Chapter 1
Introduction to
Entrepreneurial
Finance
Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of
the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information
should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations
contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of
these programs or from the use of the information contained herein.
Learning Objectives
• Understand how new venture finance is different from
corporate finance.
• Understand the centrality to new venture finance of the
objective of maximizing value for the entrepreneur.
• Briefly describe the evolution of thinking about the nature of
entrepreneurship and how entrepreneurship relates to new
venture finance.
• Describe the process of new venture formation from inception
of the idea to harvesting of the investment.
• Recognize that studying new venture finance can contribute to
better decision-making and increased potential for success.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 1
Intellectual Challenge
• Diversification of risk affects investment value.
• Investment and financing decisions are interdependent.
• Outside investors may be actively involved in a venture.
• The parties have different information (and beliefs).
• The parties have different incentives from each other.
• New ventures are portfolios of real options.
• Value to the entrepreneur is different from value to
shareholders.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 1
After This Course,
You Should Be Able To:
•
•
•
•
•
•
•
•
•
•
Construct new venture financial models
Assess the timing and amounts of financial needs
Estimate risks and expected returns of financial claims
Value financial claims in light of diversification
Evaluate alternative new venture strategies
Estimate the effects of complex options on value
Design and negotiate “deals”
Address information and incentive problems
Understand the institutions of new venture finance
Develop a business plan to attract outside funding
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 1
The Finance Paradigm
• More of a good is preferred to less.
• Present wealth is preferred to future wealth.
• Safe assets are preferred to risky assets.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 1
Types of Financial Decisions
• Investment Decisions
• Financing Decisions
• Mixed Decisions
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 1
New Business Formations & Terminations
Ne w
Ye ar
Su cce s s o r
C o m p a n ie s
T o tal
C o m p a n ie s S t a r t - u p s T e r m in a t io n s
Ne t S t a r t -
Pe r ce n t
Pe r ce n t
Fa ilu r e s
ups
T e r m in a t io n s
Fa ilu r e s
1990
7 6 9 ,0 0 0
1 4 6 ,0 0 0
9 1 5 ,0 0 0
8 4 4 ,0 0 0
6 0 ,7 4 7
7 1 ,0 0 0
9 2 .2 %
6 .6 %
1991
7 2 6 ,0 0 0
1 3 8 ,0 0 0
8 6 4 ,0 0 0
8 2 1 ,0 0 0
8 8 ,1 4 0
4 3 ,0 0 0
9 5 .0 %
1 0 .2 %
1992
7 3 7 ,0 0 0
1 3 8 ,0 0 0
8 7 5 ,0 0 0
8 1 9 ,0 0 0
9 7 ,0 6 9
5 6 ,0 0 0
9 3 .6 %
1 1 .1 %
1993
7 8 0 ,0 0 0
1 3 6 ,0 0 0
9 1 6 ,0 0 0
8 0 1 ,0 0 0
8 6 ,1 3 3
1 1 5 ,0 0 0
8 7 .4 %
9 .4 %
1994
8 0 7 ,0 0 0
1 3 7 ,0 0 0
9 4 4 ,0 0 0
8 0 3 ,0 0 0
7 1 ,5 2 0
1 4 1 ,0 0 0
8 5 .1 %
7 .6 %
A ve r ag e
7 6 3 ,8 0 0
1 3 9 ,0 0 0
9 0 2 ,8 0 0
8 1 7 ,6 0 0
8 0 ,7 2 2
8 5 ,2 0 0
9 0 .7 %
9 .0 %
Terminations with loss to creditors as
a percent of start-ups
Terminations as a percent of start-ups
100%
12%
90%
10%
8%
80%
6%
70%
4%
60%
2%
50%
0%
1990
1991
1992
1993
1994
1990
1991
1992
1993
1994
Source: Case, J., "The Dark Side" Inc. Magazine, 1997, http://www.inc.com/incmagazine/archives/27960801.html, based on The State of Small Business: A Report of the President, 1994, U.S.
Government Printing Office, Washington, D.C., 1995.
The Objective
Maximum Value for the
Entrepreneur
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 1
Caveats
• Investment value is not the only factor an entrepreneur or
investor can consider.
• The CAPM-based valuation models used in the book do not
fully describe how investors view risk.
• Risk and expected return can be estimated, but not
measured with precision.
• Not every new venture investment or financing decision
should be carefully modeled and evaluated.
• Examples in the book are not intended to suggest that any
party to a deal should try to capture all of the value for
themselves.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 1
Chapter 2
Overview of New
Venture Financing
Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of
the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information
should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations
contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of
these programs or from the use of the information contained herein.
Learning Objectives
• Learn new venture financing terminology.
• Understand the value of tying financing to performance
milestones.
• Recognize the distinguishing characteristics of the various
stages of new venture development.
• Identify the financing sources available to a new venture and
the factors favoring one financing source over another.
• Learn the basic structures and availability of various
financing sources.
• Identify the key elements of deal structure and the functions
they serve.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 2
Some Milestones for
New Venture Planning
•
•
•
•
•
•
•
•
•
Completion of Concept and Product Testing
Completion of Prototype
First Financing
Completion of Initial Plant Tests
Market Testing
Production Start-up
First Competitive Action
First Redesign or Redirection
First Significant Price Change
Block and MacMillan (1992)
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 2
Stages of New Venture Development
• Development Stage
• Start-up
• Early Growth
• Rapid Growth
• Exit
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 2
Stages of New Venture Development
Dollars
Figure 2-1
Revenue
Net Income
0
Cash Flow
Time
0
Development
Start-up
Early Growth
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Rapid Growth
Exit
Chapter 2
Sequence of New Venture Financing
•
•
•
•
•
•
•
•
•
•
Bootstrapping
Seed Financing
R&D Financing
Start-up Financing
First-stage Financing
Second-stage Financing
Third-stage Financing
Mezzanine Financing
Bridge Financing
LBO, MBO, IPO
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 2
Sources of New Venture Financing
• Self, Friends, and Family
• Business Angels
• Venture Capital Investors
• Small Business Investment Companies (SBICs)
• Trade Credit and Factoring
• Asset-based Lending
• Mezzanine Capital
• Private Placements of Equity (Relational Investors)
• IPOs
• Public Debt
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 2
Sources of New Venture Financing
Figure 2-2
Sources of New Venture Financing
Development
Start-up
Early
Growth
Rapid
Growth
Exit
Entrepreneur
Friends and Family
Angel Investors
Strategic Partner
Venture Capital
Asset-based Lender
Equipment Lessor
SBIC
Trade Credit
Factor
Mezzanine Lender
Public Debt
IPO
Acquisition, LBO, MBO
Black shading indicates primary focus of investor type.
