Entrepreneurial Finance: Strategy, Valuation, and Deal Structure 9780804770910, 0804770913

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Entrepreneurial Finance

Entrepreneurial Finance Strategy, Valuation, and Deal Structure

Janet Kiholm Smith Richard L. Smith Richard T. Bliss

Stanford Economics and Finance

An Imprint of Stanford University Press Stanford, California

Stanford University Press Stanford, California © 2011 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying and recording, or in any information storage or retrieval system without the prior written permission of Stanford University Press. Special discounts for bulk quantities of Stanford Business Books are available to corporations, professional associations, and other organizations. For details and discount information, contact the special sales department of Stanford University Press. Tel: (650) 736-1782, Fax: (650) 736-1784 Printed in the United States of America on acid-free, archival-quality paper Library of Congress Cataloging-in-Publication Data Smith, Janet Kiholm. Entrepreneurial finance : strategy, valuation, and deal structure / Janet Kiholm Smith, Richard L. Smith, and Richard T. Bliss.   p. cm.   Includes bibliographical references and index.   ISBN 978-0-8047-7091-0 (cloth : alk. paper)   1.  Venture capital.  2.  New business enterprises—Finance.  3.  Entrepreneurship.  I.  Smith, Richard L. (Richard Lester)  II.  Bliss, Richard T. (Richard Thomas), 1958–​  III.  Title.  HG4751.S594 2011  658.15′224—dc22 2010026481 Original printing 2011 Last figure below indicates year of this printing: 16  15  14  13  12

For Kelly and Erin. J.K.S. R.L.S. For my family, and especially Christine and Dylan. R.T.B.

CONT ENTS

List of Illustrations   xvii Abbreviations  xxiii Preface  xxvii Acknowledgments  xxxix About the Authors   xli

PART 1  Getting Started Chapter 1 Introduction   3 1.1 Entrepreneurship and the Entrepreneur   3 1.2 The Finance Paradigm   12 1.3 The Rocket Analogy   14 1.4 The Stages of New Venture Development   15 1.5 Measuring Progress with Milestones   17 1.6 Financial Performance and Stages of New Venture Development   19 1.7 The Sequence of New Venture Financing   21 1.8 The New Venture Business Plan   24 1.9 Organization of the Book   29 1.10 Summary  31 vii

viii  Contents



Review Questions  32



Notes  33



References and Additional Reading   34

Chapter 2  New Venture Financing: Considerations and Choices   37 2.1 Sources of New Venture Financing   37 2.2 What’s Different about Financing Social Ventures?   55 2.3 Considerations When Choosing Financing: The Organizational Form   57 2.4 Regulatory Considerations  60 2.5 The Deal  64 2.6 International Differences in Financing Options   71 2.7 Summary  73

Review Questions  74



Notes  75



References and Additional Reading   77

Chapter 3  Venture Capital   79 3.1 Development of the Venture Capital Market   80 3.2 The Organization of Venture Capital Firms   89 3.3 How Venture Capitalists Add Value   99 3.4 Investment Selection and Venture Capitalist Compensation  106 3.5 Venture Capital Contracts with Portfolio Companies   107 3.6 Venture Capital Contracts with Investors   109 3.7 The Role of Reputation in the Venture Capital Market   113 3.8 Reputation, Returns, and Market Volatility   114 3.9 Summary  115

Review Questions  116



Notes  117



References and Additional Reading   119

Contents  ix

PART 2  Financial Aspects of Strategic Planning Chapter 4  New Venture Strategy and Real Options   125 4.1 Product-Market, Financial, and Organizational Strategy   126 4.2 The Interdependence of Strategic Choices: An Example   128 4.3 What Makes a Plan or Decision Strategic?   130 4.4 Financial Strategy  131 4.5 Deciding on the Objective   132 4.6 Strategic Planning for New Ventures   134 4.7 Recognizing Real Options   137 4.8 Strategic Planning and Decision Trees   141 4.9 Rival Reactions and Game Trees   151 4.10 Strategic Flexibility versus Strategic Commitment   155 4.11 Strategic Planning and the Business Plan   156 4.12 Summary  157

Review Questions  157



Notes  158



References and Additional Reading   160

Chapter 5  Developing Business Strategy Using Simulation   162 5.1 Use of Simulation in Business Planning: An Example   163 5.2 Who Relies on Simulation?   165 5.3 Simulation in New Venture Finance   166 5.4 Simulation: An Illustration   167 5.5 Simulating the Value of an Option   171 5.6 Describing Risk  173 5.7 Using Simulation to Evaluate a Strategy   176 5.8 Comparing Strategic Choices   187 5.9 Summary  198

Review Questions  198

x  Contents



Notes  199



References and Additional Reading   200

PART 3  Financial Forecasting and Assessing Financial Needs Chapter 6  Methods of Financial Forecasting: Revenue   205 6.1 Principles of Financial Forecasting   206 6.2 Forecasting Revenue  207 6.3 Estimating Uncertainty  222 6.4 Building a New Venture Revenue Forecast: An Illustration   225 6.5 Introducing Uncertainty to the Forecast: Continuing the Illustration   228 6.6 Calibrating the Development Timing Assumption: An Example  236 6.7 Summary  239

