Chapter 1 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.
Transcript
Slide 1
Slide 2
Chapter 1 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.
Slide 3
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
Slide 4
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 Intellectual
Challenge Chapter 1
Slide 5
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 After This Course, You Should Be Able To: 2000,
Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1
Slide 6
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
Slide 7
Investment Decisions Financing Decisions Mixed Decisions Types
of Financial Decisions 2000, Entrepreneurial Finance, Smith and
Kiholm Smith Chapter 1
Slide 8
Terminations as a percent of start-ups Terminations with loss
to creditors as a percent of start-ups Source: Case, J., "The Dark
Side" Inc. Magazine, 1997,
http://www.inc.com/incmagazine/archives/27960801.html, based on The
State of Small Business: A Report of the President, 1994, U.S.
Government Printing Office, Washington, D.C., 1995. New Business
Formations & Terminations
Slide 9
The Objective 2000, Entrepreneurial Finance, Smith and Kiholm
Smith Chapter 1 Maximum Value for the Entrepreneur
Slide 10
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
Slide 11
Chapter 2 Overview of New Venture Financing 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.
Slide 12
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
Slide 13
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 Some Milestones for
New Venture Planning 2000, Entrepreneurial Finance, Smith and
Kiholm Smith Chapter 2 Block and MacMillan (1992)
Slide 14
Development Stage Start-up Early Growth Rapid Growth Exit
Stages of New Venture Development 2000, Entrepreneurial Finance,
Smith and Kiholm Smith Chapter 2
Slide 15
Figure 2-1 Stages of New Venture Development 2000,
Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2
Slide 16
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
Sequence of New Venture Financing 2000, Entrepreneurial Finance,
Smith and Kiholm Smith Chapter 2
Slide 17
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
Sources of New Venture Financing 2000, Entrepreneurial Finance,
Smith and Kiholm Smith Chapter 2
Slide 18
Sources of New Venture Financing 2000, Entrepreneurial Finance,
Smith and Kiholm Smith Chapter 2
Slide 19
Figure 2-3 Part I 1978 2000, Entrepreneurial Finance, Smith and
Kiholm Smith Chapter 2 Venture Capital Commitments by Source
Slide 20
Figure 2-3 Part II 1991 - 1995 2000, Entrepreneurial Finance,
Smith and Kiholm Smith Chapter 2 Venture Capital Commitments by
Source
Slide 21
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% Investment by Industry
- 1997 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 2
Slide 22
Percent Change from Prior Year How Changes in the Stock Market
Affect New Equity Capital Raising 2000, Entrepreneurial Finance,
Smith and Kiholm Smith Chapter 2 Figure 2-6
Slide 23
Figure 2-7 Number of Issues Gross Issue Proceeds in Millions
Number of Debt Issues by Proceeds of Issues: 1990-94 2000,
Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2
Slide 24
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 Deal
Structure 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 2
Slide 25
Chapter 3 The Business Plan 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.
Slide 26
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3
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 entrepreneurs beliefs, commitment, and capabilities. Understand
how the plan can facilitate negotiation with outside
investors.
Slide 27
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
Slide 28
What Makes the Business Plans of New Ventures Different? 2000,
Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3 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.
Slide 29
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3
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. Do the Planning Before the Writing
Slide 30
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3
Alternative Product Market and Financing Choices
Slide 31
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3
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 Contents of the Business Plan
Slide 32
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3
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 Making the Business
Plan Credible
Slide 33
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3
Protecting intellectual property Preempting rivals and first-mover
advantage Using non-disclosure agreements Relying on reputation The
Issue of Confidentiality
Slide 34
Financial Aspects of the Business Plan 2000, Entrepreneurial
Finance, Smith and Kiholm Smith Chapter 3 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
Slide 35
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. Chapter 4 New Venture Strategy
Slide 36
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 entrepreneurs 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
Slide 37
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 What Makes a Plan or Decision
Strategic?