Gray shading indicates secondary focus, or focus of a subset of investors.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 2
Venture Capital Commitments
by Source
Figure 2-3 Part I
1978
Insurance
16%
Pension funds
15%
Endowments
9%
Corporations
10%
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Individuals
32%
Foreign
18%
Chapter 2
Venture Capital Commitments
by Source
Figure 2-3 Part II
1991 - 1995
Insurance
12%
Endowments
19%
Corporations
5%
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Foreign
6%
Pension funds
46%
Individuals
12%
Chapter 2
Investment by Industry - 1997
Figure 2-4
Distribution/ Retailing
3.0%
Electronics
3.6%
Industrial
Business
Environmental
Semiconductors
Pharmaceuticals
1.0%
0.8%
1.8%
Computers
Software/ Information
3.2%
24.7%
4.5%
Services 4.7%
Medical
Instruments
5.0%
Consumer
6.6%
Biotechnology
6.7%
Communications
Healthcare
22.8%
11.4%
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 2
How Changes in the Stock Market Affect
New Equity Capital Raising
Figure 2-6
150%
100%
50%
19
94
19
92
19
90
19
88
19
86
19
84
19
82
19
80
19
78
19
76
19
74
19
72
0%
19
70
Percent Change from Prior Year
200%
-50%
-100%
Year
Change in Equity Financing
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Change in S&P 500 Index
Chapter 2
Number of Debt Issues by Proceeds of
Issues: 1990-94
Figure 2-7
500
Convertible--Noninvestment Grade
450
Convertible--Investment Grade
Number of Issues
400
350
300
Straight--Noninvestment Grade
Straight--Investment Grade
250
200
150
100
50
0
2-9.99 10-19.99 20-39.99 40-59.99 60-79.99 80-99.99
100199.99
Gross Issue Proceeds in Millions
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
200499.99
500+
Chapter 2
Deal Structure
•
•
•
•
•
“The Deal”
Term Sheet
Pre-money Valuation
Post-money Valuation
Investment Agreement
– Representations and Warranties
– Covenants and Undertakings
– Affirmative Covenants
– Negative Covenants
– Registration Rights
– Preemptive Rights
– Ratchets or Anti-dilution Provisions
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 2
Chapter 3
The Business Plan
Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of
the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information
should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations
contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of
these programs or from the use of the information contained herein.
Learning Objectives
• Learn how and why business plans of new ventures are
different.
• Know what to include and what to leave out.
• Understand the relationship to strategic planning.
• Use milestones and financial projections in the plan.
• Use the plan to signaling the entrepreneur’s beliefs,
commitment, and capabilities.
• Understand how the plan can facilitate negotiation with outside
investors.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 3
What is a Business Plan?
• A written document
• Summarizes the purpose and overriding strategy of the
venture
• Provides details on operation, financing, marketing, and
management
A set of hypotheses about an opportunity
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 3
What Makes the Business Plans of
New Ventures Different?
• Forecasts and projections usually are less precise.
• A greater investment in planning may be warranted.
• Deviations from plans are likely to be due to wrong
assumptions.
• Not very useful for evaluating manager performance.
• More likely to be relied on externally.
• More likely to be used to attract investment capital.
• Often require greater breadth of coverage.
• Unconstrained by previous decisions.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 3
Do the Planning Before the Writing
• Preparing a business plan is not the first step.
• The plan can commit the entrepreneur to an undesirable
strategy.
• Consider aspects of strategy simultaneously, not
sequentially.
• Do not lose sight of the objective.
• Analysis of strategic alternatives does not belong in the
business plan.
• Be prepared to respond to alternative proposals.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 3
Alternative Product Market and
Financing Choices
Figure 3-1
Alternative Product Market and Financing Choices:
Net Present Value to the Entrepreneur
Financing Choice
Product Market Choice
Small
Small
Large
Large
Scale
Scale
Scale
Scale
- Slow Growth
- Rapid Growth
- Slow Growth
- Rapid Growth
Entrepreneur Entrepreneur Entrepreneur +
Entrepreneur
+ Debt
+ Equity
Debt + Equity
$100
$60
$60
$20
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
$40
$80
$50
$40
$30
$20
$120
$80
$10
$90
$70
$100
Chapter 3
Contents of the Business Plan
• Focus on the purpose(s) and uses of the plan.
– Include whatever information is relevant and material.
• Make certain the audience is neither overloaded nor left to
speculate.
– Include only what is appropriate and necessary, given the use.
• Identify the key assumptions as assumptions.
– Include the support for key assumptions.
• Highlight the critical elements for success or failure.
• Delineate milestones.
– So users can evaluate success, modify assumptions, expectations, or strategy.
• Include financial projections.
– To test the plan, commit the entrepreneur, facilitate negotiation
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 3
Making the Business Plan Credible
• Demonstrate understanding of the technology, market, risks,
needs, and potential rewards.
• Provide evidence of the quality and capabilities of people
involved, and that they can function effectively as a team.
• Provide evidence that key personnel are committed.
– Bonding
– Reputation
– Certification
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 3
The Issue of Confidentiality
• Protecting intellectual property
• Preempting rivals and first-mover advantage
• Using non-disclosure agreements
• Relying on reputation
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 3
Financial Aspects of the Business Plan
• Differing views on what to include
• Is the future too uncertain to warrant careful forecasting?
