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IB395 0- FNV Lecture
Finance in New Ventures (The University of Warwick)
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IB3950 - FINANCE IN NEW VENTURES
Lecture 1: Introduction
Main focus of the module: Finance markets for new ventures and SMEs (small and medium
enterprises) (entrepreneurial finance markets):
- Debt (overdrafts, finance in leasing)
- Equity (entrepreneur selling shares to investors)
- Alternative finance (peer to peer lending, crowdfunding)
Main source of equity finance for new ventures:
- Venture Capital
- Angel Investments
- Personal savings – main source of funding
Financial constraints = “funding gaps”, why do these gaps arise?
We will take tripartite perspective: entrepreneur, finance provider and government (ex of US
funding)
- In the UK 5.9 million SMEs = 99.9% of all private sector businesses, employing 16.6 million
people, which is 60% of all private sector employees.
- 13% of the business population is new ventures. Across the OECD, SMEs account for 60% of
employment and 50/60 of value added.
à SMEs are the competitive engine of the economy.
Information asymmetry
However, entrepreneurial finance markers are imperfect. The key imperfection affecting
entrepreneurial finance markets is information asymmetry between entrepreneurs and
finance providers, both before and after funding is provided. Before, the finance provider has
less information than the entrepreneur on whether the venture will succeed, maybe because
the entrepreneur lacks a track record, or the venture may not have audited account. This may
lead to problems of adverse selection. When the information asymmetry happens after the
funding is provided, this may lead to moral hazard. For example, once entrepreneurs have
received funding, they may be tempted to put less effort in the success of the venture, or take
more risks, or even lie about the results of the venture. They can lie about their ability to repay
a loan. Adverse selection and moral hazard may result in an under-supply of finance to
entrepreneurs leading to funding gaps.
Role of finance providers
Finance providers (banks and venture capitalists) have an important role as information
producers, to counteract information asymmetry. This involves:
- Screening: process of evaluating the ventures and determining where the lending or
investing is viable. From quick credit check to a lengthy process of due diligence
- Contracting: finance providers can set terms and conditions in funding contracts to
separate low risk from high risk ventures in order to overcome problems of adverse
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selection, or setting contracts to align finance providers interests with those of
entrepreneurs and overcome problems of moral hazards.
Monitoring: finance providers can monitor the venture to ensure the entrepreneur is
putting maximum effort after the funding has been provided
Finance providers are also a source of innovation in entrepreneurial finance markets. For
example:
- Alternative finance: peer to peer lending, to fill gaps induced by traditional banks since
the financial crisis of 2008
- Small business credit scoring: since the mid 90s, small business credit scoring has
helped to lower bank screening costs and reduce the reliance on collateral to make
lending viable
Role of government (British Business Bank, established in 2014 to ensure entrepreneurial
finance markets work more effectively for SMEs)
Despite the role of finance providers as information producers, in some instances, the costs
of reducing this information may be too high. Screening costs are the costs distinguishing the
plumbs, ventures with a high success probability, from the lemons, with a low success
probability. E.g. the cost of screening or conducting due diligence for smaller equity
investments may account for 10% or more of the investment à lower in percentage terms
for bigger investment, this makes the supplier smaller equity investment unprofitable and
leads problems of equity gaps.
Agency costs are the costs to resolve conflicts of interest between a principal, in this case a
finance provider, and an agent, an entrepreneur (includes monitoring).
There are also issues of a lack of diversity in entrepreneurial finance markets:
- Lack of diversity in who provides funding and who gets the funding (4 big banks
(Barclays HSBCS …) in UK provide 85% of SME current accounts and overdrafts) only
4% of SMEs switch banks
- Lack of diversity in who gets funding (for every £1 of VC investment in the UK, less than
1p goes to all-female founder teams)
Entrepreneurs may also lack awareness of the range of funding options available. E.g. only
14% of small business owners are aware of peer-to-peer lending options à British Business
Bank was established by UK government in 2014 to ensure entrepreneurial finance markets
work more effectively for SMEs.
The British business bank does not provide direct funding, instead it works with commercial
finance providers to help them prove the suppliers funds to SMEs. It does this by using public
money.
Tasks
Enterprise capital fund, to back founders with phenomenal ideas, and increase the value of
the businesses. – passion capital
Generate new ideas as well to export to the world – enva
Innovation foundation, deploy finance for the public good – nesta
Impact of Covid 19 on SMEs:
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Over 50% of SMEs have experienced strong declines in revenue, more than half of them do
not have the reserves to survive more than 3 months without help.
Policy makers have responded with the following measures:
- Deferring payments and temporary layoffs
- Enhancing access to credit
- Providing grants and wage subsidies
Objectives of British Bank: Increase supply of finance; help increase diversity of finance,
address regional imbalances in access to finance and encourage and enable SMEs to find
appropriate finance.
Lecture 2: SME context
Ellsberg paradox: It is thought that betting for or against the known information (red ball) is
safer than betting for or against the unknown (black ball). Nevertheless, these choices of
preferences result in a violation of the sure-thing principle, which would require the ordering
of A to B to be preserved in C to D.
Entrepreneur as uncertainty bearer (Frank Knight)
Risk vs. Uncertainty
- Risk: random events have a known distribution of probabilities.
- Uncertainty: random events have an unknown distribution of probabilities.
Knight believed that business decisions were made under uncertainty: “The conception of an
objectively measurable probability or chance is simply inapplicable [to business decisionmaking].” Knight, 1921, p.231 à entrepreneurs are reliant on making decisions (e.g.,
predicting consumer demand) based on subjective opinions rather than objective knowledge.
The entrepreneur is the bearer of uncertainty
- The entrepreneur has to rely on self-financing the venture and bearing any losses.
- Important contrast with Schumpeter who believed uncertainty bearing (and losses) should
fall on the capitalist (bankers and investors).
Knight distinguished between risk that can be modeled probabilistically, from uncertainty, for
which the probabilities are unknowable. For instance, uncertainty surrounds the
implementation of new strategies, the development of new products or entry into new
markets. Similarly, the positive consequences of acquiring a competitor may have unknowable
probabilities.
According to the theory, bearing business uncertainty creates profit and the more uncertainty
taken on, the more profit can be gained. The relationship between uncertainty and gain may
be linear, or even exponential, where there are bigger payoffs on the right hand side of the
chart.
The uncertainty-bearing theory obviously views entrepreneurs as bearers of uncertainty
making it a very individualistic theory to start out with. The theory places great emphasis on
the entrepreneur’s ability to make decisions under uncertainty. The uncertainty perspective
suggests a normative dimension: that entrepreneurs who are willing to take on great
uncertainty may deserve windfall profits the rare times they do succeed.
Diversity of entrepreneurship (see Bhide, Introduction and Chapter 1)
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Bhide highlights that new ventures can take a variety of forms.
- This may or may not involve starting a business de novo.
Bhide summarizes this diversity in three dimensions:
- Irreducible uncertainty: unmeasurable risk; only resolvable by undertaking the venture not
through more prior testing/planning (see Knightian uncertainty above).
- Investment: commitment of funds and other resources by the entrepreneur, financiers, and
other stakeholders in the venture.
- Likely profit: ‘best guess’ by entrepreneur, financier, and other stakeholders of the expected
cash-flows from the venture. A subjective not objective
Diversity of new ventures
Marginal businesses (‘self-employed’)
- Low uncertainty (stable markets: well defined risk and return)
- Low level of innovation - exploiting a niche to sustain viability (‘only shop in the
village/community’) or providing a modestly differentiated product/service relative to
competitors.
- Small investment: small quantities of ‘bootstrap’ finance (self-finance, credit cards, personal
loans, funds from “friends, family and fools”)
- Low profit motive/outcome: motivated by lifestyle preferences more than money.
E.g., hairdressers, window-cleaners, and plumbers i.e., self-employed workers.
Promising start-ups (start-ups by FNV students)
- High uncertainty caused by newness of sector and entrepreneurs lack of track record
(Gates/Allen Microsoft, 1975). Also very characteristic of start-ups by students taking FNV
since 2005.
- Low/mid levels of innovation – firms may ‘piggy-back to success’ (e.g., PC businesses
exploiting consumers’ ignorance in the early 1980s: see Bhide p 44)
- Small investment: bootstrap (personal finance) - too much uncertainty for VC. Small amount
of seed capital from angel investors a possibility due to valuable option.
- Low likely profit outcome – but uncertainty generates potential upside and creates a chance
of a big financial return (‘valuable option’).
VC backed start-ups
- VC backed start-ups have very innovative ideas with large potential pay-offs.
- Uncertainty is mitigated by experienced management, rigorous business planning and
established markets.
- This profile fits a tiny minority of start-ups (<1%: see ‘pecking order’ in ‘Sources of finance’).
