk in proportion to investment. The figure establishes a baseline against which alternatives can be compared. CAPM-based valuation is used with discrete scenarios. Assumptions The venture requires a total investment of $2.5 million (of which $500 thousand is human capital). A diversified investor provides $1.2 million, the entrepreneur provides the balance. No free cash flow until the fifth year, which is a liquidity event. There are two equally likely discrete scenarios (Success and Failure) Total wealth of the entrepreneur is $2.0 million. Wealth not invested in the venture is invested in the market. No information or incentive effects.

Valuing Financial Claims with Proportional Allocation (continued)

Figure 13-4 Objective Valuation is based on reducing the equity the outside investor receives to be more consistent with required return. Does the change in allocation result in positive NPV for the entrepreneur? Assumptions The venture requires a total investment of $2.5 million (of which $500 thousand is human capital). A diversified investor provides $1.2 million, the entrepreneur provides the balance. No free cash flow until the fifth year, which is a liquidity event. There are two equally likely discrete scenarios (Success and Failure) Total wealth of the entrepreneur is $2.0 million. Wealth not invested in the venture is invested in the market. The investor's claim is reduced to a $100 thousand NPV. No information or incentive effects. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Valuing Financial Claims with Equity Shifted to the Entrepreneur (continued)

Figure 13-5 Objective Valuation is based on reducing the investment of the entrepreneur and keeping equity shares as they are. Can more value be created by reducing the entrepreneur's investment? Assumptions The venture requires a total investment of $2.5 million (of which $500 thousand is human capital). A diversified investor provides $1.805 million, the entrepreneur provides the balance. No free cash flow until the fifth year, which is a liquidity event. There are two equally likely discrete scenarios (Success and Failure) Total wealth of the entrepreneur is $2.0 million. Wealth not invested in the venture is invested in the market. The investor's claim is maintained at 48% or equity, resulting in a $100 thousand NPV. No information or incentive effects. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Valuing Financial Claims with the Entrepreneur’s Investment Reduced (continued)

How Changing the Contract Affects Value

Figure 13-6 Objective Valuation is based on staging the outside investment but without an abandonment option. Can more value be created by staging that is required? Assumptions The venture requires a total investment of $2.5 million (of which $500 thousand is human capital). A diversified investor provides $1.805 million in present value of investment, the entrepreneur provides the balance. The investor provides $805 thousand at time zero, and the balance plus interest at time two. Since the entrepreneur's commitment is made at time zero, it is treated as before. No free cash flow until the fifth year, which is a liquidity event. There are two equally likely discrete scenarios (Success and Failure) Total wealth of the entrepreneur is $2.0 million. Wealth not invested in the venture is invested in the market. The investor's claim is maintained at 48% or equity, resulting in a $100 thousand NPV. No information or incentive effects. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Valuing Financial Claims with Equity Shifted to the Entrepreneur (continued)

How Staging with Mandatory Investment Affects Value

Game Tree for Staged Investment
Entrepreneur offers multi-stage investment single-stage investment Investor accepts offer Investor rejects offer Good state: Success is likely Bad state: Success is unlikely Invest in second stage Do not invest NPV (1000,100) (0,0) (90,10) (1800,500) (400,-200) (-200,-1800) (200,-300) Terminal nodes show NPV (entrepreneur, investor) Nature chooses ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Figure 13-8 and Related Scenarios (this is one of four scenarios -investing in stage 2 with success forecasted) Objective Given a staging option, the figure evaluates a particular decision rule: Invest in Stage Two if the Good State is Expected. Other workbook pages examine the other possibilities: Invest in Stage Two if the Bad State is Expected, Do Not Invest in Stage Two if the Good State is Expected, and Do not Invest in Stage Two if the Bad State is Expected. The purpose of examining all four is to determine how the investor is likely to behave in the second stage. The more general question is can more value be created by staging that is required? Only the second stage decisions are examined (conditional on first stage investments having been made). Assumptions The venture requires a total investment of $2.5 million (of which $500 thousand is human capital). A diversified investor provides up to $1.805 million in present value of investment, the entrepreneur provides the balance. The investor provides $805 thousand at time zero, and has the option to provide the balance plus interest at time two. Probabilities of good and bad states are equal at time zero. At time two the investor knows that the probability of the good state is either .9 or .1. Figure 13-8 deals with the case where probability of the good state at time two is .9, and assumes the investment is made. Since the entrepreneur's commitment is made at time zero, it is treated as before. No free cash flow until the fifth year, which is a liquidity event. The entrepreneur's value is not examined in this figure. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