• Include in the plan, or as an appendix?
• The importance of supporting assumptions
• Relationship of projections to contract negotiation
• The value of quantifying risk
• Value as a diagnostic tool - to facilitate adaptation
• Updating the business plan
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 3
Chapter 4
New Venture Strategy
Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of
the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information
should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations
contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of
these programs or from the use of the information contained herein.
Learning Objectives
• Understand what makes a decision strategic.
• Understand the interrelationships between financing
decisions and other aspects of new venture strategy.
• Relate strategic decisions to the entrepreneur’s objective
of value maximization.
• Describe strategic alternatives in terms of real options.
• Use decision trees to identify and evaluate real options.
• Use game trees when strategic choices depend on rival
reactions.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
What Makes a Plan or Decision
Strategic?
• Strategic decisions are consequential.
• Strategic decisions are both active and reactive.
• Strategic decisions limit the range of possible future actions.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Interactive Financial Strategy
Figure 4-1
The more vertical and
horizontal integration, the
greater the financial
needs.
Outside investment is
more likely the larger the
firm.
Financial
Strategy
Type of financing
 Outside v. entrepreneur
 Debt v. equity
Financial contracts
Rapid growth reduces
financial flexibility and
requires sacrificing
control to attract outside
financing.
 Loan covenants
 Options
 Staging
Product
Organizational
Strategy
Vertical boundaries
Product
Market
Strategy




Price
Margin
Quality
Differentiation
Targeted sales
growth
Horizontal boundaries
 Scale and scope
Rapid growth requires a larger
organization. Economies-of-scope
imply more product lines.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Financial Implications of Product-Market
and Organizational Strategic Choices
Figure 4-2
Product-market
Slow growth
Rapid growth
One-level entry
Initially self-financed by
entrepreneur, growth
financed with operating
cash flows
Initially self-financed by
entrepreneur, growth
financed with operating
cash flows and outside
financing
Initial financing
includes outside equity,
growth financed with
operating cash flows
Initial financing
includes outside equity,
growth financed with
operating cash flows and
outside financing
Organization
Integrated entry
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
An Introduction to Options
• Option - A right to make a decision in the future
• Elements of an option
–
–
–
–
An underlying asset
Exercise price (strike price)
Expiration date
European or American form
• Basic options
– Call option
– Put option
• Financial options
• Real options
• Complex options
– Contingencies - Option created by some earlier action
– Interdependencies - Options with interdependent values
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
The Structure of a Call Option
Underlying Asset
Expiration
Value
Value
of Asset
Call before
Expiration
E
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Value of Underlying Asset
Chapter 4
Realized Returns on Options
Buy a Call
Write a Call
Gain
Loss
Gain
Loss
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Valuing Options
• Put-Call Parity
– Option Pricing Models based on no-arbitrage
– Stock + Put = Call + PV(Exercise Price)
– Role of complete markets
• Financial Options
– Complete markets
– Incomplete markets
• Real Options
– Complete markets
– Incomplete markets
• Complex Real Options (Rainbow Options)
– Discrete scenarios
– Simulation
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Real Options - Some Examples
• Defer - Investing now eliminates the option to defer
(learning).
• Expand - An option to defer part of the scale of investment.
• Contract - The flexibility to reduce the rate of output.
• Abandon - Stop investing, and liquidate existing assets.
• Staging - Substitute a series of small investments for one
large.
• Switching - Re-deploy resources or change inputs
(terminate).
• Change Scope - Expand or contract scope.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Techniques for Reasoning Through
Decision Trees
• Focus on the most important decisions.
• Reason forward to construct the tree.
• Track certainties and uncertainties at each decision
point.
• Calculate backwards to evaluate choices.
• Select the tree branch with the highest expected
value.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Decision Tree - Restaurant Example
• Demand may be high (30%), medium (50%), or low (20%).
• Cost of large restaurant is $750,000.
• Cost of small restaurant is $600,000.
• Entrepreneur will invest $400,000, outside investor provides the rest.
• Investor requires 1% of equity for each $10,000 invested.
• If demand is high - PV large is $1,500,000, PV small is $800,000.
• If demand is medium - PV large is $800,000, PV small is $800,000.