Revolutionary ventures
- Very high innovation and uncertainty + very big investment requirement.
- Very, very rare (see e.g., FedEx case study in Bhide Chp 7; MP3 case study in seminar 3)
Corporate initiatives
- New projects undertaken by large, well established firms (MS Windows 1.0 - 10, Intel
processors 386, 486, Pentium,…,i9)
- ‘Routinized’ innovation low uncertainty (see e.g., comparison between innovation in
Renovo (a biotech start-up) compared to innovation in Big Pharma in seminar 6)
- Investment: large amounts of corporate funding ( big expected profits).
Conclusion week 1 and 2
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SMEs play a pivotal role in the economy.
However information asymmetries are a potentially serious barrier to accessing
finance among SMEs/new ventures.
Finance providers play a critical role in information production and innovation in SME
finance markets.
Yet concerns about imperfections in SME finance markets have led the UK Government
to establish the BBB (with similar institutions already operating in other countries like
France and Germany).
Uncertainty also affects entrepreneurs’ decisions. Individuals with greater tolerance
for uncertainty are more likely to start up/grow a venture.
There exists a diversity of new ventures with different levels of uncertainty,
investment, and likely profit.
Sources of finance
Debt
Lender or a creditor entitled to a contractually agreed repayment of capital and interest from
a borrower. (interest rates are typically around 3-4%)
- Lender may also require borrower provides collateral or security à specific asset of the
borrower, for example a house, that the lender has right to sell if the borrower defaults on
the loan. Lender can also petition the court to bankrupt the borrower so its assets can be sold
to repay the loan.
- Interest payments on business loans are tax-deductible à interest payment can be
subtracted from the business earnings before calculating the tax liability.
Both internal and external sources of debt:
- Internal: non-market sources such as loans from friends and families
- External: loans obtained in entrepreneurial finance markets from banks and finance
companies
Equity
Equity investors (shareholders) are the owners of the business – they are entitled to a share
of the venture’s future profits. Sole traders (59% of the UK SMEs population). They can keep
all of the businesses after tax profits but they are also personally responsible for any losses.
If the entrepreneur wants to raise equity from other individuals, it must set-up a limited
company.
- The upside for the investor is potentially unlimited (e.g. Teels with fb who sold his shars at
1billion from 2000) but they are likely to lose their investment in the event the venture
becomes bankrupt.
- Equity is riskier than debt so investors will require a higher rate of return than lenders.
Dividend payments to equity investors are not tax deductible for the company receiving
investment (investee).
Both internal and external sources of equity:
- Internal: entrepreneurs’ investments of their own money, friends and families
- External: investments by business angels, venture capitalists or by selling new shares of the
company to the public on the stock market
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According to the BBB, the main reasons for seeking finance is to fund the businesses day to
day expenses.
Sources and appropriate uses of finance
Long-term source
- Equity
- Personal investment
External investors
- Medium & long-term loans
- Leasing and hire purchase agreements
Long-term use: Fixed assets (land & buildings, plant & equipment, vehicles etc)
Short-term source
- Overdraft & short-term loans
- Invoice finance
- Credit cards
- Trade credit
Short-term use: Working capital (debtors, stocks)
Pecking order of new ventures finance
Internal
finance
•Lowest cost finance from
well-informed insiders.
•No/little loss of control.
External debt
•Higher cost funding from
less-informed external
lender.
•Some scrutiny/interference
from lender.
•Highest cost funding as
equity is riskier than
debt.
External
•Greatest loss of control
equity
as investor has a say in
the running of the
business.
Pecking order in new ventures finances ≠ pecking order in corporate finance
- Sources of start-up finance: in 2015 personal savings accounted for 81% as main source of
funding
Task: Equity or Debt - which one is right for your business? (the business finance guide)
Evaluating new ventures for finance I
Richard Reed, co-founder, Innocent Drinks: They experienced multiple rejections. Turn down
by 20 banks and one VC investor told them you are all friends and too young. They finally
found Puto who put up 250 000 pounds who believed in tehm more than in the idea. In 2013
they sold the company for 320 million pounds.
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What information matters to seasoned investors when evaluating a new ventures
opportunities?
Sahlman’s criteria for VC investment
The information that really matters is principally qualitative not quantitative
- Investors look for entrepreneurs with super execution skillsà people: “Good ideas are a
dime a dozen… good people are rare.” Arthur Rock, Silicon Valley investor
- Opportunity: The idea, market, and
growth
- Context: The “big picture” beyond the entrepreneur’s control
- Risk and reward: Assessing the upsides and downsides of the venture
Cash-flow forecast
What does a cash-flow forecast tell you?
- How much finance the business needs (area of ‘Death Valley’).
What type of finance is appropriate (width of ‘Death Valley’).
For example:
- If Death Valley is narrow and shallow then a short term loan/overdraft may be appropriate.
- If Death Valley is wide and deep then venture capital is required (i.e., a patient investor with
deep pockets).
Seminar 1: Case study: What makes an entrepreneur? Mark Zuckerberg (Facebook)
What factors helped make Mark Zuckerberg an entrepreneur?
His hard-working skills he was more interested by the engineer side than by talking about his
project. “Technical prowess, self-confidence and ruthlessness found in successful technology
entrepreneurs.” He is a very controlled entrepreneur, over making money
What factors do you think were relatively unimportant in making him an entrepreneur?
His ability to keep his friends around him. He was not concerned about yahoo or the others
but only cared about his project.
TAKEAWAY EXAM TYPE QUESTION
What makes an entrepreneur? Assess the ‘people’ in examples of VC backed start ups, such
as Facebook and Tesla, to help explain why their ventures received investment.
“What’s wrong with most business plans? Most waste too much ink on numbers and devote
too little to the information that really matters to intelligent investors. As every seasoned
investor knows, financial projections for a new company are an act of the imagination.
Typically they are wildly optimistic…” William Sahlman à seminar 3
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Lecture 3: Sources of finance
How much did Peter Thiel invest in Facebook in 2004?
He is an American entrepreneur and venture capitalist. He is the founder of paypal. First
external investment in Facebook of 500,000 dollars à Not huge but typical for an early stage
of investment. In 2012 following Fb IPO his investment was worth a billion.
What is the main reason why SMEs seek external finance?
For providing working capital à To help the cash-flow issues, the delay between receiving
payments and billing. The second main reason is funding fixed assets, time loans
According to the pecking-order theory, new ventures choose sources of finance in the
following order…
1. Personal savings;
2. Investment by FFF;
3. Bank loans
4. Investment by angel/VC investors;
Internal sources are cheaper than external sources. Raising external equities are more
expensive because they require a higher rate of return on their investment, as it is risky. The
interest rate on bank loans is typically less than 5%. A VC or an angel investor can expect to
lose money on 50% or more of their investment so they’re looking for a higher rate of return
à more costly
The pecking order reflects…
- Issues on the supply side (finance provider) due to information asymmetries. Moral hazard
issue
- Demand side issue à the entrepreneur perceive that they are giving up control in order to
raise findings so that might put them off seeking external funding
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The ‘entrepreneurial finance journey’ provides a holistic perspective on the relationship
between finance and new-venture creation and growth.
- It encompasses the development of the venture from the initial plan/idea, through
investment and financing decisions, the outcome of funding applications (if one is made), and
finally to the consequence for the venture in terms of new-venture creation and growth.
The financing journey depends on the life-cycle stage and the growth objectives of the
entrepreneur.
- Due to information asymmetry new ventures tend to rely on internal finance (bootstrapping
and trade credit) although promising new ventures (see Bhide lecture 2) may get seed funding
from angel investors. As the venture develops a track record and becomes ‘investor ready’,
bank loans and VC (for the tiny minority with very high growth potential) may become
available.
- Regarding growth/lifestyle objectives, marginal/lifestyle businesses (see Bhide lecture 2) will
tend to follow the lower internal-finance path while more ambitious growth orientated
businesses (e.g., VC-backed start ups) will tend to follow the external-finance path.
The key takeaway from the diagram is that progress along the financing journey depends not
only information asymmetries but also on entrepreneurial cognition. Control aversion may
temper growth ambition e.g., family businesses are usually reluctant to share control with an
external equity investor (and may be happier with slower growth). Family businesses may also
be reluctant to take on bank loans as they risk losing control to the bank if they can’t keep up
with loan repayments.
“Losses loom larger than gains” Kahneman and Tversky (1979)
- For an average ‘investor’ (with a loss-aversion score of 2.5) they’d need to win £25K to
‘invest’. But this means they’re forgoing viable (positive expected NPV) ‘investment
opportunities’ that ‘win’ between £10K and £25K.
