Streetbites from the media perspective
An American invention: Venture capitalists!
Streetbites from the media perspective
 Venture capitalists grow balance sheets that show promise!
 See textbook pages 5-6 for related content on this story.
Videos for Module 3, Unit 1-of-2 (TOTAL: 9@84’10”)
o Streetbite on venture capital (9:25)
TD: Open book.pdf to chapter 3. Scroll backwards through the pages of end of chapter 2 answers
to exercises and be sure students know these are here. Scroll back to the last example of chapter
2 on balance sheet dynamics: If NewRE = $30,000 then SE & Cash, the two residual line items
on the balance sheet, “automatically” adjust so that the bottom line left equals bottom line right!
Now in the TOC click to the Venture Capital streetbite.
Year
Number of
companies
Average
per
company
($
millions)
Sum of venture
capital
financing
($ millions)
1
1,471
1.95
2,862
2
1,279
1.79
2,285
3
1,415
2.54
3,593
4
1,209
3.20
3,868
5
1,239
3.39
4,200
6
1,901
4.04
7,683
7
2,656
4.36
11,582
8
3,250
4.66
15,160
9
4,203
5.11
21,473
10
5,684
9.68
54,995
11
8,208
12.96
106,391
12
4,691
8.76
41,082
13
3,028
6.99
21,155
Sum and/or
average
40,234 /
3,095
7.4
296,329 /
22,795
TABLE 3.3 Venture capital financing
Source: National Venture Capital Association, www.nvca.org/ffax.html,
Snapshot of a dozen years circa 2003.
Lessons about the Structure of Finance
1. Venture capital firms take an equity stake in the company. That is, when the venture capitalist lends
money they actually purchase shares directly from the company. The venture capitalist is not
pursuing a fixed interest rate of return. Instead, they expect the stockholders equity and hence the
stock price eventually to rise in value.
2. The company may have reached its debt capacity as far as bank loans go, yet venture capital still may
be available. Banks tend to rely on historical records for lending decisions, whereas venture
capitalists look toward the future. “Seed investing” occurs for companies that are at very early stages
before there is a real product. Venture capitalists also invest in rapidly growing companies in their
“expansion stage.” And sometimes venture capitalists invest in “later stage” companies that are on
the verge of going public. In rare occasions, too, venture capitalists may invest in companies that
already are publicly traded.
3. Venture capitalists are activists. They use their experience to help managers of growing companies
make sound decisions about strategic marketing, planning, and development. Venture capitalists are
like farmers who love to grow successful companies. They are entrepreneurs first and financiers
second.
4. Venture capitalists grow the company but eventually intend to liquidate their equity stake. The
average venture capital investment lasts between 4 and 7 years. The different ways that the venture
capitalist liquidates the investment include: (a) the venture capitalist sells the stock back to the
company at a negotiated repurchase price; (b) the company is taken-over or merges with an
established company and the venture capitalist swaps their equity for cash or acquiring-company
stock; (c) the company goes public and the venture capitalist sells their equity through an IPO; (d) the
company goes bankrupt or reorganizes and the venture capitalist’s stock becomes worthless.
Number of
U.S.
Number of ventureU.S. IPOs
backed
IPOs
-1-2-
Year
Average
venture-backed
offer size
($ millions)
-3-
Average
venturebacked postoffer value
($ millions)
-4-
1
537
131
35.9
159.1
2
329
75
48.3
224.5
3
480
233
76.4
493.0
4
354
226
93.3
470.5
5
88
35
82.6
383.4
6
94
22
86.8
373.6
Sum
and/or
average
1,882
722
70.6
350.7
TABLE 3.4 Venture-backed initial public offerings
Source: National Venture Capital Association, www.nvca.org , Circa 2003.
About 38% of all companies going public received venture capital financing before the IPO.
Lessons about the Structure of Finance
Column 3, “offer size”, is the amount of financing that the company raises by selling stock
during the IPO. Column 4, “post offer value”, is the amount the stock is worth one-day later in
secondary market trading. The huge gap between offer size and post offer value suggests that
venture capitalists grow companies in which public markets have a lot of interest. The gap
suggests, too, that these companies underprice their stock during the IPO and leave a lot of
money on the table!
Other important non-bank sources of financing for young companies include
the Small Business Administration (read about “small business investment
companies” at www.sba.gov/INV/overview.html) and angel investors.
http://www.birminghamangels.com/ for example)
Lessons about the Structure of Finance
Chapter 3, Unit 1 of 2
Forecast financing needs and growth
Lessons about the Structure of Finance
 Find how to forecast financing needs, discover ratios that push the
flows this way and that way.
 See textbook pages 108-123 for readings relevant to this unit.
Videos for Module 3, Unit 1-of-2 (TOTAL: 9@84’10”)
o Streetbite on venture capital (9:25)
o Forecasting surpluses or deficits with cash (9:08)
o Motivation and example for balance sheet forecasting (12:03) [Example 2]
o EFN focuses on changes in TA and (TL + SE) (7:54) [EFN5a]
o EFN with a target asset turnover (9:46) [EFN6]
o Natural growth rate dynamics - overview (3:48)
o Natural growth rate dynamics - g_internal (12:58)
o The internal growth rate and ROR (9:55) [GR2b]
o EFN with a target profit margin (9:13) [EFN2bm]
Discussion from the textbook
BA4am Find 2nd year’s cash flow in two-period venture capitalist model
The Company balance sheet for year 2525 shows Total assets of $3,300 financed by
Debt of $600 and Stockholders’ equity of $2,700 . There are 190 shares outstanding at
year-end 2525. The company plans to obtain venture capital by selling 80 additional
shares at their current book value to a venture capitalist. The company agrees to
repurchase the shares at year-end 2527 at a price equal to 138% of that year’s book
value. For year 2526 the company forecasts sales of $17,820 , a net profit margin (=
net income  sales) of 7.40%, and a dividend payout ratio (= dividends  net income) of
20%. Assume debt remains unchanged. For year 2527, sales should be higher by 15%
but the net profit margin and payout ratio should remain constant. Also, assume that
debt remains unchanged.
How much total cash flow (dividends plus repurchase price) does the venture capitalist
receive at year-end 2527?
ANSWER: A ; CLUES: Net Income2526 = $1,319 ; Venture financing2525 = $1,137 ;
repurchase price = $31.20
a. $2,586
b. $2,351
c. $1,943
d. $1,766
e. $2,137
Lessons about the Structure of Finance
Growth is just like many other phenomena: there can be too much
as well as too little. The table below illustrates that company growth
rates vary widely.
Corporation
Name
AOL-Time Warner, Inc.
AT&T Corporation
Exxon Mobil
Corporation
Ford Motor Company
General Electric
Company
General Motors Corp.
IBM
Microsoft Corporation
Wal-Mart Stores, Inc.
Walt Disney Company
%∆
Total
assets
93%
67
%∆
%∆
%∆
%∆
Annual
net
dividend stock
sales income / share price
46%
66%
0%
102%
7
-2
0
-8
2
-1
-4
3
-9
18
3
8
n.a.
7
15
9
1
53
25
4
12
3
4
24
16
4
6
9
10
40
21
-15
15
8
9
0
22
7
23
6
35
33
41
-21
TABLE 3.1 Growth rates for selected variables of American corporate icons. Each number is
the annual average percentage change in the respective variable for a three year historical snapshot.
DEFINITION 3.1 Surplus and shortfall
Management should forecast future financing needs long before funds are needed.