• If demand is low - PV large is $300,000, PV small is $400,000.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Accept/Reject Decision to Invest in
Restaurant Business
Figure 4-3
High Demand (.3)
Intermediate Demand (.5)
Large
restaurant
Small
restaurant
Low Demand (.2)
High Demand (.3)
Intermediate Demand (.5)
Low Demand (.2)
Do not enter
High Demand (.3)
-$400,000 + .65 x $1,500,000 = $575,000
-$400,000 + .65 x $800,000 = $120,000
-$400,000 + .65 x $300,000 = $-205,000
-$400,000 + .8 x $800,000 = $240,000
-$400,000 + .8 x $800,000 = $240,000
-$400,000 + .8 x $400,000 = -$80,000
$0
Intermediate Demand (.5)
$0
Low Demand (.2)
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
$0
Chapter 4
Evaluation of Accept/Reject Alternatives
• Large-scale entry:
–
–
–
–
NPV conditional on high demand
= $575,000
NPV conditional on intermediate demand = $120,000
NPV conditional on low demand
= ($205,000)
NPV = .3 x $575,000 + .5 x $120,000 - .2 x $205,000
•
= $191,500
• Small-scale entry:
–
–
–
–
NPV conditional on high demand
= $240,000
NPV conditional on intermediate demand = $240,000
NPV conditional on low demand
= ($ 80,000)
NPV = .3 x $240,000 + .5 x $240,000 - .2 x $80,000
•
= $176,000
• Do not enter:
– NPV = $0
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Restaurant Business Investment with
an Option to Delay Investing
Figure 4-4
High Demand (.3)
-$400,000 + .65 x $1,500,000 = $575,000
Large
restaurant
Intermediate Demand (.5)
-$400,000 + .65 x $800,000 = $120,000
Low Demand (.2)
-$400,000 + .65 x $300,000 = $-205,000
High Demand (.3)
Small
restaurant
-$400,000 + .80 x $800,000 = $240,000
Intermediate Demand (.5)
Low Demand (.2)
-$400,000 + .80 x $800,000 = $240,000
-$400,000 + .80 x $400,000 = -$80,000
High Demand (.3)
Wait
Determine market
demand
Intermediate Demand (.5)
Low Demand (.2)
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
-$400,000 + .65 x $1,300,000
= $445,000
-$400,000 + .80 x $700,000
= $160,000
$0
Chapter 4
Evaluation of Option to Delay
• Large-scale entry strategy: NPV = $191,500
• Delay until uncertainty is resolved:
– High demand
• Build large restaurant
• NPV conditional on high demand = $445,000
– Intermediate demand
• Build small restaurant
• NPV conditional on intermediate demand = $160,000
– Low demand
• Do not enter
• NPV conditional on low demand = $0
• NPV of delay strategy:
– = .3 x $445,000 + .5 x $160,000 + .2 x $0 = $213,500
• Value of Option to Delay = $213,500 - 191,500 = $22,000
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Restaurant Business Investment with an
Option to Expand Initial Investment
Figure 4-5
High Demand (.3)
Large
restaurant
Intermediate Demand (.5)
Low Demand (.2)
-$400,000 + .65 x $1,500,000 = $575,000
-$400,000 + .65 x $800,000 = $120,000
-$400,000 + .65 x $300,000 = $-205,000
Expand
High Demand (.3)
Small
restaurant
Do not expand
Intermediate Demand (.5)
Low Demand (.2)
High Demand (.3)
Do not enter
-$400,000 + .70 x $1,400,000
= $580,000
Intermediate Demand (.5)
Low Demand (.2)
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
-$400,000 + .80 x $800,000
= $240,000
-$400,000 + .80 x $800,000 = $240,000
-$400,000 + .80 x $400,000 = -$80,000
$0
$0
$0
Chapter 4
Evaluation of Option to Expand
• Large-scale entry strategy: NPV = $191,500
• Delay until uncertainty is resolved: NPV = $213,500
• Build small, with Option to Expand:
– Conditional on High demand:
• NPV if Expand = $580,000
• NPV if Remain Small = $240,000
• Conclusion: Expand if demand is high
– Conditional on Intermediate demand:
• NPV of Remaining Small = $240,000
– Conditional on Low demand:
• NPV of Remaining Small = ($80,000)
• NPV of Small-scale entry with Option to Expand
– = .3 x $580,000 + .5 x $240,000 - .2 x $80,000 = $278,000
• Value of Expansion Option = $86,500
• Incremental value over Delay Option = $64,500
– The Options are Mutually Exclusive
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Evaluation of Option to Abandon
• Large-scale entry strategy: NPV = $191,500
• Large-scale entry with Abandonment option:
– Convert to office with $600,000 value
– NPV of converting for entrepreneur = ($10,000)
– NPV with Abandonment Option:
• = .3 x $575,000 + .5 x $120,000 - .2 x $10,000 = $230,500
– Would pay up to $39,000 extra for location that is convertible
• Small-scale entry with Expansion and Abandonment Options:
– Convert to office with $300,000 value
– NPV of converting for entrepreneur = ($160,000)
– NPV with Abandonment Option:
• = .3 x $580,000 + .5 x $240,000 - .2 x $160,000 = $262,000
– Abandonment has negative value for the small restaurant
– A result of discreteness of the analysis
• Conclusion: Build small with Expansion Option
– NPV = $278,000
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Game Trees
• The Basics
– Players
– Order of play
– Information set
– Available actions
– Payoff schedules
• Strategic interaction
– Cooperative and Non-cooperative games
– Sequential-move game - Game tree
– Simultaneous-move game - Payoff matrix
• Nash equilibrium
• Sub-game perfection
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Evaluating Strategic Games
• Develop the tree
• Prune branches involving dominated strategies
• Specify assumptions about rival actions and
reactions
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Entry Decision Game Tree
Figure 4-6
Kelly’s
Payoff
Erin’s
Payoff
$380,000
($100,000)
Enter
Erin’s
Pub
Stay Out
Large
$425,000
$0
$250,000
$200,000
$400,000
$0
$300,000
$100,000
$190,000
$210,000
$0
$300,000
$370,000
$0
$350,000
$0
$0
$0
Enter
Kelly’s Small
Bar
Erin’s
Pub
Stay Out
Large
Wait
Enter
Erin’s
Pub
Kelly’s
Bar
Small
Stay Out
Large
Stay Out
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Kelly’s
Bar
Small
Stay Out
Chapter 4
Examples of Real Options
Option
Description
Examples
Defer
To wait before taking an action
until more is known or timing is
expected to be more favorable
When to harvest a stand of trees,
introduce a new product, or replace
an existing piece of equipment
Expand or
contract
To increase or decrease the
scale of a operation in response
to demand
Adding or subtracting to the daily
flights on an airline route or adding
memory to a computer
Abandon
To discontinue an operation and
liquidate the assets
Discontinuing a research project,
closing a store, or resigning from
current employment
Stage
investment
To commit investment in stages
Staging of research and
giving rise to a series of valuations development projects or financial
and abandonment options
commitments to a new venture
Switch inputs
or outputs
To alter the mix of inputs or
outputs of a production process
in response to market prices
The output mix of refined crude oil
products or substituting coal for
natural gas to produce electricity
Grow
To expand the scope of activities
to capitalize on new perceived
opportunities
Extending brand names to new
products or marketing through
existing distribution channels
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Chapter 5
Financial Forecasting
Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of
the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information
should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations
contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of
these programs or from the use of the information contained herein.
Learning Objectives
• Learn the elements of the cash flow cycle.
• Understand the four critical determinants of a firms financial
needs: minimum efficient scale, profitability, cash flow, and
sales growth.
• Learn how to prepare a sales forecast for an established
firm.