- The social stigma of failure/bankruptcy may engender loss aversion among entrepreneurs
(by up-weighting the downside and down-weighting the upside).
Kahneman and Tversky also suggests we use shortcuts or heuristics in decision making,
which include:
- Making judgments about situations based on their similarity to comparable situations
(representativeness) E.g. lead to using stereotypes in your thinking. White male is over
represented in finance ≠ female
- Using information, which can be called to mind easily (availability) E.g. if you have been using
bank loans for all the existence of your business, you might not consider another source of
funding, which might be better
- Relying excessively on the first piece of information available (anchoring) E.g. you might
become anchored to your original business plan which may for example involve using
traditional sources of funding, even when they are better sources of funding available to the
business, you get stuck to the original idea
à These heuristics introduce biases into decision making generally. However, these biases
are especially likely in situations involving informational overload, novelty/uncertainty, high
emotions and time pressures i.e., in entrepreneurial contexts, lots of them are not aware of
all sources of funding
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Example of equity options and why
Angel Investment - for small businesses, companies, who still have to grow and are not yet
making a profit
- Usually financing amount is between 15000-50,000, rarely in the millions
- Angel investors usually ask for a stake between 15-25% so the business needs to be surethey are comfortable giving away such a stake of their business
- Angel investors will invest in businesses they feel have a realistic and strong business
proposition
Venture Capital
- This source of finance would suit a tech startup requiring a large amount of initial funding to
finance their development.
- Not only would the entrepreneur gain financial aid but potentially also advice and guidance.
- For businesses in markets with high growth potential, but are also not entirely new (i.e. with
some sort of track record). Examples of businesses this may suit include: Uber, Tesla,
Example of one debt option and why
Peer to peer lending
- Loans from individuals, businesses and institutions, generally through online platforms.
- For established business with trading history
- Decisions can be made almost instantly
- Fast growing finance type in the UK
- Interest rates on Peer-to-Peer Loans are comparable to other business loans.
- Each peer-to-peer lender has their own risk appetites à Finance providers are looking for
ventures with a trading history that meet the eligibility criteria of the platform chosen.
- This type of funding is suitable for getting a loan quickly and maintaining full control of the
business.
à Businesses should use different long/short term sources of finance appropriate to the
assets being funded (“matching principle”).
- New venture capital structures exhibit a “pecking-order” which reflects factors on both the
supply side (information asymmetries) and demand side (control aversion).
- More generally, entrepreneurial cognition plays a key role along with information
asymmetries in affecting ventures’ progress along their “entrepreneurial finance journeys”
- These cognitive issues include loss aversion and heuristics.
Seminar 2 How to fund new venture
Takeaway (exam-type question)
Discuss an idea for a new venture and the types of finance that might be appropriate to fund
it with.
Business idea: Integrated digital fashion app - gives advice and does not sell their own clothes
- An app that firstly allows you to visualise the clothes you would like to buy at a storeperhaps
in a 3D form
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- The app will also be able to tell people where to find a certain piece of clothing or a similar
item of clothing in any pictures they come across on various social media platforms
Bhide’s matrix
- Investment is medium-high because high costs associated with developing tech platform for
the app
- Likely profit: long-term profits can be optimistic but for the short-term profit will not be too
high due to the initial costs incurred
- Scalable business
- High risk business and no real certainty of cash flow
- App dysfunctionalities
- Revenue: membership for the app, commission
- Retailers could sponsor app or be advertised for a certain fee
- Promising start-up/ VC-backed start-up
How we are going to fund?
- Angel investor or some kind of equity investor
- Asking for investment from family and friends (probably form of debt with low interest rates
since there is an emotional relationship there) to develop prototype and trial out a pilot before
going to angel investor
- Using own earnings - viewed as a good thing by equity investors
- High risk high return business so equity funding deems most appropriate
- Crowd-funding
- Lots of potential problems with technology and using an app that can cause problems with
repayment of debt which is why equity is better
5 C’s assessment and how our funding compares to other entrepreneurs?
- Main issue would be collateral because there is no sufficient collateral to provide here which
will cause them to be underfinanced
- Funding decisions: quite typical of a technology focused start-up and business idea
- Compared to traditional retail businesses then it is different and they usually focus more on
debt rather than the willingness to give up stake in their business
- Vast majority of ventures are more marginal businesses types rather than our business idea
which is more towards a VC backed start-up or promising start up
Lecture 4: Do banks ration credit to new ventures?
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The 5 C’s are Capacity, character, capital, collateral and conditions.
Capital and collateral help overcome issues of adverse selection, moral hazard. If you have
your own money invested in the business capital, or liable as assets if you are in default you
are not going to put your assets unless you believe you have a chance of success.
Credit rationing
E.g. In autumn 2008 credit markets froze following the collapse of Lehman Brothers. Lehman’s
collapse was a tipping point for financial markets that had been tightening since 2007 due to
losses on US sub-prime mortgages coming to light.
In essence banks were unwilling to lend to each other because of uncertainty about the extent
of each other’s bad loans and the fear that governments would not bail them out.
The fall-out from this was that some individuals and businesses were unable to obtain loans
at any interest rate. Banks were unable to raise funds for loans to small businesses on
wholesale capital markets. Also, increased real costs of credit intermediation increased
information asymmetries between banks and entrepreneurs leading to credit rationing.
During this pandemic, the situation is different because the source of the problem is not the
financial market but it is the government shutting down the economy to stop the spread of
the virus à different causes, different solutions?
What is credit rationing?
- In a perfect market, if there is excess demand for credit (𝑄_𝑑 > 𝑄_𝑠 ) then banks will raise
the interest rate (𝑟) to clear the market.
- However, asymmetric information may give rise to credit rationing: the bank no longer
knows the individuality credit/default risk of individual borrowers but might only know the
probability of risk of a pool of borrowers.
A situation where there is excess demand for credit in equilibrium because it is not optimal
(i.e., not profit maximizing) for banks to raise the interest rate to clear the market. The bank
can’t tell who the plums are from the lemons, the plums may end up unable to get loans even
though they might be willing to pay a higher interest rates à affect adversely the probability
of default
- Due to credit rationing viable businesses may be unable to obtain credit even though they
would be willing to pay a higher interest rate to obtain credit.
- Credit rationing is different from usury laws or price caps that create an exogenous interest
rate ceiling (i.e., the bank would like to raise the interest rate but the law forbids it).
Problems posed by lack of information in the credit market
- Adverse selection – Suppose banks are unable to distinguish high risk (HR) from low risk (LR)
entrepreneurs. But also suppose banks know the proportions of HR’s and LR’s in the
population (the risk distribution).
- Banks therefore offer a single/pooled interest rate to all entrepreneurs (a weighted average
of the rates it would offer to HR’s and LR’s respectively). But this rate is too high for the LR
entrepreneurs so they may drop out of the credit market leaving behind a pool of HR
entrepreneurs.
- It may be optimal (profit maximising) for banks to set a lower interest rate to avoid this
problem – but this may lead to an under-supply of credit in equilibrium (‘credit-rationing’).
That is, some LR entrepreneurs may be left with unmet credit demands (given by 𝑄_1−𝑄_𝐶𝑅
in the following diagram).
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Credit rationing diagram
R is for the interest rates. Increase in the interest rates increase the banks return only up to a
certain point. Above the bank optimal rate Rcr, The credit rationing effect à leaving only the
lemons à less loan repayment
Supply mirrors the shape of the bank expected return function. The supply of deposit depends
on the bank expected profit, falling because of adverse selection
à If the rate is above Rcr, the market won’t clear à excess demand for loan of Q1 – Rcr
Problems posed by lack of information
- Moral hazard/agency problems – Issue here is the interests of the bank (the principal) and
the entrepreneur (the agent) may diverge after the loan has been made.
For example if the bank sets too high an interest rate then it may be in the entrepreneur’s
best interests to switch to a riskier project (to generate the higher returns needed to meet the
repayments). To ensure this does not happen the bank must incur agency costs
(contracting/monitoring), which reduce its profits.
- To keep agency costs down (and profits high), it may be optimal for the bank to keep the
interest rate below the market clearing rate. Again, credit rationing may follow (see previous
diagram).
A model of adverse selection (Fraser, 2019, 3.1.1 )
- Fraser (2019) develops a simple rational choice model which generates credit rationing
through adverse selection (based on Stiglitz and Weiss, 1981).
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- Workers differ in ability 𝑥 which is private information. The probability of venture success is
𝑝(𝑥) and the expected cash flow from the venture, which generates return for you and the
bank is 𝑦(𝑥), which are both increasing in ability. The wage a worker can earn is given by their
ability 𝑥.