When forecast sources of funds   forecast uses of funds
 
surplus


then the company expects a 
.
deficit or shortfall 
When the company forecasts a surplus then management is in the fortunate position of
debating prudent uses of surplus funds. Conversely, when the company faces an
expected shortfall then management must take strategic action to avoid financial
misfortune.
Lessons about the Structure of Finance
Section 1. Financial forecasting
1.A. Cash budgeting
 Frequency of cash budget determines discriminatory power for finding surplus or
shortfall (e.g., monthly cash budget cannot find weekly shortfalls) FF30 nxq
FF30 Cash budgeting discriminatory power for frequency
True or false: A monthly cash budget can determine whether the company expects a
surplus or deficit for the entire month but is incapable of determining external financing
needs during any particular week.
a. True
b. False
FORMULA 3.1 External financing needs
EFN is a positive number when expected uses of cash exceed expected sources.
 expected



 External 


 expected 
Total liab ilities 
  
 Financing   
Total
assets
& Stockholders' 


 Needs 






equity


When EFN is positive, there are insufficient funds to finance the company’s expected
assets and the company should arrange additional financing to cover the shortfall. A
negative EFN, conversely, implies a surplus — the company expects to have more than
enough financing to support expected assets.
EFN1b Static EFN with average age of inventory change; word choices
EXAMPLE 2 Find EFN in a static setting
Suppose a company’s balance sheet looks as follows:
Cash
Inventory
PP&E
Total Assets
Company Balance Sheet
Assets
Liabilities
$ 100
$ 200 Current Liabilities
400
350 Long term Debt
500
450 Stockholders’ Equity
$1,000
$1,000 Total Liabilities & Equity
Also suppose that Sales equal $2,500 and that Cost-of-goods sold equal $1,875. The company
realizes that if they cut by 30 days the length of time that inventory stays on the shelf before sold,
and all else remains the same, the company reduces the amount of inventory required. If the
company proceeds with this inventory policy change, what is the effect on external financing
needs?
Lessons about the Structure of Finance
SOLUTION
The definition from table 2.5 for the “average age of inventory” is:
 average 

 365 x ( Balance Sheet Inventory)
 age of  
 inventory  ( AnnualCost  of  goodssold )



365 x $400
$1,875
77.8 days
Reducing by 30 the number of days that inventory remains on the shelf lowers the
average age of inventory to 47.8 days. Set average age of inventory to 47.8 and hold
cost-of-goods-sold the same as before at $1,875. Solve for the new balance sheet
Inventory as:
47.8 days 
365 x ( Balance Sheet Inventory)
$1,875
Balance Sheet Inventory  $245
The balance sheet after the policy change lists Inventory at $245. The original balance
sheet lists Inventory at $400. This policy change decreases the amount of inventory
that the company keeps on hand. So far, we deduce the following:
Forecast Company Balance Sheet (Preliminary)
Assets
Liabilities
Cash
$ 100
$ 200 Current Liabilities
Inventory
245
350 Long term Debt
PP&E
500
450 Stockholders’ Equity
Total
$845
$1,000 Total Liabilities & Equity
Assets
Note that the above bottom-lines cannot remain unequal even for a second!
 expected



 External 

  expected   Total liab ilities 
 
 Financing   

 Needs  Total assets   & Stockholder' s 




equity


=
$845  $1,000
=
$155
Lessons about the Structure of Finance
EFN < 0 means surplus!! What the final balance sheet looks like depends on how the
surplus is used! Increase assets to 1000 or decrease liabilities to 845, what to do?
Add one more fact to make this problem:
EFN1b Static EFN with average age of inventory change; word choices
Company sales equal $48,000 for the year ending December 31, the costs-of-goods
sold (cgs) equal 80% of sales, and the inventory was replaced about every 76 days
(inventory turnover in days = 365  inventory turnover ratio; inventory turnover ratio =