• Learn how to prepare a sales forecast for a new venture.
• Develop a financial model of a venture using pro forma
analysis to integrate income statement, balance sheet, and
cash flow items.
• Identify publicly available data sources to provide an
objective basis for underlying assumptions of the financial
model.
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Benefits of Financial Forecasting
• A disciplined means to evaluate the cash needs of a
venture
• An aid to determine whether a proposed venture deserves
the entrepreneur’s investment of capital and effort
• A means to compare the expected values of strategic
alternatives
• A way to demonstrate project merits to investors and to
use in negotiating ownership
• A way to identify appropriate benchmarks for assessing
project development
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
The Firm as a Cash Conversion
Process
Process
Cash
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Firm
Future
Cash
Chapter 6
The Cash Flow of a Business Venture
Capital
(equity and debt)
Infusions
Beginning cash
Reinvestment
(to retained earnings)
Expenditures
Employees
Materials
Fixed Assets
Production
Inventory
Cash sales
Ending Cash
Equity Returns
Debt Service
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Credit Sales
Accounts
Receivable
Collections
Taxes
Chapter 6
Key Determinants of Financial Needs
1) Minimum efficient scale and capital
intensity
2) Profitability
3) Cash flow
4) Sales growth
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Manufacturer’s Long Run Average Cost
(LRAC)
Figure 6-2
Dollars
Q
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Q*
Quantity
Chapter 6
Factors that Increase
a Firm’s Cash Needs
• Competition in markets where the minimum efficient scale
(MES) of an enterprise is large
• Low profit margins
• High rates of sales growth
• Increased reliance on depreciation of assets and less on
expensing of assets
• Expectation of low cash flow levels
• Increased trade credit offered (accounts receivable as a
fraction of assets is high)
• Decreased trade credit used (accounts payable as a fraction
of assets is low)
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Introduction to Pro Forma Analysis
Assumptions for a simple asset-driven
business model:
• Sales = 2 x Beginning Assets
• Net Income = Sales x 0.1
• Retained Earnings = Beginning Assets x 0.06
• Dividends = Net Income - Retained Earnings
• Ending Assets = Beginning Assets + Retained Earnings
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Asset-driven Pro Forma Model
Assets
S/A
Sales
Retained
Earnings
ROS
Net Income
Retention
Dividends
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Five Year Pro Forma Analysis
for a Simple Business Venture
Figure 6-3
Y ear
B e g in n in g
S a le s
A s s ets
Net
R e t a in e d
In c o m e
E a rn in g s
D ivid e n d s
E n d in g
A s s ets
1
$1,000,000
$2,000,000
$200,000
$60,000
$140,000
$1,060,000
2
$1,060,000
$2,120,000
$212,000
$63,600
$148,400
$1,123,600
3
$1,123,600
$2,247,200
$224,720
$67,416
$157,304
$1,191,016
4
$1,191,016
$2,382,032
$238,203
$71,461
$166,742
$1,262,477
5
$1,262,477
$2,524,954
$252,495
$75,749
$176,747
$1,338,226
Assumptions:
Sales = 2 x Beginning Assets
Net Income = Sales x 0.1
Retained Earnings = Beginning Assets x 0.06
Dividends = Net Income - Retained Earnings
Ending Assets = Beginning Assets + Retained Earnings
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Integrating Pro Forma
Financial Statements
• Basic Pro Forma Financial Statements (and some others)
–
–
–
–
Sales Forecast
Income Statement
Cash Flow Statement
Balance Sheet
• The statements are interdependent
– Income Statement changes affect Balance Sheet and Cash Flow (e.g.,
higher profit may lead to increased cash balances).
– Balance Sheet changes affect Income Statement and Cash Flow (e.g.,
borrowing leads to interest expense and reduces taxes).
• A financial model should integrate the statements
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Integration of Financial Statements:
The Circular Flow
Figure 6-4
Beginning
Balance
Sheet
Income
Statement
Cash
Flow
Statement
Ending
Balance
Sheet
Sales
Forecast
Assumptions
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Key Questions to be Answered
in a Sales Forecast
1) When will the venture begin to generate revenue?
2) How rapidly will revenue grow?
3) Over what span of time (3 years, 5 years, 10 years, etc.)
should the forecast be made?
4) What is an appropriate forecasting interval (weekly, monthly,
annually, etc.)?
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Forecasting the Sales
of an Existing Business
• The forecast can be based on the existing track
record of the business
• Some considerations
–
–
–
–
Forecasting in levels or changes
Forecasting in real or nominal terms
Weighting of historical data
Forecasting based on underlying factors for which
forecasts exist
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Combining Growth Rates and Current Sales
Levels to Forecast the Sales
of an Existing Business
Year
-6
-5
-4
-3
-2
-1
$2.0
$2.4
$2.7
$2.6
$2.6
$2.9
Sales Growth
+20%
+12.5%
-3.7%
0%
+11.5%
Inflation
+3%
+6%
+7%
+4%
+2%
Change in Real GDP
+3%
+1.5%
-1%
-1%
+2%
Sales (millions)
Average Sales Growth = 8.06%
Range = -3.7% to 20%
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Forecasting in Real Terms
Year
-6
-5
-4
-3
-2
-1
Sales Growth
+20%
+12.5%
-3.7%
0%
+11.5%
Inflation
+3%
+6%
+7%
+4%
+2%
Real Sales Growth
+17%
+6.5%
-10.7%
-4%
+9.5%
Average Real Sales Growth = 3.66%
Range = -10.7% to 17%
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Using Weighting to Improve a Forecast
Year
-6
-5
-4
-3
-2
-1
Real Sales Growth
+17%
+6.5%
-10.7%
-4%
+9.5%
Weight Factor
1/15
2/15
3/15
4/15
5/15
1.13%
0.87%
-2.14%
-1.07%
3.17%
Weighted Growth
Weighted Average Real Sales Growth = 1.96%
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Using Regression Analysis to Forecast
Regression Model:
Expected Real Sales Growth = 3.34% + 5.24 x Change in Real GDP
Year
-5
-4
-3
-2
-1
Change in Real GDP
+3%
+1.5%
-1%
-1%
+2%
Expected Sales Growth
+15%
+7.5%
-5%
-5%
+10%
Real Sales Growth
+17%
+6.5%
-10.7%
-4%
+9.5%
Difference
+2%
-1%
-5.7%
+1%
-0.5%
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
Forecasting for a New Venture
• No track record on which to rely
• Yardstick approach
– Comparable firms in relevant dimensions
– IPO prospectuses
– Other data sources
• Fundamental analysis
–
–
–
–
–
Market and market share
Engineering cost estimates
Demand-side approach - How much customers would buy
Supply-side approach - How fast the venture can grow
Credibility and support for assumptions
• Mixed approach
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
General Rules of Financial Forecasting
Part 1
• Build and support a schedule of assumptions.