- Banks do not observe 𝑝(𝑥) and therefore set the interest rate based on the average
ability/success probability 𝑝 ̅ (there is a pooling equilibrium), which generates an expected
cash flow (from the bank’s perspective) of 𝑦 .̅
- If banks raise the interest rate 𝑟 the first entrepreneur to leave the market is the most able
(the interest rate is too high for their ability and they can earn more as a wage worker).
- This decreases 𝑝 ̅ (and 𝑦 )̅ among the remaining entrepreneurs which may reduce the bank’s
expected profits 𝐸(𝑅_𝐵 ) if the interest rate is raised too high.
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• Expected venture cash flow is
y(x)=p(x)[R-(1+r)B]
• R≡firm revenues; B≡loan amount.
• At interest rate r, define the marginal
entrepreneur x(r) who is indifferent
between entrepreneurship and wage
work
y[x(r)]=p[x(r)][R-(1+r)B]=x(r)
Under
selection
the
marginal
entrepreneur is the
most
able in the pool of
entrepreneurs and
the
first
to
leave
entrepreneurship if
r
increases.
- This
causes an increase
in r
to
have
two
opposing effects on expected bank profits, which depend on p ̅ not p(x) in a pooling
equilibrium:
1. An increase in r increases the loan repayment (1+r)B conditional on the venture
generating the cash flows needed to make the repayment (+Effect 1).
2. An increase in r lowers p ̅ (and y )̅ (see previous diagram) and hence reduces the
average repayment ability of entrepreneurs (- Effect 2).
- (- Effect 2) is the “adverse selection effect”. At some level of r the total effect (+Effect
1) + (-Effect 2) is negative and therefore the slope of the expected bank profit function
E(R_B )becomes negative (i.e., E(R_B ) is concave in r). See diagram on slide 10.
• As shown in the diagram, low ability
workers, x<x(r), become
entrepreneurs (y(x)>x) and high
ability workers with x>x(r) become
wage workers (y(x)<x).
• An increase in the interest rate shifts
y(x) downwards to y′(x). This lowers
the ability of the marginal
adverse
Critique of credit rationing
1. Under adverse selection, a credit rationing equilibrium only occurs if the interest rate
required to clear the market lies above the bank optimal rate rCR (corresponding to a ‘high
demand’ on slide 10). The market clears if the market-clearing rate is less than rCR (see ‘low
demand’ on slide 10).
2. Asymmetric information may give rise to favourable selection (see Fraser, 2019, 3.3).
- Under favourable selection the marginal entrepreneur is the least able entrepreneur.
Raising the interest rate causes lower ability entrepreneurs to drop out, which
increases p ̅ (and y )̅ among the remaining pool of entrepreneurs Þ no credit
rationing.
- This situation arises if entrepreneurship rewards high ability workers more than wage
work (there is greater separation of types in entrepreneurship). High ability workers
therefore select into entrepreneurship where they earn a higher income.
- This means, under favourable selection, the y(x) (expected cash flow) curve is steeper
than the wage curve (y=x) at higher ability levels (see next slide).
3. Banks can design loan contracts with more than one term that separate types (see
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Favourable selection model (Fraser, 2019, 3.3)
Expected cash flows are steeper than the wage curve at higher ability levels à the marginal
entrepreneurs is the least able
Higher ability workers to select into entrepreneurship whereas before low ability select
entrepreneurship
Increase in the interest rates will cause the expected cash flow curve to drop down à
Marginal entrepreneurship has higher ability than they did before and cause the least able
entrepreneur to drop out of the borrowing pool à no adverse selection effect à increase
bank profit
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• Under favourable selection, low ability workers,
x<x(r), become wage
workers (y(x)<x) and high ability workers with x>x(r) become entrepreneurs
(y(x)>x).
• An increase in the interest rate shifts y(x) downwards to y′(x). This increases
the ability of the marginal entrepreneur from x(r) to x′(r).
• A higher r also increases the average probability of success p (̅ r) and average
cash flow among remaining entrepreneurs (y (̅ r) shifts upwards to y ̅′(r)).
• There is no credit rationing in this case because raising the interest rate always
increases expected bank profits.
• Under favourable selection there is too much lending because low ability
entrepreneurs (with unviable ventures) are drawn into entrepreneurship by
cheaper borrowing costs (compared to perfect information), which are
subsidised by high ability entrepreneurs.
-
-
The 5C’s underpin the credit evaluation processes (“lending technologies”) used by
banks and, in general, involve both hard and soft information.
However, if information costs are high, credit rationing may occur.
In these situation problems of adverse selection and moral hazard, caused by
information asymmetries, mean that raising the interest rate may no longer be profit
maximizing for banks.
And yet, credit rationing (and too little lending) is not an inevitable outcome of
information asymmetries. For example, information asymmetries may give rise to
favorable selection and too much lending.
Tasks: evaluating new ventures for finance
“Cash is king” How to manage cash flow as a startup?
Virgin start-up is a not for profit company that provides start-up loans, mentors and advices
for aspiring entrepreneurs It is hard to expand with little cash. Biggest challenge in start-up à
cash flow
Funding Circle’s evaluation process: What happened when you apply through us for a loan:
- Application is online
- We are going to see 3 months business statements, last sets of full filed accounts at company
house, Profit and loss statements
- Underwriting assistant: initial credit checks for both the consumer and the business, look at
financials and documents submitted
- We are after affordability and profitability. Then we send an “application approved” and a
loan contract
- Then we need a full loan contract, direct debit mandate… and ready to be on the market
place
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à Hard information (information that can be reduced to numbers), to decide whether to
allow a business on its platform to receive funds from the crowd
Theo Paphitis presses Lord Mandelson on why banks aren't lending to small businesses.
2009 (during the recession)
13 million people’s jobs depend on small businesses.
It is very important that the funds need to be available. Because of the recession, the banks
are cautious. But large companies also need to pay for SMEs early invoices of their supply
chain business bills ≠ where the banks are not going to step in.
Business loan service: The Coronavirus Business Interruption Loan Scheme
- Loan will now be demand-led
- The government will provide the lender with a guarantee of up to 80%of the loan balance
- To be alive you have to be turning over less than 45 million pounds a year
- The first twelve months is interest-free
Key problem with this scheme:
- The decision to give the loan still lies with the bank
- You must be seen as viable (if you had a business that was king of broken before, the chances
of getting a loan are very slim).
- You have to demonstrate that this really is a short-term problem but when will things get
back to normal?
“Asymmetric information and market failure” Fraser 2019
What are the diff between hard and soft information?
- Hard information: information that is easily reduced to numbers. The collection of hard
information may be delegated to low skilled workers and/or automated with the use of
computers, which reduces transactions costs. In addition, hard information may be stored and
processed in a standard format which introduces economies of scale into its production. Due
to these scale economies, large banks have an advantage over small banks in using lending
technologies based on hard information
- Soft information: often communicated in the form of text, the translation of which into a
numeric score (i.e., the ‘hardening of soft information’) involves a loss of information. It is
more easily communicated
What is credit rationing?
Credit rationing – a situation in which lenders are unwilling to advance additional funds to
borrowers at the prevailing market interest rate
Under adverse selection, banks are unable to distinguish high risk from low risk entrepreneurs
although the bank may know the proportions of high risk and low risk entrepreneurs in the
population (corresponding to the risk distribution). In that case, the bank will pool high risk
and low risk entrepreneurs and offer them a single interest based on a weighted average of
the rates it would offer to high risk and low risk types respectively if it could distinguish them.
But, this pooled rate may be too high for the low risk entrepreneurs causing them to drop out
of the credit market leaving behind a pool of mainly high-risk entrepreneurs. It may therefore
be optimal (i.e., profit maximising) for the bank to set a lower interest rate to avoid this
problem. However, this may lead to an under-supply of credit in equilibrium (i.e., creditrationing)
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Lecture 5: are entrepreneurs financially constrained?
Tasks: Are entrepreneurs financially constrained?
Designing loan contracts to overcome credit rationing
- The pooling of different types of entrepreneur leads to the possibility of credit rationing (see
task 6/lecture 4).
- There is no way to separate types with just one (interest-rate) term in a loan contract
- However, designing loan contracts with more than one term may be able to separate types
and overcome credit rationing.
“How can lenders design loan contracts to overcome credit rationing?” (Bester model)
Bester model (see Fraser, 2019, section 3.2.2)
- In Bester’s model the bank is unable to observe directly whether the entrepreneur is a high
risk (𝑏) or low risk type (𝑔)
- Instead the bank offers different loan contracts involving different interest rate (𝑟) and
collateral terms (𝐶) to the high risk and low risk types respectively.
- If the contracts on offer are incentive compatible then the high risk and low risk types selfselect into the contract intended for their risk type.
- This results in a separating equilibrium (i.e., no credit rationing) in which entrepreneurs signal
their risk type through their choice of contract.