annual cgs  Inventory balance). The Company is considering a change in their
inventory ordering policy. As a result, they believe that sales would remain constant in
the forthcoming year, yet the length of time that inventory stays on the shelf would
change by 38 days (shelf time increases). If the financing rate for inventories is 16%
per year, what is the effect on their annual inventory financing costs?
{ CLUES: Inventory original = 7996 ; Inventory new = 11993}
a. The policy change results in additional annual costs of $556
b. The policy change results in additional annual savings of $640
c. The policy change results in additional annual costs of $736
d. The policy change results in additional annual savings of $736
e. The policy change results in additional annual costs of $640
B2. Forecasting external financing needs when internal financing is available
Given the sales forecast, the basic procedure for finding EFN is given below:
(1) Forecast the Total assets required for sustaining desired future sales. Most likely, use a financial
ratio to link future sales with specific asset categories and then estimate Total assets.
(2) Forecast the future Total liabilities & Stockholders’ equity that you expect to accumulate. There are 3
reasons these might change from current values:
a. Some liabilities such as Payables often increase spontaneously and proportionately with Sales
b. Stockholders’ equity increases because expected Sales creates New retained earnings
c. Pre-commitments might cause Notes and Long term debt to change. Otherwise, these should remain
constant for forecasting.
(3) Compute EFN as the difference between expected Total assets from step 1 and expected Total
liabilities & Stockholders’ equity from step 2. A summary formula for this general procedure is:
FORMULA 3.2 External financing needs, concise version
Let ΔA equal the change in Total assets (that is, At – At-1 ) expected throughout the next
period, let ΔL equal the forecast change in spontaneous liabilities, and let Rt equal the
forecast internal financing from New retained earnings. The company must arrange for
financing during period t equal to EFNt, where:
EFNt = ΔA – ΔL – Rt
Lessons about the Structure of Finance
EFN2bm Find EFN given sales growth and changing net profit margin
Find below the Company’s financial statements for year 2525.
$375
$870
$3,000
$4,245
Balance Sheet, 12/31/2525
Income, 1/1 – 12/31/2525
Cash & securities
$715 Current liabilities
Sales
$25,500
Inventory
$1,230 Debt
total costs $25,200
PP&E
$2,300 Stockholders’ equity
net income $300
Total assets
$4,245
dividends $170
new retained earnings $130
For 2526 the company plans 12.70% sales growth. They plan to hold constant the
asset turnover (salestotal assets) and payout ratio (=dividendsnet income). They
plan to increase Current Liabilities spontaneously with sales, while holding Debt
constant.
Suppose the company decides to institute cost-cutting measures that should increase
the net profit margin (=net income  sales) by 2.20% above its value of year 2525.
Given the above plan, how much external financing is needed for year 2526?
ANSWER: A ; CLUES: Net Income2526 = $970
a. $28
b. $25
c. $23
d. $19
e. $21
Lessons about the Structure of Finance
PANEL A: Status Quo for year 2525
Balance Sheet, 12/31/2525
Income Statement, 1/1 to 12/31/2525
400 Debt (D)
Sales
$3,000
.
600 Equity (SE)
total expenses
2,850
Total (A)
$1,000 Liabilities &
Net Income
150
$1,000
Equity
Dividends
60
New Retained Earnings (R)
90
PANEL D: End-of-year financial ratios
12/31/2525
12/31/2526
status quo
growth @ ginternal
asset turnover ratio: (sales  total assets)
12/31/2526
growth @
gsustainable
net profit margin: (net income  sales)
payout ratio: (dividends  net income)
debt-to-equity ratio: (debt  Stockholders’ equity)
TABLE 3.2 Natural growth rate dynamics
FORMULA 3.3 The internal growth rate
A company with constant asset turnover ratio, net profit margin, and dividend payout
ratio that relies exclusively on internal financing grows at the “internal growth rate”:
g internal 

