© 2007 Thomson South-Western

Chapter 26Entrepreneurial Finance

And Venture Capital

Professor XXXXXCourse Name / Number

22

Entrepreneurial Finance

Entrepreneurial growth companies

Rapidly growing public or private firms

Large external funding needs and imperfect access to public financial markets

Often based on proprietary technology or unique service

Challenges:

Need to fund rapid growth externally Mostly intangible assets; Little ability to borrow Extremely high risk, potentially high return

companies Must attract top people with minimum cash

outlay

Entrepreneurial growth companies very reliant on equity finance

33

Types of Venture Capital Funds

Institutional venture capitalists SBICs Financial and corporate venture capital Corporate venture capital Capital limited partnerships

“Angel” capitalists

44

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

55

Geographic and Industrial Investment Patterns

Venture capital investments are highly concentrated geographically.

California usually receives over half US total VC investment. Silicon Valley attracts 25-50% of total.

New England, NYC, Washington DC also major recipients

Investments predominant in high-technology industries;

Specific target industries change over time.

Are venture capital investments profitable though?

66

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

77

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

%

88

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

99

How Investments Are Structured

Venture capitalists almost always invest using convertible preferred stock.

Venture capitalists typically make early and expansion stage investments.

The earlier the stage of investment, the more onerous the venture capitalists’ terms will be (price, control surrendered)

Staged financing

Preserves cancellation option for venture capitalist at each stage

Same venture capitalists tend to remain throughout a firm’s development.

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Distribution of Rights and Responsibilities

Venture capital contracts allocate risk, return, and ownership rights between the entrepreneur (and other existing owners of a portfolio company) and the fund, depending on (1) the experience and reputation of the

entrepreneur (2) the attractiveness of the portfolio

company as an investment opportunity (3) the stage of the company’s development (4) the negotiating skills of the contracting

parties (5) the overall state of the market

1111

Typical VC Investment Contract Covenants

Ownership right agreements: set voting rights, board seats

Ratchet provisions: protect the venture capitalist in the event of new equity sales

Demand registration rights, participation rights, repurchase rights: exit strategies for

venture capitalist

Stock option plans: designed to attract and motivate key managers

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Convertible Securities

1. Because convertible debt or preferred stock is a distinct security class, contract terms and covenants specific to that issue are negotiable. F

2. Firms can create multiple classes of convertible debt or preferred stock, and use these securities to construct complex contracting arrangements with different investor groups.

2. Seniority places the VC ahead of the entrepreneur in the line of claimants on the firm’s assets should the firm not succeed.

3. Give VCs the right to participate in the upside when portfolio companies thrive.

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The Pricing Of Venture Capital Investments Based on company’s development stage, expected future

firm value and entrepreneur prestige Earlier the development stage, higher the return

demanded Expected future market value based on firm’s expected

earnings (NI) and likely P/E ratio at exit date (IPO or merger). Algebraically: Exp MV = Exp(NI) x P/E

Venture capital pricing inputs: Required return (r), years to exit via merger or IPO (n), and initial investment amount (A) Looking for expected firm value in n years (FV) From this determine fraction of equity (%Equity) VC

receives

An example....

Venture capitalist to provide $5 million

IPO expected: n = 5 yrs; Exp(NI)= $4,000,000; P/E = 20

A = $5,000,000; r = 50%.

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The Pricing Of VC Investments

Step 1: compute value of VC stake at exit date:

FV = A (1+r)n = $5,000,000 x (1.50) 5 = $38,000,000

Step 2: compute expected firm market value at exit date: Based on Exp(NI) and expected P/E ratio:

Expected MV = Exp(NI) x P/E = $4,000,000 x 20 = $80,000,000

Step 3:compute fraction of firm’s equity VC will take today:

%Equity = FV ÷ Exp MV = $38,000,000 ÷ $80,000,000 = 0.475

So venture capitalist invests $5 million, receives 47.5% of firm.

Very expensive financing!!

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Venture Capital Exit Strategies

(1) IPO of shares to outside investors

(2) Sale of the portfolio company directly to another company

(3) Selling the company back to the entrepreneur/founders (the redemption option)

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Venture Capital Exit Strategies

Preferred exit vehicles: IPO, followed by mergers

On average, IPOs return about 4 times initial VC investment Mergers less than half as profitable

Third exit: forced sale (redemption) to entrepreneur

Venture capitalists do not sell many shares at IPOHold for 1-2 years after IPO, then distribute shares to limited

partners

1717

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

1818

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

1919

European Private Equity Raised by Type ofInvestor, Year 2003 (€ 29.096 billion total investment)

2020

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

2121

Investment Returns to Categories of EuropeanPrivate Equity Investment, 1984–2003

2222

European Venture Capital

European venture capital (EVC) comparable to U.S. in size

Investment concentrated geographically and industrially

Technology accounts for increasing fraction of EVC

2323

Key Requirements For A Strong Venture Capital Industry

A tradition of entrepreneurship and risk-taking A well-established legal system, with good investor protection A supportive, but non-interventionist, government A stable regulatory system that doesn’t penalize start-ups A free (and mobile) labor market, rich in engineering talent A non-punitive taxation regime that allows use of stock options A strong R&D culture, especially in universities or national labs A vibrant IPO market, but could be a result, not a prerequisite Funded pension system (independent funds) very helpful

What economic, cultural and legal features will promote a strong venture capital industry?

2424

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