This shows the first two of four results
This shows the first two of four results. Between these two, both with success forecasted, the investor would make the second stage investment. Look at individual spreadsheets for payoffs from different outcomes and actions. Note the differences in investor ownership share. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Investor Valuation of Two-Stage Investment with Discrete Scenarios (continued)
This shows the second two, with failure forecasted - the investor would not invest. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Investor Second-Stage Investment Decisions
This is a summary of the results and shows the second-stage decisions. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Figure 13-10 Objective Given a staging option,and the expected decisions of the outside investor, Determine value to the entrepreneur. This sheet is also used to determine the weights that will yield a $100 thousand NPV for the investor. Assumptions The venture requires a total investment of $2.5 million (of which $500 thousand is human capital). $1.5 million is provided at time zero, and the balance at time 2. A diversified investor provides up to $1.805 million in present value of investment, the entrepreneur provides the balance. The investor provides $805 thousand at time zero, and has the option to provide the balance plus interest at time two. Probabilities of good and bad states are equal at time zero. At time two the investor knows that the probability of the good state is either .9 or .1 and chooses optimally. Since the entrepreneur's commitment is made at time zero, it is treated as before. No free cash flow until the fifth year, which is a liquidity event. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Entrepreneur Valuation of Discrete Scenarios with Second-Stage Investment Optional (continued)

Staged Investment with Abandonment Option
Figures 13-11, 13-12 ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Simulation is an easier approach to use
This shows the first part of a simulation model of two-stage investment by an outside investor. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Simulation: Conditional Stage-2 Investment (cont
Simulation: Conditional Stage-2 Investment (cont.) (Note: figures do not relate to prior slide These are total investments, and cash inflows and outflows from a sample iteration of the model. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

This uses the same model, but breaks it down to study the marginal decisions to invest in the first and second stages and the entrepreneur’s decision to offer the venture. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Abbreviated Example (continued) (note: figures do not relate to prior slide)
This is the rest of the spreadsheet, looking at the first-stage only piece and the incremental value of the second stage.. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

This spreadsheet uses simulation results to evaluate the second-stage decision.

Valuing the Second-Stage Option Claims by Discounting the Conditional Cash Flows (continued)
Rest of spreadsheet shows value to the entrepreneur, for purpose of aligning incentives. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

This looks at the primary decision, assuming the second-stage decision is made rationally.

Valuing Financial Claims by Discounting All Expected Cash Flow (continued)

Valuing Financial Claims by Discounting All Expected Cash Flow (continued)
Example of simulation results - using the decision tree simulator. Need to show how to use this feature of venture.sim.

Results of Simulating the Decision Tree
Alternative simulation results. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Simulation Tree Results Under Alternative Market Potential Assumptions

Chapter 8 Venture Capital

Historical Development of Venture Capital as an Institution

Venture Capital New Commitments

Sources of Venture Capital Funds

The Organizational Structure of a Venture Capital Fund

Organizational Structure of Venture Capital Investment
Portfolio Companies Value creation Generate deal flow Screen opportunities Harvest investments Negotiate deals Monitor and advise General Partners Venture Capital Fund Pension plan Endowments Life insurance companies Corporations Individuals Limited Partners Effort and 1% of capital Annual Management Fee 2-3% Carried Interest 20-30% of Gain 99% of Investment Capital Capital Appreciation 70-80% of Gain Investment Capital and Effort Financial Claims ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14

Summary of Terms: Venture Capital Limited Partnership Agreement

Managing the Investment Portfolio

Allocation of Venture Capitalist Time

The Venture Capital Investment Process
Development of Fund Concept Secure Commitments from Investors Generate Deal Flow Closing of Fund First Capital Call Year 0 Screen Business Plans Evaluate and Conduct Due Diligence Negotiate Deals and Staging Additional Capital Calls Invest Funds 2-3 years Value Creation and Monitoring Board service Performance evaluation and review Recruitment management Assist with external relationships Help arrange additional financing 4-5 years Harvesting Investment IPO Acquisition LBO Liquidation Distributing Proceeds Cash Public Shares Other 2-3 years or more 7-10 years plus extensions

Incentive Conflicts and Structures

Key Covenant Classes of Venture Capital Limited Partnerships

Chapter 9 Choice of Financing

A Partial List of Financing Sources for New Ventures and Private Business
Asset-based Lending Business Angels Capital Leasing Commercial Bank Lending (various forms) Corporate Entrepreneurship Customer Financing Direct Public Offering Economic Development Program Financing Employee-provided Financing Equity Private Placement Export/Import Bank Financing Factoring Franchising Friends and Family Public Debt Issue Registered Initial Public Offering Research and Development Limited Partnerships Relational Investing or Strategic Partnering Royalty Financing Self (bootstrapping) Small Business Administration Financing Small Business Investment Company Financing Term Loan Vendor Financing Venture Capital ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