Slide 38
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 Interactive Financial Strategy
Slide 39
Figure 4-2 2000, Entrepreneurial Finance, Smith and Kiholm
Smith Chapter 4 Financial Implications of Product-Market and
Organizational Strategic Choices
Slide 40
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
Slide 41
Value of Asset Value of Underlying Asset Underlying Asset E
Expiration Value Call before Expiration 2000, Entrepreneurial
Finance, Smith and Kiholm Smith Chapter 4 The Structure of a Call
Option
Slide 42
Buy a Call Write a Call Loss Gain Loss 2000, Entrepreneurial
Finance, Smith and Kiholm Smith Chapter 4 Realized Returns on
Options
Slide 43
Put-Call Parity 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
Complete markets Incomplete markets Complex Real Options (Rainbow
Options) Discrete scenarios Simulation 2000, Entrepreneurial
Finance, Smith and Kiholm Smith Chapter 4 Valuing Options
Slide 44
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 Real Options - Some
Examples
Slide 45
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
Slide 46
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 Decision
Tree - Restaurant Example
Slide 47
Figure 4-3 2000, Entrepreneurial Finance, Smith and Kiholm
Smith Chapter 4 High Demand (.3) Large restaurant Do not enter
Small restaurant Intermediate Demand (.5) Low Demand (.2) High
Demand (.3) Intermediate Demand (.5) Low Demand (.2) High Demand
(.3) Intermediate Demand (.5) Low Demand (.2) -$400,000 +.65 x
$1,500,000 = $575,000 -$400,000 +.65 x $800,000 = $120,000
-$400,000 +.65 x $300,000 = $-205,000 -$400,000 +.8 x $800,000 =
$240,000 -$400,000 +.8 x $400,000 = -$80,000 $0 Accept/Reject
Decision to Invest in Restaurant Business
Slide 48
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 $575,000 +.5 x $120,000 -.2 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 $240,000 +.5 x
$240,000 -.2 x $80,000 = $176,000 Do not enter: NPV = $0 2000,
Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4
Slide 49
Figure 4-4 Large restaurant Wait Small restaurant High Demand
(.3) Intermediate Demand (.5) Low Demand (.2) High Demand (.3)
Intermediate Demand (.5) Low Demand (.2) High Demand (.3)
Intermediate Demand (.5) Low Demand (.2) -$400,000 +.65 x
$1,500,000 = $575,000 -$400,000 +.65 x $800,000 = $120,000
-$400,000 +.65 x $300,000 = $-205,000 -$400,000 +.80 x $800,000 =
$240,000 -$400,000 +.80 x $400,000 = -$80,000 Determine market
demand -$400,000 +.65 x $1,300,000 = $445,000 -$400,000 +.80 x
$700,000 = $160,000 $0 2000, Entrepreneurial Finance, Smith and
Kiholm Smith Chapter 4 Restaurant Business Investment with an
Option to Delay Investing
Slide 50
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 $445,000 +.5 x $160,000 +.2 x $0 = $213,500
Value of Option to Delay = $213,500 - 191,500 = $22,000 2000,
Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4
Evaluation of Option to Delay
Slide 51
Figure 4-5 Large restaurant Do not enter Small restaurant High
Demand (.3) Intermediate Demand (.5) Low Demand (.2) High Demand
(.3) Intermediate Demand (.5) Low Demand (.2) High Demand (.3)
Intermediate Demand (.5) Low Demand (.2) -$400,000 +.65 x
$1,500,000 = $575,000 -$400,000 +.65 x $800,000 = $120,000
-$400,000 +.65 x $300,000 = $-205,000 -$400,000 +.80 x $800,000 =
$240,000 -$400,000 +.80 x $400,000 = -$80,000 $0 Expand Do not
expand -$400,000 +.70 x $1,400,000 = $580,000 -$400,000 +.80 x
$800,000 = $240,000 2000, Entrepreneurial Finance, Smith and Kiholm
Smith Chapter 4 Restaurant Business Investment with an Option to
Expand Initial Investment
Slide 52
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
$580,000 +.5 x $240,000 -.2 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 Expand
Slide 53
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 $575,000 +.5 x
$120,000 -.2 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) NPV with Abandonment
Option: =.3 x $580,000 +.5 x $240,000 -.2 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
Slide 54
The Basics 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 Game Trees
Slide 55
Develop the tree Prune branches involving dominated strategies
Specify assumptions about rival actions and reactions 2000,
Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4
Evaluating Strategic Games
Slide 56
Figure 4-6 $380,000 ($100,000) Kellys Bar Erins Pub Erins Pub
Erins Pub Kellys Bar Enter Stay Out Enter Stay Out Large Small Wait
Kellys Payoff Erins Payoff Large Small Stay Out Large Small Stay
Out $425,000 $0 $250,000 $200,000 $400,000 $0 $300,000 $100,000
$190,000 $210,000 $0 $300,000 $370,000 $0 $350,000 $0 $0 $0 Kellys
Bar Enter Stay Out 2000, Entrepreneurial Finance, Smith and Kiholm
Smith Chapter 4 Entry Decision Game Tree
Slide 57
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4
Extending brand names to new products or marketing through existing
distribution channels 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 ExamplesDescriptionOption 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 Examples of Real Options
Slide 58
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. Chapter 5 Financial Forecasting
Slide 59
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
Slide 60
A disciplined means to evaluate the cash needs of a venture An