Rt
At  Rt
(retention ratio)(ROA)
1  (retention ratio)(ROA)
(retention ratio)(ROA)
when ROA 
when ROA 
Net income t
Total assets t
Net income t
Total assets t1
The variables R and A denote New retained earnings and Total assets, respectively.
The “ROA” is the return-on-assets.

Lessons about the Structure of Finance
Derivation of formula 3.3 assumes that the following ratios are constant: asset turnover
ratio; net profit margin; and dividend payout ratio.
PANEL B: Effect on year 2526 of growth at rate ginternal
Balance Sheet, 12/31/2526
Income Statement, 1/1 to 12/31/2526
400 Debt (D)
Sales
.
Equity (SE)
total expenses
Total (A)
Liabilities &
Net Income
Equity
Dividends
New Retained Earnings (R)
GR4 Find TA next year given components for ginternal
Find below the company’s income statement.
Income, 1/1 - 12/31/2525
Sales
$20,000
Total costs
$18,900
Net income
$1,100
Dividends
$460
New retained earnings
$640
Total assets at 12/31/2525 equal $3,770 . If the company is growing at their internal
growth rate, what are Total assets at 12/31/2526?
a. $6,044
b. $4,541
c. $5,494
d. $4,995
e. $4,128
EXERCISES 3.2
8. Find below the Company’s financial statements for year 2525.
Balance Sheet, 12/31/2525
$360 Current assets
$960 Debt
$2,500 PP&E
$1,900 Stockholders’ equity
$2,860 Total assets
$2,860
Income, 1/1 – 12/31/2525
Sales
$13,200
total costs $12,600
Net income $600
Dividends $220
New retained earnings $380
For 2526 the asset turnover (=SalesTotal assets), net profit margin (=Net income  Sales),
payout ratio (=DividendsNet income) and price-to-earnings ratio (now 14.3) will be constant.
The number of shares outstanding is 100. The firm seeks maximum growth by relying
exclusively on retained earnings; external financing will be zero. For the shareholder that buys a
share at year-end 2525 and holds the stock through year-end 2526, what is the rate of return?
©GR2a,b
ANSWER: We find the rate of return to equity as the increase in market capitalization plus total
dividends (the rate of return to one share is identical to the rate of return to all equity; this approach works
when no shares are issued). Market capitalization at year-end 2525 equals $8,580 (= 14.3 x $600). Apply
formula 3.3a and find that ginternal equals 15.32% (= $380 / ($2,860 – $380)). Because of constant ratios
Lessons about the Structure of Finance
find that Net income2526 equals $692 (= $600 x (1 + .1532)). Market capitalization at year-end 2526
becomes $9,895 (= 14.3 x $692). Dividends2526 equals $254 (= $220 x (1 + .1532)). The stockholder rate
of return therefore equals 18.28% (= ($9,895 + $254 – $8,580 ) / $8,580)).
Lessons about the Structure of Finance