Review Questions  240



Notes  241



References and Additional Reading   242

Chapter 7 Methods of Financial Forecasting: Integrated Financial Modeling   243 7.1 An Overview of Financial Statements   244 7.2 The Cash Conversion Cycle   248 7.3 Working Capital, Growth, and Financial Needs   251 7.4 Developing Assumptions for the Financial Model   256 7.5 Building a Financial Model of the Venture   266 7.6 Adding Uncertainty to the Model   277 7.7 NewCompany: Building an Integrated Financial Model   281 7.8 Summary  293

Review Questions  294



Notes  295



References and Additional Reading   296

Contents  xi

Chapter 8  Assessing Financial Needs   297 8.1 Sustainable Growth as a Starting Point   299 8.2 Assessing Financial Needs When the Desired Growth Rate Exceeds the Sustainable Growth Rate   304 8.3 Planning for Product-Market Uncertainty   306 8.4 Cash Flow Breakeven Analysis   310 8.5 Assessing Financial Needs with Scenario Analysis   315 8.6 Assessing Financial Needs with Simulation   319 8.7 How Much Money Does the Venture Need?   324 8.8 Assessing Financial Needs with Staged Investment   331 8.9 Summary 334

Review Questions  335



Notes  336



References and Additional Reading   336

PART 4 Valuation Chapter 9  Foundations of New Venture Valuation   341 9.1 Perspectives on the Valuation of New Ventures  342 9.2 Myths about New Venture Valuation   343 9.3 An Overview of Valuation Methods   347 9.4 Discounted Cash Flow Valuation   352 9.5 The Relative Value Method   363 9.6 Valuation by the Venture Capital Method   367 9.7 Valuation by the First Chicago Method   369 9.8 Reconciliation with the Pricing of Options   370 9.9 Required Rates of Return for Investing in New Ventures   372 9.10 Matching Cash Flows and Discount Rates   374 9.11 Summary  378

Review Questions  379

xii  Contents



Notes  380



References and Additional Reading   382

Chapter 10  Valuation in Practice   386 10.1 Criteria for Selecting a New Venture Valuation Model   386 10.2 Implementing the Continuing Value Concept   388 10.3 Implementing DCF Valuation Methods   396 10.4 New Venture Valuation: An Illustration   412 10.5 The Cost of Capital for Non–US Investors   427 10.6 Summary  428

Review Questions  429



Notes  429



References and Additional Reading   430

Chapter 11 The Entrepreneur’s Perspective on Value   432 11.1 Opportunity Cost and Choosing Entrepreneurship   434 11.2 The Entrepreneur as an Underdiversified Investor   437 11.3 Valuing Partial-Commitment Investments   430 11.4 Implementation: Partial Commitment   452 11.5 Shortcuts and Extensions   457 11.6 Benefits of Diversification   464 11.7 A Sanity Check: The Art and Science of Investment Decisions  466 11.8 Summary  469

Review Questions  470



Notes  471



References and Additional Reading   472

Contents  xiii

PART 5  Information, Incentives, and Financial Contracting Chapter 12 Deal Structure: Addressing Information and Incentive Problems   477 12.1 Some Preliminaries  478 12.2 Proportional Sharing of Risk and Return   479 12.3 Asymmetric Sharing of Risk and Return   481 12.4 Contract Choices That Allocate Expected Returns  483 12.5 Contract Choices That Alter Venture Returns   489 12.6 Implementation and Negotiation   490 12.7 A Recap of Contracting with Asymmetric Attitudes toward Risk  493 12.8 Information Problems, Incentive Problems, and Financial Contracting   494 12.9 A Taxonomy of Information and Incentive Problems   495 12.10 Essentials of Contract Design   508 12.11 Organizational Choice  516 12.12 Summary  520

Review Questions  522



Notes  522



References and Additional Reading   525

Chapter 13  Value Creation and Contract Design   529 13.1

Staged Investment: The Venture Capital Method   530

13.2 Staged Investment: CAPM Valuation with Discrete Scenarios  536 13.3 Valuation-Based Contracting Model   545 13.4 Negotiating to Increase Value, Signal Beliefs, and Align Interests   549 13.5 Using Simulation to Design Financial Contracts   550 13.6 Information, Incentives, and Contract Choice   560 13.7 Summary  567

xiv  Contents



Review Questions  568



Notes  568



References and Additional Reading  569

Chapter 14  Choice of Financing   571 14.1 Financing Alternatives  571 14.2 The Objective and Basic Principles of the Financing Decision  573 14.3 An Overview of the Financing Decision Process   575 14.4 First Step: Assess the Current Stage and Condition of the Venture  577 14.5 Second Step: Assess the Nature of the Venture’s Financial Needs  584 14.6 Financing Choices and Organizational Structure   589 14.7