aid to determine whether a proposed venture deserves the
entrepreneurs 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 Benefits of Financial Forecasting 2000, Entrepreneurial
Finance, Smith and Kiholm Smith Chapter 6
Slide 61
Firm Cash Future Cash 2000, Entrepreneurial Finance, Smith and
Kiholm Smith Chapter 6 The Firm as a Cash Conversion Process
Slide 62
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6
The Cash Flow of a Business Venture Fixed Assets Capital (equity
and debt) Infusions Beginning cash Expenditures EmployeesMaterials
Production Inventory Ending Cash Equity ReturnsDebt ServiceTaxes
Cash sales Accounts Receivable Credit Sales Collections
Reinvestment (to retained earnings)
Slide 63
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
Slide 64
Figure 6-2 Quantity Dollars Q Q* Manufacturers Long Run Average
Cost (LRAC) 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Slide 65
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) Factors that Increase a Firms Cash Needs
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
6
Slide 66
Introduction to Pro Forma Analysis 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 Assumptions for a simple
asset-driven business model: 2000, Entrepreneurial Finance, Smith
and Kiholm Smith Chapter 6
Slide 67
Assets Sales Net Income Retained Earnings Dividends S/A ROS
Retention 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6 Asset-driven Pro Forma Model
Slide 68
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 Five Year Pro Forma Analysis for a Simple
Business Venture 2000, Entrepreneurial Finance, Smith and Kiholm
Smith Chapter 6
Slide 69
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 Integrating Pro Forma Financial Statements
Slide 70
Figure 6-4 Assumptions Ending Balance Sheet Cash Flow Statement
Income Statement Beginning Balance Sheet Sales Forecast Integration
of Financial Statements: The Circular Flow 2000, Entrepreneurial
Finance, Smith and Kiholm Smith Chapter 6
Slide 71
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.)?
Key Questions to be Answered in a Sales Forecast 2000,
Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6
Slide 72
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
Slide 73
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
Slide 74
Forecasting in Real Terms Average Real Sales Growth = 3.66%
Range = -10.7% to 17% 2000, Entrepreneurial Finance, Smith and
Kiholm Smith Chapter 6
Slide 75
Using Weighting to Improve a Forecast Weighted Average Real
Sales Growth = 1.96% 2000, Entrepreneurial Finance, Smith and
Kiholm Smith Chapter 6
Slide 76
Using Regression Analysis to Forecast Regression Model:
Expected Real Sales Growth = 3.34% + 5.24 x Change in Real GDP
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
6
Slide 77
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
Slide 78
General Rules of Financial Forecasting 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 firms 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 Part 1
Slide 79
General Rules of Financial Forecasting 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 models 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
Part 2
Slide 80
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). New Company Assumptions 2000,
Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6
Slide 81
Figure 6-5 Part II 10) Entrepreneurs 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. New Company Assumptions 2000,
Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6
Slide 82
(Forecast generated monthly, selected months shown) Figure 6-6
New Company Sales Forecast 2000, Entrepreneurial Finance, Smith and
Kiholm Smith Chapter 6
Slide 83
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.
Slide 84
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
Slide 85
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
Slide 86
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 The Many Uses of
Valuation 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
Slide 87
Beauty is in the eye of the beholder. The future is anybodys
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. Valuation Myths 2000, Entrepreneurial
Finance, Smith and Kiholm Smith Chapter 8
Slide 88
Hurdle Rates For Venture Capital 2000, Entrepreneurial Finance,
Smith and Kiholm Smith Chapter 8
Slide 89
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? Venture Capital Realized Rates of Return (based on various
studies) 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
Slide 90
Valuation Methods Value = Present value of future cash flows
Two conceptually equivalent approaches The choice of method depends
on information availability. RADR - Risk-Adjusted Discount Rate CEQ
- Certainty Equivalent Cash Flow 2000, Entrepreneurial Finance,
Smith and Kiholm Smith Chapter 8
Slide 91
What cash flows should be valued? What discount rate should be
used? Issues for RADR Valuation 2000, Entrepreneurial Finance,
Smith and Kiholm Smith Chapter 8
Slide 92
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
Slide 93
Opportunity cost of capital Estimating the Discount Rate CAPM
All measures are based on holding period returns. 2000,
Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8 What
discount rate should be used?