Bester model (step 1): the bank’s iso-profit lines
r
C
In step one we look at the profit the banks derived from lending to high and low risk ventures.
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The line labeled pi B and pi G are called Iso-profit line. They represent loan contracts with
different combinations of interest and collateral that yields the same level of expected profit
to the bank.
If the entrepreneur repays the loan, the bank receives the interest payments R on the capital
borrowed. If the entrepreneur does not repay the loan, the bank will seize the entrepreneur
collateral C. In particular, for contracts along pi b, the upper rise of profit line, the bank is
maximizing expected profit from lending to high-risk entrepreneur.
Similarly, for contract along pi G, the lower Iso-profit line, the bank is maximizing expected
profit from lending to low risk entrepreneur.
à The Iso-profit lines sloped downwards because the bank can earn the same level of
expected profit by charging a higher interest rate r with a lower collateral requirement C, or
by charging a lower interest rate with a higher collateral requirement. For any given level of
expected bank profit, there is a trade-off between interest and collateral. In terms of the
Iso-profit curves, the bank charges the high-risk entrepreneur a higher interest rate due to
their lower probability of repayment. This means pi b above pi G. However, as the collateral
requirements c increases, the bank’s return in the event of default also increases. Since
default is more likely for the high-risk entrepreneur, as the collateral requirement increases,
the bank can reduces the interest rates by more along pi b relative to pi g was holding the
expected profit constant. This is why pi b is steeper than pi g.
Bester model (step 2): entrepreneurs’ indifference curves
πg_g
π
b
The indifference curve Ib and Ig represent combinations of interests and collaterals that yield
the same level of happiness or utility to the entrepreneur. An indifference curve closer to the
origin implies higher utility. The state of perfect happiness is the origin denoted O (loan
contract with no interest and collateral requirement).
The slope of indifference curves show how willing entrepreneurs are to accept a lower interest
payment on return for offering more collateral C. The high risk entrepreneur is less willing to
accept a lower r in return for offering more collateral, because they are more likely to fail and
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have to give up the collateral to the bank à indifference curve b steeper than indifference
curve g
Bester model (step 3): separating equilibrium
In the final step, we combine the bank Iso-profit lines and the entrepreneurs indifference
curves to show the equilibrium that separate types investors models.
First, suppose the bank offers contracts T b just to the rigt of G, as shown in the diagram.
Entrepreneurs behaving in their self-interest will self select into the contract which maximize
their utility. This means the high risk B select T b and the low risk g type will select T G. If,
instead, a b-type took a contract just (i.e., infinitesimally) to the right of Tg then their utility
would fall. Equally, if a g-type took Tb then their utility would fall. There would be on an
indifference curve farther from the origin than if they stuck with their intended contract T b.
In other words, these contracts are incentive compatible, and result in equilibrium with no
credit rationing
à The key requirement for incentive compatible contracts is that Ib and Ig cross once on or
between πb and πg. This is known as the single crossing property. In addition, in a competitive
market, Tb and Tg are unique: any other contracts satisfying the crossing property involve
lower borrower utility. Therefore, these contracts must be offered if credit markets are
competitive.
Critique of bester’s model
Wealthy individuals may also be less risk averse (and inclined to take on risky projects). This
obscures the collateral-offering signal in the Bester model.
You need wealth/assets in order t
o signal your risk type. Low wealth/low risk individuals cannot signal their risk type.
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Lack of collateral is a principal motive for govt. loan guarantee schemes for new ventures (e.g.,
Enterprise Finance Guarantee administered by the BB).
Are entrepreneurs financially constrained? Is personal wealth important for entrepreneurs’
decisions to start-up and grow their businesses?
“Why might new venture creation depend on the entrepreneur’s personal wealth?” (EJ
model)
The EJ model
EJ is a model of occupational choices under financial constraints. Rational people choose
entrepreneurship if and only if y > w, where y is “entrepreneurial income” and w is the “wage
rate”. An important determinant of y is entrepreneurial ability O “theta”. In absence of
financial constraints there are direct and indirect effects of Theta on y.
O has direct and indirect effect on y. E.g. Jeff Bezos can use capital more efficiently than I can,
so he invest more in his venture than I would. This is shown by the arrow from O to K*, which
is the entrepreneur optimal investment. In turn higher optimal investment k* increases the
scale and incomes from their venture shown by the arrow from k* to y.
The direct effect of entrepreneur ability on entrepreneurial income arises because more able
entrepreneurs are more productive for any level of investment. If you give two entrepreneurs
the same amount of capital, the more able entrepreneur would earn a higher income from it,
shown by the arrow from O to y.
à In the absence of financial constraints, the only factor determining whether you become
entrepreneur is your entrepreneur ability.
The problem: financial constraints (step 1)
Individuals have to post collateral on loans to signal their ability (as in the Bester model) due
to information asymmetries.
Ej assumes that the maximum amount an individual can borrow is proportional to their wealth
(𝑧)
- The bank’s lending rule is to lend at most, with a factor of proportionality lambda minus 1.
(therefore no wealth no bank finance) with lambda >1. Accordingly the entrepreneur can use
their personal wealth to invest in assets for the firm, which can be used as loan collateral
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For a typical small business, the maximum they can invest in their ventures, would be 1.4
times their wealth. More able entrepreneurs are more likely to be constrained because they
have a higher optimal investments k*.
Lecture 5
To determine your credit score a credit scoring company will use your gender and race but
nor your race and religion.
Investors on Funding circle’s platform benefit from returns of 4.5-6.5% per year, default rates
of only 3.9% and investment in a diversified portfolio of borrowers.
South West Seafoods FINANCIAL CONSTRAINTS: CASE STUDY 1 (Mr D: interviewed in autumn
2013)
- Why is South West Seafoods unable to obtain a loan from the bank to help fund expansion?
- What are the implications of financial constraints for South West Seafoods?
- What if any are the alternative financing options for South West Seafoods?
Mr. D à discouraged borrower
Mr D runs a very successful seafood distribution company in the South West of England.
- He owns 2 factories, employs 250 people and has a turnover of £12m.
- He has an MBA and is very experienced in business planning and the formal aspects of
applying for finance.
Why is South West Seafoods (SWS) unable to obtain a loan from the bank to help fund
expansion?
- Mr D wants to expand SWS, export more to China, and rebuild the factories which requires
major investment.
- SWS needs funds for both fixed capital (rebuilding the factories) and working capital (to fund
large stocks of crabs for sale over the year).
But raising the finance is very difficult…
- “We are very profitable, but if we need to borrow £300-400k, they’ll immediately say ‘what
can we have as a guarantee against it? But having built up the business by putting any money
we’ve got back in, all of the properties and anything we have is already signed up against other
loans, so we have no more capital to sign over.”
Despite Mr D’s track record, risk adverse banks aren’t willing to fund his grand vision for South
West Seafoods:
“We have a great working relationship with a couple of people [relationship managers] we
deal with on a day to day basis, but it’s always that case that if you ask for something big,
these people have got no decision making capabilities at all. If you want anything of any size
it gets referred to London and the computer makes a decision based on criteria we don’t
necessarily fall into.”
Essentially Mr D/SWS, despite being personally ambitious and very successful, was being
turned down for a loan due to a lack of collateral. Also the bank is risk averse towards
particular sectors such as seafood distribution (which is very seasonal leading to irregular
cash-flows over the year). Mr D is nostalgic for the ‘old days’ of relationship lending:
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“You are still talking about somebody looking at a formula, rather than in the old days when
the bank manager had an appreciation for who you are and what you do.”
Decisions are based on computers models, based on criteria that business don’t fall into.
What are the implications of financial constraints for South West Seafoods?
In light of his experiences of rejection by the bank, Mr D feels discouraged from applying again
to the banks
“So I think a lot of us have given up on talking to banks as regards to finance for anything
other than the basic stuff e.g., invoice discounting.”
But this means lower growth…
“…we might say forget it [about growth plans], and think about which [factory] is best place
to run, and shut one down.”
…and the perceived general lack of support for enterprise might even result in shutting the
venture down…
“It gets to a point where you’re thinking ‘I’m earning less than my staff, why am I taking this
risk? Why don’t I just work for someone else as the hassle isn’t worth it’ ... It’s almost as if
they don’t want you to succeed.”
Due to his previous experiences, of being rejected by the banks, not because of the business
being bad in itself, but because of the sector he was in, he wasn’t able to get funding. That left
him with big scars. He does not feel able to apply to get funding and will reduce his ambitions,
perhaps even shut down. Why should you go through all of this hassle if at the end of the day
you don’t get credit and get low return?