How Financial Distress Affects Financing Choices   591

14.8 How Reputations and Relationships Affect Financing Choices  594 14.9

Avoiding Missteps and Dealing with Market Downturns   596

14.10 Summary  599

Review Questions  600



Notes  601



References and Additional Reading  605

PART 6  Harvesting and Beyond Chapter 15 Harvesting   611 15.1 Going Public  612 15.2 Acquisition  625 15.3 Management Buyout  633 15.4 Employee Stock Ownership Plans   634 15.5 Roll-Up IPO  638

Contents  xv

15.6 The Harvesting Decision   640 15.7

Venture Capital Harvesting and the “Internet Bubble”   643

15.8 Summary 648

Review Questions  649



Notes  650



References and Additional Reading   654

Chapter 16 The Future of Entrepreneurial Finance: A Global Perspective   658 16.1

Completing the Circle   659

16.2 Breaking New Ground   664 16.3 Public Policy and Entrepreneurial Activity: An International Comparison  669 16.4 The Future of Entrepreneurial Finance   683

Notes  689



References and Additional Reading   691

Index  695

I L L U S T R AT I O N S

FIGURES

1.1 1.2 1.3 1.4 1.5 2.1 2.2 2.3 2.4

Survival rates of new ventures   6 Global difference in supportiveness for starting and doing business   8 Entrepreneurial involvement of workforce, 2006   10 Stages of new venture development   16 Financial performance and stages of new venture development   20 Sources of new venture financing   38 New venture capital investments by sector   42 New venture capital investments by region   43 Corporate venture capital investment as a percentage of total venture capital investment  47 2.5 Global growth of factoring as a source of financing   51 2.6 Percentage of businesses by form and business receipts (tax year 2003)   60 2.7 Worldwide sources of business financing, 2007    72 3.1 New venture capital commitments, 1969–​2009   81 3.2 Venture capital investments in the United States, 1970–​2009   84 3.3 Pension fund assets allocated to equity securities, by country   85 3.4 Venture capital investments by stage of development   86 3.5 Sources of new commitments of venture capital   87 3.6 European new private equity commitments   88 3.7 Organizational structure of venture capital investment   90 3.8 Net quarterly returns to limited partners of venture capital funds   93 3.9 The venture capital investment process   95 xvii

xviii  Illustrations



3.10 4.1 4.2 4.3



4.4



4.5



4.6 5.1 5.2 5.3



5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 5.12 5.13 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 7.1 7.2 7.3 7.4 7.5

Allocation of venture capitalist time   102 The interdependent components of strategy   126 Expiration date values of call and put options on Amazon.com stock   138 Decision tree for accept/reject decision to invest in restaurant business   144 Decision tree for investing in a restaurant business, with the option to delay investing until uncertainty about market demand is resolved   147 Decision tree for investing in a restaurant business, with the option to expand the initial investment    149 Entry decision game tree   153 Warehouse simulation model   169 Results of simulating the warehouse model   170 Simulation model of stock price and put and call option expiration values  172 Simulation of 12 months of stock price performance S   172 Illustrations of Venture.SIM statistical distributions   175 Unconditional simulation results   182 Distribution of market size estimates generated by simulation   184 Histogram of unit sales simulation results    185 Convergence of the entrepreneur’s NPV   186 Small restaurant—NPV to entrepreneur   191 Large restaurant overlaid with small—NPV to entrepreneur    192 Subtree for restaurant learning option with simulated uncertainty   194 Subtree for restaurant expansion option with simulated uncertainty   197 NewCompany revenue assumptions   226 NewCompany revenue forecast   227 NewCompany revenue simulation assumptions   233 Discrete probability approach to simulating development timing   234 NewCompany simulated distribution of development timing   235 NewCompany revenue forecast—sample trial results   236 New drug approval times: 1970–​2001   237 New drug approval times in 2000   238 The cash conversion cycle of the firm   249 Working capital policy template T   253 Simulation results from the Morebucks financial model   281 NewCompany integrated financial model assumptions   282 NewCompany expected financial performance   288

Illustrations  xix



7.6 NewCompany credit line balance for five simulation trials and summary table of key variables for 10,000 trials   292 8.1 Sustainable growth model template T   300 8.2 Financial leverage and sustainable growth   303 8.3 iFree breakeven analysis   314 8.4 NewCompany simulation: Credit line balance for Years 1–​6   321 8.5 NewCompany results of initial financing choices   331 8.6 NewCompany results of second-stage investment decision rule   333 9.1 Distribution of VC fund average annual IRRs   343 9.2 VC returns to limited partners by vintage year, 1981–​2008   346 9.3 How portfolio risk depends on the number of assets in the portfolio   356 9.4 The Capital Asset Pricing Model (CAPM)   357 9.5 Certainty equivalence in popular culture   362 10.1 Using continuing value to estimate the worth of a new venture   389 10.2 Price/earnings ratio of the S&P 500 Index, 1956–​2008   394 10.3 Using arithmetic or geometric average returns   399 11.1 Attributes of entrepreneurs: Evidence concerning their wealth, savings, and diversification  436 11.2 How venture risk and diversification affect the entrepreneur’s cost of capital  440 11.3 The capital market line and required rates of return for diversified and undiversified investors  442 11.4 Net present value (NPV) and percentage of risk capital invested in venture  457 11.5 Why diversification adds value   465 12.1 Agency cost of outside equity   504 13.1 Staged investment model of aircraft navigation software venture   539 14.1 Selected financing sources for new ventures   572 14.2 The financing decision process   576 15.1 The IPO issue pricing process for a firm commitment underwriting   615 15.2 Structure of a private leveraged ESOP   637 15.3 Roll-Up IPO  639 15.4 Morgan Stanley High-Technology Stock Index, 1995–​2005   644 15.5 Numbers of exits of venture-backed firms via IPO and merger and the NASDAQ Index by quarter (1978–​2009)   647 16.1 Early-stage entrepreneurial activity and GDP per capita, 2008   670 16.2 Gross expenditures on R&D, 2006   671 16.3 Entrepreneurship and the BRIC countries   672