Slide 94
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
Slide 95
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 r F M
MM 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
8
Slide 96
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 Risk M 2000, Entrepreneurial
Finance, Smith and Kiholm Smith Chapter 8
Slide 97
The Capital Asset Pricing Model Figure 8-5 Beta 1.0 Return
Security Market Line Market Portfolio r r F M 2000, Entrepreneurial
Finance, Smith and Kiholm Smith Chapter 8
Slide 98
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
Slide 99
Matching Cash Flows to Discount Rates for Various Financial
Claims Figure 8-6 2000, Entrepreneurial Finance, Smith and Kiholm
Smith Chapter 8
Slide 100
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
Slide 101
CAPM The CEQ Form of the CAPM 2000, Entrepreneurial Finance,
Smith and Kiholm Smith Chapter 8
Slide 102
Slide 103
Chapter 7 Financial Contracting 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.
Slide 104
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13 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. Learning Objectives
Slide 105
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13
Slide 106
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13
Slide 107
Determining the Required Shares of Staged Investment 2000,
Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 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
10.30 percent. 10.30 % = 10.05 % / (100 % - 2.43 %) Similarly, the
the required share for the investor in the first round is 31.77
percent. 31.77 % = 27.80 % / (100 % - 2.43 % - 10.05 %)
Slide 108
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
Slide 109
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13 Step 1: Estimate the expected cash return and total risk
(standard deviation of cash flows) of the entrepreneurs financial
interest in the venture. Step 2: Estimate the expect cash return
and risk of the entrepreneurs 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 entrepreneurs total portfolio. Step 4: Value the
portfolio by the CEQ method (based on its total risk). Step 5:
Infer the value of the entrepreneurs investment in the venture by
subtracting the market value of the entrepreneurs investment in the
market index portfolio. Evaluating the Entrepreneurs Investment
Based on Expected Returns
Slide 110
Single-Stage Investment with Discrete Scenarios
Slide 111
Valuing Financial Claims with Proportional Allocation
(continued) 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
Slide 112
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13
Slide 113
Valuing Financial Claims with Equity Shifted to the
Entrepreneur (continued) 2000, Entrepreneurial Finance, Smith and
Kiholm Smith Chapter 13
Slide 114
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13
Slide 115
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13 Valuing Financial Claims with the Entrepreneurs Investment
Reduced (continued)
Slide 116
How Changing the Contract Affects Value 2000, Entrepreneurial
Finance, Smith and Kiholm Smith Chapter 13
Slide 117
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13
Slide 118
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13 Valuing Financial Claims with Equity Shifted to the Entrepreneur
(continued)
Slide 119
How Staging with Mandatory Investment Affects Value 2000,
Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13
Slide 120
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13 Game Tree for Staged Investment Nature chooses Entrepreneur
offers multi-stage investment Entrepreneur offers single-stage
investment Investor accepts offer Investor rejects offer Investor
accepts offer Good state: Success is likely Bad state: Success is
unlikely Invest in second stage Do not invest NPV (1000,100) NPV
(0,0) NPV (90,10) NPV (0,0) NPV (1800,500) NPV (400,-200) NPV
(-200,-1800) Do not invest NPV (200,-300) Terminal nodes show NPV
(entrepreneur, investor)
Slide 121
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13
Slide 122
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13
Slide 123
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13 Investor Valuation of Two-Stage Investment with Discrete
Scenarios (continued)
Slide 124
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13 Investor Second-Stage Investment Decisions
Slide 125
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13
Slide 126
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13 Entrepreneur Valuation of Discrete Scenarios with Second-Stage
Investment Optional (continued)
Slide 127
Staged Investment with Abandonment Option Figures 13-11, 13-12
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13
Slide 128
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13
Slide 129
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13 Simulation: Conditional Stage-2 Investment (cont.) (Note:
figures do not relate to prior slide
Slide 130
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13
Slide 131
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13 Abbreviated Example (continued) (note: figures do not relate to
prior slide)
Slide 132
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13
Slide 133
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13 Valuing the Second-Stage Option Claims by Discounting the
Conditional Cash Flows (continued)
Slide 134
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13
Slide 135
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13 Valuing Financial Claims by Discounting All Expected Cash Flow
(continued)
Slide 136
Slide 137
Results of Simulating the Decision Tree 2000, Entrepreneurial
Finance, Smith and Kiholm Smith Chapter 13
Slide 138
Slide 139
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
13 Simulation Tree Results Under Alternative Market Potential
Assumptions
Slide 140
Chapter 8 Venture Capital 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.