Arc of discouragement
Discouraged borrowers (DBs) (Fraser, 2019, 4.1)
- Much focus in credit-market studies on viable businesses that are unable to obtain any or all
of the funding applied for: Information asymmetries à adverse selection/moral hazard à
market failure/credit rationing (see lecture 4). In the presence of information asymmetry, they
are information costs that business incurs in making a loan application, and they are no
guarantee that if you apply you will be approved à costs but don’t get the credit (tend to be
good borrowers who get discouraged because it is costly)
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- However, DBs don’t even apply for loans because they believe they will be rejected (selfrationing). In Kon and Storey (2003) DBs arise due to credit market failure: ‘Good’ borrowers
under-invest because applying for loans is costly and the bank may mistake them for a ‘bad’
borrower.
- Conversely, if banks are well informed then ‘bad’ borrowers are less likely to apply
(discouragement is an ‘efficient self-rationing mechanism’: Han et al, 2009). Evidence that
longer banking relationships increase (reduce) the likelihood of discouragement among higher
(lower) risk firms (Han et al, 2009) à when information asymmetries are low discouragement
is efficient.
Why are there DBs?
Discouragement occurs when the perceived cost of making a loan application outweighs the
perceived chances of the application being successful (Kon and Storey, 2003).
What factors shape the perceived prob. of success?
- Previous experiences with lenders.
- The borrowing experiences of peers in business.
- Media reports of bank lending?
Are there cognitive biases in perceptions?
We can’t tell just looking at the associates of discouragement.
We need a model of DBs to test whether entrepreneurs like Mr D have biased perceptions of
credit availability.
DB model (Fraser, 2019, 4.1)
Entrepreneurs are defined in terms entrepreneurial ability features, but in the x access we don’t
have wealth but omega (ø) àthe perceived probability of making a successful loan application
Individuals with higher capital demands are going to be the ones who apply for loans. If the
market were perfect then every individual would apply for loan. But we have those applications
costs and that what introduced this idea of discourages borrowers.
Ø0 à perceived success threshold, separates the DBs from those of the successful who
therefore apply.
An ability threshold (ø0) separates ventures with capital demands (ø>0) from those without
capital demands (ø<ø0).
- Location of ø0 depends on cost of borrowing (interest rate/debt aversion) and capital already
invested. W0 à negative slope, High ability individuals are more likely to make the
application, because they derive a high return from borrowing, which overcome any issue of
your perceptions of being turn down.
- In a perfect credit market all ventures with capital demands are applicants.
In imperfect credit markets information asymmetries mean that loan applications are costly
(due to information costs).
- A perceived success threshold (w0) separates the discouraged, whose perceived chances of
success fall below the threshold (w<w0), from the non-discouraged (w>= w0)
The location of this threshold depends on perceived application costs (hurdles) including:
- Perceived cost/hassle of applying (+)
- Perceptions that the bank will ask for security/terms and conditions (+)
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Determinants of gaps between perceived and actual success probabilities: “perception bias”
à satisfaction with banks is one of the key factors and leads to business to underestimate
their likelihood to make a successful loan application
Perceptions bias – summary
- Perceptions (bias) vary with the economic cycle. Perceptions improve as confidence returns.
- Perceptions are sensitive to levels of satisfaction with bank. A key reason for dissatisfaction
is previous rejection and how this was handled (see Mr D case study). Suggests anchoring on
previous experiences, which leads to cognitive bias and underinvestment.
- Bigger perceptions bias for smallest firms. Least sophisticated/confident businesses.
- Awareness of Lending Code/Principles improves perceptions. Raise expectations about
service entitlement (Mr D lacking awareness of lending support initiatives)
- Marginal negative impact of media coverage. Not a primary cause of poor perceptions (see
qual. analysis).
- Negative experiences of business peers more significant.
à Maybe policies to help encourage businesses to consider again borrowing, e.g. improving
relations with banks and entrepreneurs, raising awareness of the support that is available e.g.
awareness of lending codes and principles.
Takeaways from week 4/5 tasks and lecture 5
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-
-
-
-
Bester model indicates separation of types (high and low risk) is possible with collateral
(solving the credit-rationing problem).
However, EJ model indicates able entrepreneurs may be financially constrained by a lack
of collateral leading to lower new-venture creation and performance.
While SBCS has reduced lenders’ reliance on collateral larger loans (>£25-30K) will still
require collateral. In addition SBCS often perceived as remote and impersonal, which may
lead to dissatisfaction with the bank following rejection (e.g., Mr D/SWS case study).
Increase in P2PL following GFC of 2008-2009 partly due to badly handled rejections which
scarred entrepreneurs and encouraged them to look to alternative finance sources (e.g.,
Mr D/SWS case study).
Discouraged (self-rationed) borrowers are empirically as important as rejected (creditrationed) borrowers. (But DBS are less well understood/researched than credit-rationed
borrowers.)
Again, scarring experiences with banks may lead entrepreneurs to under-estimate the
likelihood of making a successful loan application leading to “excessive” discouragement
and underinvestment (e.g., Mr D/SWS case study).
Tasks: Non-bank debt
Leasing/hire purchase
1. Leasing and hire purchase are both forms of asset finance that can be used to acquire assets
for the business.
2. This a low-risk form of debt finance that is often used if the business requires new
equipment, which would otherwise be unaffordable due to cash-flow constraints.
3. Leasing and hire purchase can be useful to businesses at any stage. Both forms of debt are
secured against the new assets, so available to both start-ups and large, established
organizations.
Lecture 6: Development in lending new ventures
Tasks: Developments in lending (less wealthy entrepreneurs)
A smart new business loan for people with no credit | Shivani Siroya TED ideas worth
spreading
SS is a founder of Tala, smartphone lending app
Data proves trust by looking beyond income, such as location consistency, stability in key
relationship, network diversity à helping improve access to finance among unbanked
entrepreneurs in emerging economies.
Small business credit scoring with innovations like Tala is helping improving people’s life
around the world by helping small entrepreneurs to receive credits.
SBCS (Fraser, 2019, 3.2.4)
- Credit scoring uses statistical methods to predict the borrower’s probability of default (PD):
- The credit-scoring model is developed using a large sample of firms.
- A loan applicant’s characteristics are later input into the model to obtain a
prediction of their PD.
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- Behavioral scoring uses data from the entrepreneur’s bank accounts (how well the
entrepreneur runs his financial affairs, data includes credit and debit turnover, on
whether the entrepreneur has exceeded its overdraft limits…).
- The credit/behavioral score determines whether the application is approved and the price
of the loan (see video on next slide).
- Use of SBCS grew rapidly in the early 1990s following FICO’s discovery that small firms’ PD
is more influenced by the entrepreneur’s personal credit history than business
characteristics/financial ratios à this influence reflects the important roles of the
entrepreneurs and their personal finances in determining the success or failure of the
business
- The key benefit of credit scoring is that the borrower doesn’t need collateral
How a FICO Credit Score is Determined | Federal reserve bank
Credit score:
- A person financial history 35%
- Amount owed relatives to limits 30%
- Length of credit history 15%
- Frequency of new credit 10%
Crowdfunding and Peer-to-peer lending, the democratisation of entrepreneurial finance?
This is an area of entrepreneurial finance that’s really taken off among entrepreneur and
students. By crowdfunding, entrepreneurs moved away from traditional financial
intermediaries like banks, they use online platform from the crowd to get money.
In debt crowdfunding or peer-to- peer lending, people expect to get their money back with
interests.
Equity crowfunding involves people investing in an opportunity in exchange for equity.
Donation/ reward cf people have a personal motivation to invest and expect not financial
return.
A graphic of Judge Business school in 2018 Shows that the peer to peer lending has the largest
volume of funding, with over 2 billion pounds in lending via online platforms in 2017, which
accounted for around 10% of total new SME loans that year. By contrast only 60 millions
pounds in peer to peer loans were made in 2012.
Factors for this increase:
- The advent of web 2.0 in 2004 created the right technological and economic environment
for crowdfunding to take off
- Following the financial crisis 2007-2008, low interest rates led savers to search for high
returns and new types of assets, including crowdfunding investment + bad experience with
banks
P2PL (Fraser, 2019, section 8)
Funding circle is a leading example of successful FinTech entrepreneurship in the UK following
the financial crisis. The British business bank supports peer to peer lenders such as funding
circle in order to improve the diversity funding options available to entrepreneurs or promote
competition in entrepreneurial finance markets.
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Investors on platforms may base their investment decisions on both hard (numerical) and soft
(non-numerical) information about the fund seeker
- “What is small business credit scoring (SBCS) and why has it risen in importance since the
1990s? What has been the impact of SBCS on small business lending?”
- “What is peer-to-peer lending (P2PL) and why has it risen in importance since the Great
Financial Crisis of 2007-8? Explain how P2PL works using the example of Funding Circle.”