xx  Illustrations

TABLES

16.4 Early-stage high-growth entrepreneurship (prevalence rate in the adult population)  674 2.1 Common organizational forms in the United States   57 3.1 Summary of terms of venture capital limited partnership agreement   94 3.2 Standard provisions of venture capital term sheet for convertible preferred investment  110 3.3 Key covenant classes in venture capital limited partnerships   111 4.1 Financial implications of product-market and organizational strategic choices  135 4.2 Examples of real options   141 5.1 Assumptions and statistical processes of the large restaurant model   180 6.1 Aviation navigation yardstick companies   216 6.2 Fundamental analysis of general aviation market and revenue forecast  219 7.1 Income statement  245 7.2 Balance sheet  246 7.3 Cash flow statement   248 7.4 Key business ratios for eating and drinking establishments   259 7.5 Peet’s Coffee and Tea, Inc. financials prior to IPO   261 7.6 Peet’s Coffee and Tea, Inc. common size statements   263 7.7 Peet’s Coffee and Tea, Inc. financial ratios   264 7.8 Step 1 of pro forma financial model for Morebucks: Income statement assumptions  268 7.9 Step 2 of pro forma financial model for Morebucks: Working capital and fixed assets assumptions   270 7.10 Step 3 of pro forma financial model for Morebucks: Investment assumption  274 7.11 Morebucks sensitivity to key assumptions   277 7.12 Pro forma financial model for Morebucks with simulation S   279 7.13 NewCompany pro forma financial statements S   284 7.14 NewCompany assumptions T   291 8.1 Revenue and expense assumptions of iFree at various user levels   311 8.2 Pro forma financial data for iFree at various user levels   313 8.3 iFree scenario analysis   317 8.4 NewCompany simulation results for alternative initial financing decisions  327 9.1 Measures of expected cash flow   375 9.2 Matching cash flows to discount rates for various financial claims   376 10.1 Historical stock and bond returns   398

Illustrations  xxi



10.2 10.3 10.4 10.5

Equity betas by SIC code   401 Beta and correlation estimates for recently public firms   403 Standard deviation of market return for various holding periods   408 Valuation Template 1: RADR valuation based on a discrete scenario cash flow forecast T   416 10.6 Valuation Template 2: CEQ valuation based on a discrete scenario cash flow forecast T   418 10.7 Valuation by the VC method using various discount rates   424 11.1 Valuation Template 3: Present value of the entrepreneur’s wealth and commitment T   449 11.2 New venture simulation model S   453 11.3 Valuation Template 4: Valuation—Partial commitment of the entrepreneur T   455 11.4 Valuation Template 5: Entrepreneur’s cost of capital T   461 11.5 Underdiversification premium  463 12.1 Valuation Template 6: Investor value and value of entrepreneur’s partial commitment T   486 12.2 Comparative valuation of outside financing alternatives   492 12.3 The new venture underinvestment problem   500 12.4 The contracting framework   519 13.1 Valuation Template 7: VC method—Single-stage investment T   531 13.2 Valuation Template 8: VC method—Multistage investment T   532 13.3 Financial model based on business plan   537 13.4 Valuation template 9: VC method—Single-round financing T   538 13.5 DFC valuation of unstaged investment   541 13.6 DFC valuation of staged investment   543 13.7 Valuation-based contracting model of ownership shares   544 13.8 Risk and return of entrepreneur’s financial claim   548 13.9 Valuation of entrepreneur’s interest in venture   549 13.10 New venture simulation with conditional second-stage investment   553 13.11 New venture simulation: Incremental effects of conditional second-stage investment  555 13.12 Valuing the second-stage option claims by discounting the conditional cash flows   557 13.13 Valuing financial claims by discounting all expected cash flows   559 14.1 Comparison of angel investor and venture capital / private equity investment styles  581 14.2 Initial public offering and bond issue cost by issue size   588 15.1 Private placement discounts compared to equity market value   631