Factors That Affect the Choice of Financing
Financial needs of the venture Stage of Development Financial Condition Product-market Considerations Organizational Considerations Track Record/Reputation/Relationships ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

Financial Needs of the Venture
Immediacy of the need Size of the immediate need Duration of the immediate need Cumulative need ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

Stage of Development Completeness of the management team
Ease of communicating the venture’s merit Value of managerial/consulting services Importance of flexibility/adaptability ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

Financial Condition Risk/Return characteristics of the venture
Taxable income status Operating cash flow status Time to a liquidity event Transferability of tax benefits to investors Available collateral Cash flow cycle ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

Product-market and Organizational Considerations
Importance of rapid growth Importance of relationship with a supplier or distributor Dedication of distributors to the product Value of centralization of control ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

Track Record/ Reputation/Relationships
Track record of the venture Importance of future financing needs Past failure or financial distress Likely failure in the near future Reputation of the entrepreneur Relationships with financing sources ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

Some Financing Choices
Securitization Strategic investing Franchising Venture capital Angel investing Corporate venture investing SBA programs Direct public offering Factoring R&D Limited Partnerships Vendor financing Public offering ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

Estimates of Financing to Small Businesses and New
Ventures as of 1992. Source Amount Percent Principal owner 524.3 31.33% Angel finance 60 3.59% Venture capital 31 1.85% Other equity 215.2 12.86% Total equity 830.6 49.64% Commercial banks 313.8 18.75% Finance companies 82.1 4.91% Other institutions 50.1 2.99% Trade credit 264.1 15.78% Other business financing 82.1 4.91% Government 8.1 0.48% From principal owner 68.5 4.09% Credit cards 2.4 0.14% Other individuals 24.5 1.46% Total debt 842.9 50.37% Total 1673.4 100.00% Note: Includes all non-farm, non-financial, non-real estate small businesses Source: Berger and Udell (1998). ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

Chapter 10 Harvesting Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Harvesting Alternatives
Initial public offering Private placement / private sale Roll-up IPO Management buy-out Employee stock ownership plan © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

The Underwritten IPO Process
The role of the underwriter Issue pricing Due diligence Certification Distribution Market making Harvesting by going public In the IPO After the IPO Cost of public offering Cost of harvesting by going public © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

The IPO Issue Pricing Process for a Firm Commitment Underwriting
Figure 16-1 New Information from Market Comparable Firm Values New Information from Market Comparable Transactions and IPOs Filing Range reported in Preliminary Prospectus Issue Price reported in Final Prospectus Preliminary Estimate of Value Discounted Cash Flow Valuation Indications of Interest from Roadshow New Information from Due Diligence Information from Issuer “Take down” Due Diligence

IPO Cost Underwriter fee: 5-7 percent of proceeds
Direct issuing cost: 1-5 percent of proceeds Underpricing: percent of proceeds Total : percent of gross proceeds 17-31 percent of net proceeds © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

Cost of Harvesting by Going Public
IPO usually is a small fraction of total value. Selling shareholders normally harvest in the aftermarket. Selling shareholders bear their share of the dollar-valued cost of the IPO. Percentage cost of IPO is less important than percentage cost of harvesting. © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

Private Placement / Private Sale
Exchange modes Equity for cash Assets for cash Equity or assets for equity Valuation Discounts compared to public market value Cost of private sale Choice of public or private sale © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

Roll-up IPO The underlying theory of value creation
The off-setting costs Structural solutions Net benefit (cost v. share value) Examples © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

Roll-up IPO Figure 16-3 Owner of Private Company A
Owner of Private Company B Owner of Private Company C Exchange of shares for new shares, cash, and employment contracts New Company IPO Public Market Investors © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

Family-owned Businesses and ESOPs
Leveraged v. unleveraged ESOPs Advantages and disadvantages of ESOPs Valuation of ESOP shares to owners to employees © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

Structure of a Private Leveraged ESOP
Owner/ Entrepreneur Figure 16-2 Panel (a) ESOP Initiation Sell shares to ESOP trust for cash ESOP Trust Establish ESOP Plan Company Evaluation of equity for fee Cash loan secured by Company shares Valuation Service Bank

Panel (b) Annual Retirement Contribution Funding Company Annual retirement contribution ESOP Trust Funding of employee retirement Employees Evaluation of equity for fee Loan repayment/ Release of shares Valuation Service Bank © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

Panel (c) Share Redemption at Employee Retirement Company Annual Retirement contribution ESOP Trust Share redemption by Trust Employees Evaluation of equity for fee Valuation Service © 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

Chapter 1 Introduction to Entrepreneurial Finance

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