• Begin with a forecast of sales.
• If sales growth is expected to track inflation, consider
forecasting sales in real terms.
• When using historical data to forecast, consider a weighting
scheme that focuses on the firm’s most recent experiences.
• For new ventures, choose several “yardstick” firms to use in
developing underlying assumptions regarding expected
performance.
• Integrate the pro forma balance sheet and income
statement variables through a financial model.
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
General Rules of Financial Forecasting
Part 2
• Consider time span. To assess financial need, project at least
until the firm expects follow-on financing. To determine
venture value, extrapolate to the point of harvest.
• Determine the planning horizon of the venture to establish
forecasting intervals.
• Test the model’s rationality by tracing line items across
financial statements.
• Apply sample scenarios and compare outcomes to estimates.
• Try a basic sensitivity analysis to ensure that the model yields
reasonable results when magnitudes and growth rates of key
variables change.
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
New Company Assumptions
Figure 6-5: Part I
1) Development will require 18 months, during which no sales will be made.
2) Initial sales of $10,000 in the 19th month.
3) Sales will grow 8% per month in real terms for three years and at the inflation rate
thereafter.
4) Cash operating expenses during the development period of $15,000 per month, plus
inflation.
5) Inflation at 9 percent per year.
6) A $200,000 production facility will come on line at the end of month 18. The facility is
to be leased by the company for the first 5 years of operation, with monthly payments
of $3,000.
7) Gross profit of 60% of sales revenue on materials costs with trade discounts.
8) Selling expenses of 15% of sales.
9) Administrative expenses of $2,000 per month beginning in month 19, growing at the
inflation rate, plus 15 percent of sales (Included in development period operating
expense total).
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
New Company Assumptions
Figure 6-5 Part II
10) Entrepreneur’s salary of $3,000 per month through the first full year of sales
(included in initial operating expenses), increasing thereafter by $500 per month.
11) Corporate tax rate of 45%. No loss carry forward.
12) All sales are for credit. The average collection period is 45 days. No discount for
prompt payment.
13) The inventory turnover rate is 5 times per year, measured against ending
inventory.
14) The company desires to maintain the greater of 30 days’ sales in cash or
$10,000.
15) All materials are purchased on credit, with terms of 2/10 net 30. The company
anticipates paying in time to receive the discount. The payables period is 10
days.
16) The entrepreneur will borrow any funds necessary at a rate of 1% per month.
17) Initial investment by the entrepreneur of $200,000. Additional financing as
needed by borrowing on a line of credit.
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 6
New Company Sales Forecast
Figure 6-6
(Forecast generated monthly, selected months shown)
M o n th
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
S a le s
1
$0
12
$0
18
$0
19
$ 1 0 ,0 0 0
24
$ 1 5 ,2 5 3
30
$ 2 5 ,3 1 4
36
$ 4 2 ,0 1 2
42
$ 6 9 ,7 2 4
48
$ 1 1 5 ,7 1 7
54
$ 1 9 2 ,0 4 7
60
$ 2 0 0 ,8 5 3
66
$ 2 1 0 ,0 6 3
72
$ 2 1 9 ,6 9 5
78
$ 2 2 9 ,7 6 8
Chapter 6
Chapter 6
The Framework of
New Venture Valuation
Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of
the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information
should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations
contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of
these programs or from the use of the information contained herein.
Learning Objectives
• Know the difference between a “hurdle rate” and a realized
rate of return.
• Know why hurdle rates for new ventures usually are higher
than realized rates of return.
• Know the difference between a hurdle rate and the
opportunity cost of capital.
• Know how to use the Capital Asset Pricing Model to
estimate cost of capital.
• Know how to use the risk-adjusted discount rate and
certainty equivalent forms of the CAPM.
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
Learning Objectives (continued)
• Know the limitations of the CAPM for new venture
valuation
• Know the differences between the CAPM and the Option
Pricing Model and be able to reconcile their use.
• Know how diversifiable risk affects expected returns.
• Know why the valuation of the entrepreneur is likely to be
different from that of the investor, and how to use the
information in deal negotiation.
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
The Many Uses of Valuation
• Strategic Planning
• Estate Planning
• Partnership formation and dissolution
• Initial public offering (IPO)
• Stock options and Employee stock ownership plans
(ESOPs)
• Mezzanine financing
• Negotiating a merger or sale of a venture
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
Valuation Myths
• Beauty is in the eye of the beholder.
• The future is anybody’s guess.
• Investors in new ventures demand very high expected
rates of return to compensate for the risks.
• The outside investor determines what the venture is worth.
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
Hurdle Rates For Venture Capital
Rates of Return (ROR) Sought by Venture Capital Investors
Stage
Annual ROR%
Typical Expected Holding
Period (Years)
Seed and start-up
First stage
Second stage
Expansion
Bridge and mezzanine
LBOs
Turnarounds
50 - 100% or more
40 - 60%
30 - 40%
20 - 30%
20 - 30%
30 - 50%
50% +
More than 10
5 – 10
4–7
3–5
1-3
3-5
3-5
Jeffrey A. Timmons, New Venture Creation, 4th ed., (Irwin: Chicago) 1994, p. 512.