A B B R E V I AT I O N S



A assets A/P accounts payable A/R accounts receivable BDC business development company BEP breakeven point BRIC Brazil, Russia, India, and China BS balance sheet BV book value CAPM Capital Asset Pricing Model CEQ certainty equivalent CF cash flow CML capital market line COGS cost of goods sold D debt or dividend per share (depending on context) D&A depreciation and amortization D/E debt to equity ratio D/V debt to value ratio DCF discounted cash flow DPO direct public offering E equity E/V equity to value ratio EBIT earnings before interest and taxes

xxiii

xxiv  Abbreviations



EBITDA earnings before interest, taxes, depreciation, and amortization EBT earnings before tax ERISA Employee Retirement Income Security Act ESOP employee stock ownership plan FDA Food and Drug Administration FY fiscal year g* sustainable growth rate GAAP Generally Accepted Accounting Principles GDP gross domestic product GEM Global Entrepreneurship Monitor GP general partner ICA Investment Company Act of 1940 IFRS International Financial Reporting Standards INT interest expense IPO initial public offering IRR internal rate of return IS income statement IT information technology LBO leveraged buyout LP limited partner M&A merger and acquisition MBO management buyout MV market value NAICS North American Industry Classification System NAV net asset value NI net income NPV net present value NVCA National Venture Capital Association NWC net working capital NYSE New York Stock Exchange OCF operating cash flow OECD Organization for Economic Cooperation and Development OEM original equipment manufacturer OPM Black-Scholes Option Pricing Model OTC over-the-counter P price per share P&L profit and loss

Abbreviations  xxv



P/E PEG PP&E PV R R&D RADR ROA ROR ROS RP RV SBA SBIC SBIR SEC SEO SG&A SIC SME SML TY VC WACC

price to earnings ratio price earnings to growth property, plant, and equipment present value retention ratio (1 − dividend payout ratio) research and development risk-adjusted discount rate return on assets rate of return return on sales risk premium relative value Small Business Administration Small Business Investment Company Small Business Innovation Research Securities and Exchange Commission seasoned equity offering selling, general, and administrative expenses Standard Industrial Classification small and medium-size enterprise security market line tax year venture capital/capitalist weighted average cost of capital

PR EFAC E

History abounds with examples of extraordinary entrepreneurs whose new ideas and products have changed the world. Many people are enamored with the idea of creating new products and starting businesses. Accompanying the interest in venture creation, there is broad interest in venture capital, in investment banking, and in careers related to new venture financing, deal structuring, and harvesting. Our primary motivation for writing this book is to empower students and practitioners to be more successful in developing and financing their ideas. Our overriding orientation is to apply the theory and methods of finance and economics to the rapidly evolving field of entrepreneurial finance. This book is unique several ways. First, it builds on and significantly extends the tools and methods of corporate finance and financial economics to approach the difficult and important financial problems associated with starting and growing new ventures. Building on the foundations of financial economics makes the lessons more general and memorable and the applications easier to implement in varied settings. Mastery of the framework facilitates clearer and more defensible evaluation of different opportunities and choices than is possible on the basis of heuristics and intuition. With reliable and rigorous tools, you can be more confident that the decisions you make will be the right ones. Second, while many books address aspects of entrepreneurship (writing business plans, leading and managing new ventures, etc.), this book has a unique and direct focus on the question of how new venture financing choices can add value and turn marginal opportunities into valuable ones. We emphasize value creation as the objective of xxvii

xxviii  Preface

each financial choice that an entrepreneur or investor makes—issues of strategic planning, staging, valuation, deal structure, risk and diversification, choice of financing, and exit. Understanding how each choice affects value has the potential to add tremendous value to ideas and innovations. Third, in contrast to other books on entrepreneurial finance, we specifically address the influences of risk and uncertainty on new venture success. We use discrete scenario and simulation analysis throughout the book to evaluate alternative strategies, to assess financial needs, to assess risk and expected cash flows as elements of valuation, and to compare different deal structures and contract terms. Fourth, because assessment of cash needs and valuation both depend on projections of cash flow, we devote significant attention to methods of forecasting the pro forma financial statements of new ventures in an integrated fashion. Integration enables the entrepreneur or investor to use financial forecasting to conduct scenario analysis and to simulate such things as how cash needs are affected by growth rates that are faster or slower than expected. Fifth, we provide a comprehensive survey of approaches to new venture valuation with an emphasis on applications. Our approach to valuation is more comprehensive than most because we approach valuation from a contracting perspective that is affected by the different assessments of the entrepreneur and the investor. We recognize that the entrepreneur’s unique circumstances can lead to value conclusions different from those of a well-diversified investor.