à Explains how peer to peer lending works using the example of funding circle + case of
Shivani with Tala, which you can link into your answer. Other platforms like prosper.com
where investors can lend to individual borrowers, the investors lending decisions can be based
on hard and soft decisions including photos of the videos and campaign video about the
project.
Lecture 7: Sources of equity finance and Issues in venture capital
An angel investment is typically to 15k to half a million
In the Amit, Brander, and Zott model, VC monitoring increases entrepreneurial efforts e’ by
raising entrepreneurs productivity
VCs should take minority equity stakes in portfolio companies to maximise entrepreneurial
effort
Equity crowdfunding
- Equity CF has grown very rapidly since the GFC 2007-8. It has both financial and non-financial
benefits for entrepreneurs and investors. E.g., helping to fill funding gaps and raise the firm’s
profile (see BrewDog, seminar 5).
- However information/control issues are particularly acute: Is the crowd able to conduct
effective due diligence? FCA estimates investors lose their entire capital in 50-70% of
ventures.
- CF investors have little control over investment terms: E.g. equity stakes may be diluted by
subsequent fund-raising (e.g., Equity for Punks I-VII)
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- Crowdfunded businesses do not benefit from the non-financial services provided by
seasoned (angel/VC) investors.
- IP protection issues. There is a risk of sharing too much too soon with the crowd E.g., Lunatik
à an entrepreneur Scott Wilson raised almost a million dollars on Kickstarter had a lucrative
idea to turn an ipod Nano into a smart watch but they were lots of imitators who came along
necause he had not protected his idea. He lost at it because of a lack of adequate protection
in place.
BrewDog (founded 2007) were an early adopter of equity CF. BrewDog’s first campaign Equity
for Punks (EfP) I was conducted in 2009. BrewDog’s seventh EfP campaign (EfP Tomorrow) is
live:
They’re taking away funding from the VC and help democratize finance.
Is equity CF helping to democratise entrepreneurial finance?
Research suggests (Cumming et al, 2018):
- Younger entrepreneurial teams are both more likely to launch equity crowdfunding offerings
than IPOs, and are more likely to successfully complete an equity crowdfunding offering.
- However, female and ethnic minority entrepreneurs are not more likely than males/nonminorities to successfully raise funds by equity crowdfunding (although minority
entrepreneurs do attract a higher number of investors).
VC case study: Renovo
BioNTech (founded 2008 by Ugur Sahin and Ozlem Tureci) have developed a vaccine for Covid19 with 90%-plus efficacy (Nov 9th 2020). Renovo (founded 2000 by Mark Ferguson and
Sharon O’Kane) were trying to develop an efficacious therapy for scar-free wound healing.
Renovo raised a (UK) record series-A funding round of £8m from Atlas Venture (£6m) and
Chase Capital (£2m) in 2000.
Why did Renovo receive VC funding?
Sahlman’s criteria
People: very talented academics with the commercial abilities
- Prof Mark Ferguson (University of Manchester): Became youngest full Professor
(biochemistry) in UK aged 28:“came across [to VCs] as a first rate visionary, and was clearly a
highly driven and committed individual.” Barnes (2004), p. 391.
- Dr Sharon O’Kane: Quickly established an international reputation as a first rate scientist
after arriving at Prof. Ferguson’s lab in 1993.
Opportunity/Context/Risk and Reward
- Renovo’s vision was to build: “the world’s leading drug discovery company focused on scarfree wound healing therapies.” Barnes (2004), p. 379
-The healthcare market is the largest on the planet. Projected to reach $10.059 trillion by
2022 (Deloitte, 2019)
- However, the development of new drugs involves high costs, lengthy development periods,
and high risks. Regulatory context: The high costs involved reflect the stringent FDA/EMA
regulations (clinical trials) for the development and approval of new drugs.
- But the corresponding pay-offs for successful drugs are huge with blockbuster drugs
generating close to $1bn sales per annum: “this is a high stakes, high rewards industry” Barnes
(2004), p. 383.
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à You either win big or lose big
VC control mechanisms
How do VCs mitigate uncertainty and exert control over the entrepreneur’s behaviour?
- Staged capital infusions.
- Active involvement of VC in portfolio companies (see “A day in a life of a VC” and Amit,
Brander, and Zott model in week 6 task, Issues in VC).
- Investing in the form of convertible preference shares.
- Syndication.
The Renovo case study and pro forma Term Sheet*(the legally biding investment documents)
to the deal (see Barnes, 2004, appendix 5) highlights VC control mechanisms in practice
Staged capital infusions
- Key part of the VCs monitoring/control mechanism – allows VC to adjust investment as the
story unfolds Option to increase investment if venture achieves pre-agreed performance
milestones. But preserves the option for VC to abandon poorly performing projects.
- Key agency theory prediction for staged capital infusions is that in situations of high
information asymmetries the VC needs to monitor the venture more frequently the duration
of each funding round is shorter.
- Gompers (1995) finds that early stage companies receive more rounds and less per round
(supplied with capital a “little and often”). This keeps the entrepreneur on a “tight leash”.
Staged capital infusions: Case studies
Apple Computers received 3 rounds of VC funds
- Round 1: $518,000 ($0.09 per share) (Jan 1978)
- Round 2: $704,000 ($0.28 per share) (Sept 1978)
- Round 3: $2,331,000 ($0.97 per share) (Dec 1980)
- At each stage the growing investment reflected the resolution of uncertainty about Apple’s
prospects (it’s a plum!). The venture is receiving more capital and give less equity just before
their IPO where they raised 100 million and made investors millionaires in the process.
Federal Express
- Round 1: $12.25 m ($204.17 per share) (Sept 1973)
- Failed to meet revenue/profit projections. To avoid financial collapse financiers agreed:
- Round 2: $6.4m ($7.34 per share) (March 1974)
- Performance continued to decline:
- Round 3: $3.88m ($0.63 per share) (Sept 1974).
- VC intervened extensively in FedEx’s strategy. Went public in 1978 at $6 per share.
- Declining share price at each round gave VC more shares/more control.
Active involvement of VC in portfolio companies
- Active involvement of VCs in Renovo: “Seed deals at Atlas come with a commitment to spend
time with the company” Barnes (2004) p. 394
- Also Atlas Ventures were biotech specialists. This was an important consideration behind
Prof. Ferguson’s choice of investor: “any VCs he spoke to had to be of the highest reputation,
understand biotech intimately, have a proven track record in the field…” Barnes (2004), p 394
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- The term sheet also includes: the right for the VCs to appoint members of the board of
directors; and veto rights on key financial/strategic decisions.
What went wrong with SoftBank’s investment in Wework?
WeWork got too much money too fast and without effective oversight. SB lack of due
diligence, monitoring and service provision to WeWork.
Tasks: sources of equity finance
Equity funding escalator
Venture capital
Equity
crowdfunding
Angel investors
Owner’s equity
Average personal
savings below £7K.
Perhaps more
internal equity
from wealthy FFF’s.
Angels investing
their own money.
Typical investment
£15K-500K (more
from syndicates).
Investment up to
£4.3m if no
prospectus for
investors. More if a
prospectus is
provided (see
BrewDog case
study seminar 5).
Total equity CF in
the UK about 13%
of angel and VC
investment (see
appendix).
VCs investing other
people’s money.
Investments
typically £2m£30m.
VC is very risky. VC
will lose money on
over a third of the
capital invested
Majority of VCs
portfolio return
generated by a few
“superstars” (7% of
the capital
invested).
Angels use their own money to provide seed funding in return for a minority shareholding. On
the issue of control aversions, because angels are ordinary shareholders whose claims rank
alongside entrepreneurs, their interests are aligned with entrepreneurs. Therefore angels
won’t force entrepreneurs to do risky things with their businesses that they don’t want to do.
In video 2 the chair of the UK crowd funding association highlights that as well as raising
finance, crowd funding can help raising the firm profile à importance of providing investors
with information about the people, opportunity risks and rewards of the venture (such as
campaign video).
VCs investors get involved after angels, or when the ventures can show that they have a
consumers base. VCs investors expect the right to sit on the company’s board. They invest for
4 to 5 years or longer. They invest over several rounds of funding (4 funding rounds would be
series A, B, C, D…) and may bring other VCs. If companies get to the 4th funding round they
may expect to receive investments of over 10 million pounds.
Issues in venture capital
Why are VC backed start-ups so rare?
Demand side:
- Lack of growth potential.
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-
Lack of investment readiness.
Control aversion (see appendix). Among small firms entrepreneurs are not willing to take
risks.
Supply side:
- High information asymmetries,
- High fixed costs of screening and monitoring Þ equity gap for small scale investments.
- Historically low returns on VC investment (see appendix).