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
Venture Capital Realized Rates of
Return (based on various studies)
• 14% - 92 firms in ‘60s and ‘70s.
• 23% - before fees, 100 firms in the ‘60s
• 16% - public fund stock returns from 1959 to 1985.
• 27% - 11 firms from 1974 to 1979.
• 13.5% - from 1974 to 1989.
• 20.7% - from 1987 to 1996.
How are the hurdle rates reconciled with
realized rates?
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
Valuation Methods
• Value = Present value of future cash flows
• Two conceptually equivalent approaches
– RADR - Risk-Adjusted Discount Rate
PV  
t
Ct
(1  rt ) t
– CEQ - Certainty Equivalent Cash Flow
Ct  RDt
PV  
t
(
1

r
)
t
F ,t
The choice of method depends on information availability.
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
Issues for RADR Valuation
• What cash flows should be valued?
• What discount rate should be used?
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
Factors Affecting the Discount Rate
for RADR Valuation
• Compensation for deferring consumption (time value)
• Compensation for bearing risk (risk premium)
• A measure of risk - the standard deviation of holding
period returns.
• The discount rate is not a matter of personal risk
tolerance.
– It is market determined
– It is based on opportunity cost
• The discount rate depends on the ability of an investor to
diversify.
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
Estimating the Discount Rate
• Opportunity cost of capital
• What discount rate should be used?
rj ,t  rF ,t  RPj ,t
• CAPM
RPj ,t   j , M (rM ,t  rF ,t )
 j ,M  j
j 
M
All measures are based on holding period returns.
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
The Feasible Set and the Efficient Set
of Risky Portfolios
Figure 8-2
Preferred portfolio of highly risk-averse investor
Return
Preferred portfolio of risk-tolerant investor
Efficient Set
Feasible Set
Risk
(Standard Deviation)
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
The Efficient Set, the Market Portfolio,
and the Capital Market Line
Figure 8-3
New preferred portfolio of highly risk-averse investor
Return
New preferred portfolio of risk-tolerant investor
Capital Market Line
rM
Efficient Set
Market Portfolio
rF
M
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Risk
Chapter 8
How Portfolio Risk Depends on the
Number of Assets in the Portfolio
Figure 8-4
Risk
Portfolio
Diversifiable
Risk
M
Non-diversifiable
Risk
Number of Assets in Portfolio
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
The Capital Asset Pricing Model
Figure 8-5
Return
Security Market Line
rM
Market Portfolio
rF
1.0
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Beta
Chapter 8
Measures of Cash Flow
Expected Actual Cash Flow
Operating Cash Flow
Operating Cash Flow = EBIT + Depreciation Expense - Capital Expenditures Increase in NWC
Cash Flow to All Investors (both stockholders and creditors)
Total Capital Cash Flow + EBIAT = Operating Cash Flow - Actual Taxes
Cash Flow to Creditors (expected in light of default risk, potential
prepayment, potential additional borrowing)
Debt Cash Flow = Expected Interest Payments + Expected Net Debt Service
Cash Flow to Stockholders (expected in light of expected cash flows to
creditors)
Equity Cash Flow = Operating Cash Flow - Expected Interest Payments Expected Net Debt Service - Expected Actual Taxes
Other Measures of Cash Flow
Contractual Cash Flow to Creditors (assuming no default or prepayment)
Contractual Cash Flows to Creditors = Contractual Interest Payments + Contractual
Net Debt Service
Unlevered Free Cash Flow (expected if no debt financing)
Unlevered Free Cash Flow - Operating Cash Flow - Theoretical Taxes as Unlevered
Matching Cash Flows to Discount
Rates for Various Financial Claims
Figure 8-6
Financial Claim
Cash Flows to All
Investors
Cash Flow
Total Capital
Cash Flow with
Actual Financing
Discount Rate
rA = rF + A(rM – rF)
Unlevered Free
Cash Flow to All
Investors
Total Capital
Cash Flow with
All Equity
Financing
WACC = (D/V)*(1-t*)rD + (E/V)*rE
Cash Flow to
Creditors
Debt Cash Flow
rD = rF + D(rM – rF)
Cash Flow to
Stockholders
Equity Cash Flow rE = rF + E(rM – rF)
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Comment
The required rate of return on assets is used to value
cash flows that are actually expected to be received
by all claimants given the target capital structure of
the venture. The effect of tax deductibility of
interest payments is reflected in the cash flows.
The Weighted Average Cost of Capital (WACC) is
used to value hypothetical cash flows as if the
venture were financed entirely with equity. In this
case, the tax benefit of debt financing is reflected as
an adjustment to the cost of debt capital. The
correct tax adjustment is not the corporate tax rate,
but one that measure the net advantage of debt
financing, giving consideration to the offsetting
effects of personal taxes.
The cost of capital for debt depends on the extent to
which debt service payments are subject to market
risk.
The cost of capital for equity depends not on the
total risk of the equity, but on the market component
of the risk.
Chapter 8
Issues for CEQ Valuation
• What cash flows should be valued?
• How are risky cash flows adjusted to their certainty
equivalents?
• What is the discount rate for valuing certain future cash
flows?
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 8
The CEQ Form of the CAPM
• CAPM
RPj   j , M (rM  rF )
Cj
PV j
 1  rF 
Cj 
PV j 
 (C j , rM )( C / PV j )
j
M
(rM  rF )
M
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
 (C j , rM ) C
(rM  rF )
j
1  rF
Chapter 8
Chapter 7
Financial Contracting
Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of
the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information
should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations
contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of
these programs or from the use of the information contained herein.
Learning Objectives
• Understand how and why staging and other real options
affect the values of new venture financial claims.
• Value the financial claims of a new venture using either
discrete scenario analysis or simulation.
• Use financing modeling and valuation techniques to study
game theoretic issues that arise for the parties to a new
venture.
• Construct financial contracts to signal information and align
incentives.