Why Study Entrepreneurial Finance? Whether you are or see yourself as an entrepreneur, a corporate financial manager dealing with new projects, a venture capitalist, or a social entrepreneur, a solid understanding of entrepreneurial finance can help you make better decisions. Couple this with the estimate that over 50 percent of new businesses fail within a few years, and the value of understanding new venture finance becomes clear. Perhaps more telling is that while some businesses do survive, the entrepreneur may not. Nonfounders are appointed CEO within a few years of operation in the majority of venture capital–backed start-ups. How can the hazards and pitfalls of forming new ventures be avoided or mitigated? We believe the answer is to understand the financial economic foundations and use the best available decision-making tools and

Preface  xxix

methods. A new venture should not be undertaken unless the expected reward is high enough to compensate for the value of forgone opportunities. Investing personal resources and time in a venture that should never have been pursued is just as serious an error as failing to invest in a good venture. Throughout the book, we reiterate and demonstrate through examples that this tradeoff of risk and return is not easy to assess intuitively. Rather, this is an area where analytical rigor can add considerable value. Even the best initial projections, however, can prove to be overly optimistic as the future unfolds. It is important to base the decision to continue or abandon a venture on the same kind of rigorous analysis that was used in making the original decision. It is all too easy to continue investing time and resources in a venture that is destined for mediocre long-run performance or to give up on a venture that has experienced a temporary setback but still offers the potential for substantial gain. Finally, it is a rare individual who is good at both recognizing an opportunity and managing the venture to capitalize on that opportunity. Careful design of the organization and its relations at the outset helps assure that a venture does not fail just because the visionary was not well suited to manage the day-to-day operations. Careful design also can help assure that the entrepreneur does not lose control of the venture unnecessarily.

What Makes Entrepreneurial Finance Different from Corporate Finance? It is natural to wonder why entrepreneurial finance is worthy of special study—why aren’t the principles of corporate finance directly applicable in an entrepreneurial setting? After all, a basic course in corporate finance concerns investment and financing decisions of large public corporations and generally introduces valuation techniques such as discounted cash flow and cost of capital analysis. The limitation, however, is that corporate finance theory assumes away a number of issues that are of secondary importance in a large corporate setting, but are critical to decision making for new ventures. These distinctions make entrepreneurial finance an intellectually challenging area worthy of special study. The focus on entrepreneurship and early-stage ventures dramatically changes the way the finance paradigm is applied. Moreover, certain techniques of entrepreneurial finance—such as thinking about investment opportunities as portfolios of real options— while they are particularly useful in a new venture setting, are also ­useful

xxx  Preface

in the context of a large public corporation. They just normally do not receive much attention in corporate finance courses. We highlight eight important differences: 1. The inseparability of new venture investment decisions from financ­ ing decisions 2. The limited role of diversification as a determinant of investment value 3. The extent of managerial involvement by investors in new ventures 4. The substantial effects of information problems on the firm’s ability to undertake a project 5. The role of contracting to resolve incentive problems in entrepreneurial ventures 6. The critical importance of real options as determinants of project value 7. The importance of harvesting as an aspect of new venture valuation and the investment decision 8. The focus on maximizing value for the entrepreneur as distinct from maximizing shareholder value Interdependence between Investment and Financing Decisions In corporate finance, investment decisions and financing decisions are treated as independent. The manager decides in which projects the firm should invest by comparing the return on the investment to the market interest rate for projects of equivalent risk. The manager does not need to consider simultaneously how ownership of the assets will be financed or whether the firm’s shareholders prefer high-dividend payouts or capital gains. Of course, investment decisions and financing decisions are not completely independent in large public corporations. However, the inter­ dependencies are generally simple and are usually addressed by making incremental adjustments to net present value (NPV). For start-up businesses, however, the interdependencies between investment and financing decisions are much more complex. Among other things, the entrepreneur will probably place a very different value on the new venture than will well-diversified investors. These differences are important because the entrepreneur cannot normally sell shares of a private venture to generate funds for current consumption (analogous

Preface  xxxi

to receiving a dividend). Therefore, simple adjustments to NPV cannot be used to address the divergence of valuations between the entrepreneur and the investor. More generally, some investment choices are contingent upon certain financing choices. For example, rapid growth may be possible only with substantial outside financing, whereas a large corporation might be able to finance the entire project with internally generated funds. The linkage between investment choices and financing choices creates complexity that does not arise in corporate finance. Diversifiable Risk and Investment Value In corporate finance, the NPV of an investment is determined by applying a discount factor to expected future cash flows. Corporate finance proposes that the discount factor depends only on nondiversifiable risk. But this proposition relies on the assumption that investors can diversify at low cost. Although the assumption holds for many investors in a new venture (e.g., venture capitalists, wealthy angel investors, or large lenders), it categorically does not hold for the entrepreneur. In fact, the entrepreneur often must invest a large fraction of his or her financial wealth and human capital in the venture. This difference between entrepreneurs and investors in their ability to diversify results in the project value for entrepreneurs being different from the project value for investors. In corporate finance, value additivity implies that allocation of financial claims does not affect the decision to accept a project. But for new ventures, because entrepreneurs and investors view risk differently, each ascribes a different value to the same risky asset. As a result, value additivity does not hold and the allocation of financial claims becomes important. Managerial Involvement of Investors In public corporations, investors (stockholders and creditors) generally are passive and do not contribute managerial services. Nor do they normally have access to significant inside information. In contrast, some investors in new ventures (e.g., venture capitalists and angel investors) frequently provide managerial and other services that contribute to the venture’s success. Typically, these investors will have access to inside information that they gain as a result of their continuing investment in the venture.