- Liquidity risk/lack of exit routes (such as IPO) à providing possibilities for investors to
convert their investment in some cash at some point in the future.
How are VC funds organised?
A good reputation is essential for the ability to raise follow-on funds. The VC carry interest
depends on the capital gain of the fund, which motivates the VCs to maximize value creation
with the portfolio companies. Ventures capital investments are highly liquid. The fixed term
of the ltd partnership agreement set an upper limit on the time the investors’ money is tied
up in the fund. The 10 years lifespan gives VCs enough time to create value in the portfolio.
VC CYCLE
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Why do venture-capital firms exist? (What do VCs do and how do they find/create value?)
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The video highlights that Dana Mead, a KPCB Partner VC spends 10% of his time screening
investment opportunities. However there is x 99% of the ventures that apply for funding,
which indicates there is a very high threshold for VC investment and resonates with an early
discussion of the rarity of VC backed startup. Now he is an established VC sits on 12 companies
boards of directors and spend less time to look at new investments opportunities. He spends
20% of his time networking with entrepreneurs and others VCs. This helps with finding
investments opportunities and provide companies with larger amounts of funding, and 70%
of his time supporting portfolio companies (recruiting, raising money…)
VCs exist because they are more efficient than other investors in coping with problems caused
by information asymmetries (adverse selection and moral hazard)
Due diligence
The due diligence process can separate the “plums” from the “lemons”.
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Monitoring
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Provision of services
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1. VCs operate in sectors with high information asymmetries where they can add most value
through due diligence, monitoring, and service provision.
2. However within the sectors where VCs have an advantage they prefer ventures/markets
with lower information asymmetries.
3. VCs should not take a large equity stake (α) in the venture to avoid discouraging
entrepreneurial effort. But it can provide advice and mitigate moral hazards.
“Why are VC backed start-ups so rare? How do VCs find “plums” and create value with their
portfolio companies?”
Tasks equity for punks
1. Campaign related factors.
2. Crowdfunder related factors.
3. Crowdfunding platform related factors.
4. Fund-seeker related factors.
Lecture 8: Guest speaker
Task: Basics of VC valuation methods
Valuation forms the basis for determining the share of equity that the entrepreneur needs to
sell to the VC in return for investments.
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Present discounted value (PDV) of free cash flows (FCF)
Free cash flow to equity (FCF)= Net income + depreciation - ∆working capital - capital
expenditure + net new debt
In practice however, begin by separating the cash-flows, over a finite investment period T,
into two parts (“divide and conquer”):
1. An explicit forecast period in years 1,…,T-1 plus
2. A terminal value in the exit year T: the present value of the FCF’s generated beyond the
explicit forecast period (the business is mature, less risky and growing smoothly at this stage).
LifeStem (fictional)
Figures in
2020 2021F
£’000’s
Net Income
50
Depreciation
20
D Working Capital
-25
Capital
Expenditure
-2,500
Cash flow
-2,455
Ending cash
200 -2,255
balance
2022F 2023F 2024F
851
75
-200
2025F
4,500 11,750 23,275
180
200
340
-800 -1,000 -2,500
-7,500 -5,500
-5,500
-5,000
-6,649 -1,000
6,250 18,275
-8,904 -9,904
-3,654 14,621
Q1. Value the business using the PDVFCF method.
Q2. What share of ownership does the entrepreneurial team need to sell to the VCs for a
£10m investment?
Lecture 9: Finance in New Ventures Exit strategies
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Harvesting
- Process of selling ownership in a privately held business to realize the value created by
entrepreneurs and investors. Cash-out time for VC (and maybe also the entrepreneur).
- Main liquidity events:
- Going public: Initial Public Offering (IPO).
- Trade sale.
- Management buyout (MBO).
- Liquidation (involuntary sell of assets).
- Important to set out the exit strategy for seasoned investors in the business plan.
- Harvesting options will increase the value/attractiveness of the venture by reducing liquidity
risk (see Sahlman’s criteria in week 2 task “Evaluating new ventures for finance I” and seminar
3 MP3.com).
- IPO – see below
- Trade sale/acquisition: Acquisition by another business (usually in the same sector)
- Buyer is well informed about the business being acquired ( lower transaction costs
relative to IPO).
- Value to buyer depends on ‘stand alone’ value + strategic gains (minus transaction
costs).
- For example, consider Google’s acquisition of YouTube (see appendix)
- Management Buy-Out: Repurchase of the VCs shares by the management team (funded by
debt or another VC/investor):
- Buyer is almost perfectly informed about the venture ( lowest transaction costs).
- Liquidation: One third of all investments result in a total or partial loss – see week 6 task,
“Sources of equity finance” (and table on next slide).
Initial Public Offering (IPO)
Sale of new shares to public market investors (primary market transaction/offering) (Different
from cash out event for entrepreneurs and inside investors which involves sales of used
shares)
- In fact the IPO raises more capital for the business and establishes a market for the firm’s
shares (see MP3.com case study – seminar 3 – and Michael Robertson. The Highs of MP3. –
YouTube discussing the IPO).
- The Underwriting Agreement between the investment bank and existing shareholders will
contain a lock-up clause prohibiting ‘insiders’ from selling their shares for 180 days.
- Key liquidity event for entrepreneur/investors is a secondary offering (sale of used shares)
around 6 months after the IPO.
An IPO is very expensive: e.g., an AIM flotation costs around 6-7% of the funds raised: AIM
Flotation Process: A Guide To Joining AIM | AIM-Watch (aim-watch.com).
- Only stellar performers in the portfolio will be taken public.
- These are the “golden few” with a ROI of 10 times plus (i.e., 60% p.a.)
Basic problem is that public investors are poorly informed about the venture relative to inside
investors.
- Outsiders need to be convinced that the venture is a plum not a lemon.
- Another key benefit of an IPO is also about raising the public profile of the business
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IPO lock-up clause (signalling): insiders are better informed than public investors…
A lock-up agreement is a contractual provision preventing insiders of a company from selling
their shares for a specified period of time. They are commonly used as part of the initial public
offering (IPO) process.
It is important that insider shares do not flood the market because that would cause the price
to plummet and send a bad signal to pubic investors if inside investors start selling their
shares. WeWork when the IPO was pulled because it was revealed that WeWork was making
significant losses and Adam Neuman sold 700 million dollars of his shares before the IPO so
bad signal. In the US the lock up is not required by law whereas in the UK if you are issuing
shares there is a one-year lock-up period required by the listing rules.
Role of an investment banker (intermediary between issuing company and the public) is to:
- Conduct due diligence on the issuing company to establish its financial situation and
investment intent. This is written up in a prospectus’. Addressing information gaps to make
sure they’re investing in plums and not in lemons. E.g. at the time of fb IPO there was a
transition period of concerns about fb establishing itself on smartphone.
- Market the firm’s shares and establish the offering price (achieved through ‘road-show’
presentations to brokers and institutional investors).
Typically, the investment bank takes on the mispricing risk by buying the shares from the
issuing company just before the IPO (firm commitment contract).
In return for marketing and underwriting the shares the investment bank earns an
underwriting spread
- Difference between investment bank’s proceeds from public investors and what it pays to
the issuing company.
- Under a best efforts contract the investment bank does not take on the mispricing risk –
charges a cheaper fee for simply marketing the shares.
Facebook – a reluctant IPO
Mark Zuckerberg was reluctant to take FB public. (He had previously refused a billion dollar
offers from Yahoo)
- He had to after the number of shareholders passed 500.
- Registration statement filed with the SEC on Feb 1st 2012.
FB went public on May 18th 2012.
- Issued 421m shares @ $38 per share raising $16bn and valuing FB at $104bn.
- The lead investment banks (Morgan Stanley, JP Morgan Chase and Goldman Sachs) shared a
fee of $176m.
However FB IPO widely seen as a debacle.
- Share price fell below $18 by Sept 2012
- What went wrong?
- Unfriended: The Facebook IPO Debacle - WSJ In Depth - YouTube
Facebook IPO - conclusion
There are winners from the Facebook IPO
- Peter Theil invested $500K in 2004 and cashed out with over a $1bn – an ROI of ~160% pa!
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- Greylock Partners (VCs) made $289m – 18×its investment over 6 years (62% pa).
- Not to mention Mark Zuckerberg who is now (Nov 2020) worth $102bn – he retained a 22%
ownership share in FB and 57% of voting rights.
The big losers were retail investors (looking for quick gains). Those that bought and held their
shares would also have made big gains (Facebook shares currently trading at almost $278 in
late Nov 2020). Also Morgan Stanley and NASDAQ’s reputations took a hit. MS did not lead
on Twitter IPO in 2013. Similarly Twitter floated on the NYSE rather than NASDAQ.
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