Slide 141
Historical Development of Venture Capital as an Institution
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
14
Slide 142
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
14 Venture Capital New Commitments
Slide 143
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
14 Sources of Venture Capital Funds
Slide 144
The Organizational Structure of a Venture Capital Fund 2000,
Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14
Slide 145
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
14 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
Slide 146
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
14 Summary of Terms: Venture Capital Limited Partnership
Agreement
Slide 147
Managing the Investment Portfolio 2000, Entrepreneurial
Finance, Smith and Kiholm Smith Chapter 14
Slide 148
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
14 Allocation of Venture Capitalist Time
Slide 149
The Venture Capital Investment Process Development of Fund
Concept Secure Commitments from Investors Generate Deal Flow
Closing of Fund First Capital Call Screen Business Plans Evaluate
and Conduct Due Diligence Negotiate Deals and Staging Additional
Capital Calls Invest Funds Distributing Proceeds Cash Public Shares
Other Harvesting Investment IPO Acquisition LBO Liquidation Value
Creation and Monitoring Board service Performance evaluation and
review Recruitment management Assist with external relationships
Help arrange additional financing Year 0 2-3 years 4-5 years 2-3
years or more 7-10 years plus extensions
Slide 150
Incentive Conflicts and Structures 2000, Entrepreneurial
Finance, Smith and Kiholm Smith Chapter 14
Slide 151
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
14 Key Covenant Classes of Venture Capital Limited
Partnerships
Slide 152
Chapter 9 Choice of Financing 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.
Slide 153
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
15 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
Slide 154
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
Slide 155
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 Financial Needs of the
Venture
Slide 156
Completeness of the management team Ease of communicating the
ventures merit Value of managerial/consulting services Importance
of flexibility/adaptability 2000, Entrepreneurial Finance, Smith
and Kiholm Smith Chapter 15 Stage of Development
Slide 157
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 Financial Condition
Slide 158
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 Product-market and Organizational
Considerations
Slide 159
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 Track Record/ Reputation/Relationships
Slide 160
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
Slide 161
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
15
Slide 162
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
15 SourceAmountPercent Principal owner524.331.33% Angel
finance603.59% Venture capital311.85% Other equity215.212.86% Total
equity 830.649.64% Commercial banks313.818.75% Finance
companies82.14.91% Other institutions50.12.99% Trade
credit264.115.78% Other business financing82.14.91%
Government8.10.48% From principal owner68.54.09% Credit
cards2.40.14% Other individuals24.51.46% Total debt 842.950.37%
Total 1673.4100.00% Note: Includes all non-farm, non-financial,
non-real estate small businesses Source: Berger and Udell (1998).
Estimates of Financing to Small Businesses and New Ventures as of
1992.
Slide 163
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.
Slide 164
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
Slide 165
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
Slide 166
The IPO Issue Pricing Process for a Firm Commitment
Underwriting Figure 16-1 Comparable Firm Values Comparable
Transactions and IPOs Discounted Cash Flow Valuation Information
from Issuer Preliminary Estimate of Value New Information from
Market New Information from Due Diligence Filing Range reported in
Preliminary Prospectus New Information from Market Indications of
Interest from Roadshow Take down Due Diligence Issue Price reported
in Final Prospectus
Slide 167
Underwriter fee: 5-7 percent of proceeds Direct issuing cost:
1-5 percent of proceeds Underpricing: 10-15 percent of proceeds
Total : 16-27 percent of gross proceeds 17-31 percent of net
proceeds 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 16 IPO Cost
Slide 168
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 Cost of Harvesting by Going Public
Slide 169
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
Slide 170
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
Slide 171
Roll-up IPO 2000, Entrepreneurial Finance, Smith and Kiholm
Smith Chapter 16 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
Slide 172
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
Slide 173
Structure of a Private Leveraged ESOP Panel (a) ESOP Initiation
Company Establish ESOP Plan ESOP Trust Sell shares to ESOP trust
for cash Owner/ Entrepreneur Evaluation of equity for fee Cash loan
secured by Company shares Valuation Service Bank Figure 16-2
Slide 174
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
16 Structure of a Private Leveraged ESOP 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
Slide 175
2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter
16 Structure of a Private Leveraged ESOP 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