xxxii  Preface

Information Problems and Contract Design Separate from differences that arise even when the entrepreneur and investors agree about the expected future cash flows of a venture (and know that they agree), differences in value can arise because of the magnitude and importance of the information problem between the parties. Although information gaps also exist between insiders and outsiders of public corporations, the gaps need not materially affect the investment decisions of public corporation managers. Public corporations generally can, and often do, make investment decisions without much immediate regard to the question of how investors perceive the value of the investment. Generally, these managers need not convince investors, lenders, or employees that a project is worth undertaking, at least in the short run. The situation is very different in the case of a start-up business that requires outside financing. In the latter case, investors look specifically to the venture to provide a return on their investments. Moreover, there is often no easy way for the entrepreneur to communicate her true beliefs about the potential for success of a new venture. From a financial perspective, this places considerable emphasis on finding ways to signal the entrepreneur’s confidence in the venture. Incentive Alignment and Contract Design Incentive contracting clearly plays a role in the large public corporation. On the positive side, managerial stock options and performance bonuses are intended to align the interests of managers and investors. On the negative side, debt covenants and similar provisions are designed to discourage reliance on risky debt financing that can lead to inefficient investment decisions and other agency costs associated with heavy reliance on debt. The issues are similar for start-up businesses, but reliance on incentive contracts is, in some respects, more compelling. In contrast to the managers of public corporations, investors generally keep the entrepreneur on a short leash. There are compelling reasons to find ways of investing in the projects of unproven entrepreneurs. An investor who is good at identifying the untested entrepreneurs who are likely to succeed can participate profitably in new ventures that would have been rejected by a less astute investor. The result is that investors use a variety of contractual devices to supplement their ability to identify and motivate high-­quality entrepreneurs.

Preface  xxxiii

The Importance of Real Options Knowledgeable students and practitioners of corporate finance know to value projects by discounting expected future cash flows back to NPV. Even in the corporate setting, this approach is oversimplified, except with respect to the most basic independent investment projects. The reality is that most investing involves a process of acquiring, retaining, exercising, and abandoning options. Nonetheless, the common practice of ignoring options in corporate investment decisions suggests that they often are of secondary importance to the decision. The values of real options associated with an investment depend on the degree of uncertainty surrounding the investment. For projects such as investments in research and development or an investment in a new industry, uncertainty levels are likely very high. This uncertainty adds to the importance of considering embedded option values. Nowhere is the importance of option values more central to investment decision making than for a start-up business. Staging of capital infusions, abandonment of the project, growth rate acceleration, and a variety of other choices all involve real options and contribute to the need for a process of investment decision making that focuses on recognizing and valuing the real options that are associated with the project. Harvesting the Investment In corporate finance, investment opportunities are evaluated based on their capacity to generate free cash flow for the corporation. The investment decision does not depend on when the cash flows are distributed to investors, except that corporations generally will not retain cash that they cannot invest profitably. In their decisions to invest in the shares of a public corporation, investors normally give little consideration to when they will sell or to valuation and costs associated with selling. Investing in new ventures is different. New venture investments normally are not liquid and often do not generate any significant free cash flow for several years. Most investors in new ventures, and many entrepreneurs, have finite investment horizons. To realize returns on their investments, a liquidity event must occur (e.g., a public offering of equity by the venture or private acquisition of the venture for cash or freely tradable shares of the acquirer). Such liquidity events are the main ways investors in new ventures realize returns on their investments. Because of the importance of liquidity events, they generally are forecasted explicitly. The forecasts are formally factored into valuation of the investment.

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Value to the Entrepreneur The final difference between start-ups and public corporations is the focus on the entrepreneur. In the public corporation, the focus of decision making is on investment returns to shareholders. In a start-up, the true residual claimant is the entrepreneur. In the corporate setting, maximum shareholder value is the most frequently espoused financial objective. In contrast, the objective of the entrepreneur in deciding whether to pursue the venture and how to structure the financing is to maximize the value of the financial claims and other benefits that the entrepreneur is able to retain as the business grows. It is easy to envision cases where an objective of maximizing share value would not be in the entrepreneur’s best interest. This is particularly true if the entrepreneur is unable to convince investors of the true value of the project and would therefore have to give up too large a fraction of ownership, or if the entrepreneur values other considerations besides share value.

What’s New about This Book? This book builds on our previous book, Entrepreneurial Finance (2000, 2004). Like the earlier book, it ties the applications to the underlying disciplines of finance and economics. This book, published by Stanford University Press, is reorganized and updated to reflect the latest knowledge in finance and is streamlined to stress applications in key areas: valuation, adding value through deal structure and staging, and choice of financing. The chapter on venture capital is more fully developed than in the earlier book, and decision trees and simulation are presented with more examples and step-by-step analysis. We devote additional attention to financial forecasting and the construction of integrated pro forma financial statements, as both are key to valuation, contracting, and assessment of cash needs. The analysis of new venture valuation methods is more comprehensive, whereas we have streamlined the discussion and analysis of contracting between entrepreneurs and investors. For the most part, we draw upon recent academic literature in finance and economics as the foundation for our coverage. We break new ground in several areas by presenting material and analytical approaches that extend the frontier of academic research related to entrepreneurial finance.

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The book’s focus is broader than entrepreneurial finance in the context of US institutions. Instead, we have incorporated a significant international perspective by illustrating throughout the book the many similarities and the differences in analysis for US ventures versus international ventures. The book also is not limited to stand-alone entrepreneurial ventures. Rather, we have included analysis of the approaches that large corporations take, and the special challenges they face, when they seek to encourage entrepreneurship within their organizations— sometimes referred to as “intrapreneurship” or “corporate venturing.”

Intended Audience While this book can be used as a text in an advanced finance or entrepreneurship course, its intended audience is broader. The book is appropriate for students, entrepreneurs, practitioners involved with new ventures, and corporate financial managers looking for ways to encourage corporate venturing. We have designed the book for readers who are familiar with the basic concepts and tools of corporate finance, accounting, economics, and statistics and who seek a rigorous and systematic approach to adding value to new ventures through financing and deal structure. On the companion website, we provide brief reviews for those who feel the need for a refresher on some key background concepts. This book is appropriate for MBA students, master’s of finance students, advanced undergraduates in business and economics, and executive MBA students. In our own teaching, we use the book and related materials with students at all levels. Because entrepreneurial finance draws from and integrates all areas of management, a course developed around the book can serve as a capstone integrative experience to the MBA or an undergraduate business degree. The book can be used effectively in an entrepreneurial finance course or in a course on venture capital and private equity. It is designed to be used either as a stand-alone resource or in conjunction with cases or a business planning exercise. Each chapter includes end-of-chapter review questions. The book website has end-of-chapter problems that are designed to give hands-on opportunities to apply the lessons of each chapter. The book can be used in a variety of different course formats: • Some users like our use of simulation throughout the book. For those, we provide our proprietary software, Venture.SIMTM, and

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we also provide files on the website that contain examples and problem solutions that are prepared using Crystal Ball and @Risk. • For those who are oriented to case method teaching, we have provided a series of our own interactive cases that correspond to the book chapters and have developed a list of commercially available cases that work well with the book. • For those who see value in linking the coverage of entrepreneurial finance to a business planning exercise, the organization of the book follows the normal organization of the thought processes and financial contents of a business plan.

A Note about the Website and Internet Resources The book is designed to be used most effectively in conjunction with resources we provide on the book website, www.sup.org/entrepreneurial finance. Much of the book relates to software, spreadsheets, templates, simulation applications, and interactive cases and tutorials that are available for download. For those teaching from the book, we also provide PowerPoint presentations by chapter. Instructor-specific resources are password protected. Instructors can gain access to teaching materials that accompany the book by contacting Stanford University Press at [email protected]. The website contains problems and interactive cases, along with solutions, that complement the book material. Where appropriate, we have designated the portions of the book and website resources with symbols to designate the following: indicates that the section or problem requires simulation software. Presentations in the book are developed using Venture.SIM. T indicates that the figure is a template that can be downloaded from the book website and modified or adapted by the user to examine a different set of assumptions. S

All Excel figures in the book, including charts, are available as downloadable files so that the user can review the spreadsheet structure and cell formulas. When we use quantitative examples in discussion, the website normally includes a file that contains the back-up spreadsheet analysis.

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Simulation As a user of this book, you have access to Venture.SIM, a simple simulation package that is useful for addressing the kinds of uncertainty issues that arise for new ventures. Venture.SIM is an Excel add-in that can be set up to launch each time you open Excel or only when you want to use it. Whenever we use simulation, we present the results as Venture.SIM output. Because many readers will be familiar with commercial simulation packages such as @Risk and Crystal Ball, we provide @Risk and Crystal Ball versions of the simulation analysis on the book website. When we show you the Excel syntax for a simulated cell in a spreadsheet, we will use the Venture.SIM syntax. If you are a user of one of the other commercial packages, you can study the parallel syntax by opening our example files. For users who do not plan to emphasize simulation, we have marked sections of the book that are focused on applying simulation to entrepreneurial finance as well as the figures and tables that require installing the Venture.SIM add-in to Excel in order to open properly. The book’s companion website contains suggested outlines for those who wish to emphasize simulation and those who do not. Spreadsheets and Templates The website contains soft copies of the figures and tables in the book, including several templates that you can use to study your own new venture valuation questions (i.e., you can easily edit the template to study and value your own cash flow projections).

ACKNOWLEDGMENTS

In preparing the book, we have benefited from numerous comments from colleagues, students, venture capitalists, business angels, entrepreneurs, and friends. Over the years, an impressive group of reviewers and adopters have provided comments that have sharpened the presentation. Ilan Guedj (University of Texas, Austin), Frank Kerins (Montana State University), and several anonymous reviewers prov