• Evaluate the effects of alternate financial contracts on the
values of the financial interests of the entrepreneur and
outside investor.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
Valuation Template 6
Single-Stage Investment - Venture Capital Method
Income Statement Information
Year
0
Earnings Before Interest and After Tax
1
2
($500,000)
($200,000)
$700,000
$700,000
3
4
$400,000 $1,400,000
5
$2,500,000
Cash Flow Information
External Funds Required to Support Operations $700,000
$700,000
$700,000
$0
Equity Capital Raised
$3,240,927
Beginning Cash Balance
Uses of Cash
Cash Invested in Marketable Securities
Return on Invested Cash
Ending Cash Balance
$3,240,927 $2,642,564 $2,020,267 $1,373,077
$700,000
$700,000
$700,000
$700,000
$2,540,927 $1,942,564 $1,320,267
$673,077
$101,637
$77,703
$52,811
$26,923
$2,642,564 $2,020,267 $1,373,077
$700,000
$700,000
$700,000
$0
$0
$0
$0
$0
$0
$0
$0
30.00%
25.00%
Investor Valuation and Ownership Allocation
Investor Hurdle Rate
Continuing Value Earnings Multiplier
Continuing Value of Venture
Required Future Value of Investment
Ownership Share Required
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
50.00%
45.00%
40.00%
35.00%
15
$37,500,000
$24,610,789
65.63%
Chapter 13
Valuation Template 7
Multi-Stage Investment - Venture Capital Method
Income Statement Information
Year
0
Earnings Before Interest and After Tax
1
2
($500,000)
($200,000)
$700,000
$700,000
3
4
$400,000 $1,400,000
5
$2,500,000
Cash Flow Information
External Funds Required to Support Operations $700,000
Equity Capital Raised
$1,373,077
$1,373,077
Beginning Cash Balance
Uses of Cash
Cash Invested in Marketable Securities
Return on Invested Cash
Ending Cash Balance
$1,373,077
$700,000
$673,077
$26,923
$700,000
$700,000 $1,373,077
$700,000
$700,000
$0
$673,077
$0
$26,923
$0
$700,000
$700,000
$700,000
$0
$700,000
$700,000
$700,000
$0
$0
$0
$700,000
$700,000
$0
$0
$0
$0
$0
$0
$0
$0
35.00%
30.00%
25.00%
Investor Valuation and Ownership Allocation
Investor Hurdle Rate
Continuing Value Earnings Multiplier
Continuing Value of Venture
Investor's Required Future Value and
Equity Share
Third Stage
Second Stage
First Stage
Ownership Required
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
50.00%
45.00%
40.00%
15
$37,500,000
Required Required
Beginning
Ending
Share
Share
Value
2.43%
2.43%
$910,000
10.30%
10.05% $3,767,723
31.77%
27.80% $10,426,803
40.28% $15,104,527
Chapter 13
Determining the Required Shares of
Staged Investment
Equation (1) shows how the required fraction of equity can be
determined when future rounds of financing are anticipated.
Fraction of Equity Required = Ending Fraction of Equity Required x
(1 - Sum of Fractions Required by Investors in Future Rounds)
(1)
Using this equation, the required share of the investor in the second
round is 10.30 percent.
10.30 % = 10.05 % / (100 % - 2.43 %)
Similarly, the the required share for the investor in the first round is
31.77 percent.
31.77 % = 27.80 % / (100 % - 2.43 % - 10.05 %)
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
Staging and Market Capitalization
Investors are disappointed if capitalization does not increase
from one round of financing to the next. Figure 13-2 shows why.
Investment
Round
Investment
Share of Equity
Received
Capitalization
First Stage
$1,373,077
31.77%
$4,321,992
Second State
$1,373,077
10.30%
$13,330,844
Third Stage
$700,000
2.43%
$28,806,584
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
Evaluating the Entrepreneur’s
Investment Based on Expected Returns
• Step 1: Estimate the expected cash return and total risk (standard
deviation of cash flows) of the entrepreneur’s financial interest in the
venture.
• Step 2: Estimate the expect cash return and risk of the
entrepreneur’s investment in the market portfolio.
• Step 3: Use the above results and the correlation between the
venture and the market to estimate the expected cash return and
total risk of the entrepreneur’s total portfolio.
• Step 4: Value the portfolio by the CEQ method (based on its total
risk).
• Step 5: Infer the value of the entrepreneur’s investment in the venture
by subtracting the market value of the entrepreneur’s investment in
the market index portfolio.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
Single-Stage Investment with Discrete Scenarios
Valuing Financial Claims with Proportional Allocation
Market Information
Risk-free Rate of Interest
Market Rate or Return
Market Risk Premium
Market Standard Deviation
Correlation Between Venture and Market
Venture Cash Flows
Time
Success Scenario
Failure Scenario
Expected Cash Flow
Standard Deviation
Beta of Venture
$
$
$
$
Investor Interest and Value
Share of Investment
Share of Equity
Cash Flows
Success Scenario
Failure Scenario
Expected Cash Flow
Standard Deviation
Value of Interest
NPV of Interest in Venture
21.67%
76.23%
54.57%
44.72%
0.445
0
(2,500)
(2,500)
(2,500)
-
1
2
3
4
$
$
$
$
5
11,000
3,000
7,000
4,000
1.00
$
$
$
$
5,280
1,440
3,360
1,920
$
$
1,905
705
48.00%
48.00%
$
$
$
$
(1,200)
(1,200)
(1,200)
-
Valuing Financial Claims with Proportional Allocation
(continued)
Entrepreneur Interest and Value
Share of Investment
Share of Equity
Entrepreneur's Wealth
Fraction of Wealth Invested in Venture
52.00%
52.00%
$2,000
65%
Cash Flows of Investment in Venture
$
Success Scenario
$
Failure Scenario
$
Expected Cash Flow
$
Standard Deviation
(1,300)
(1,300)
(1,300)
-
$
$
$
$
5,720
1,560
3,640
2,080
Cash Flows of Investment in Market
$
Expected Cash Flow
Standard Deviation
(700)
$0
$
$
1,234
313
(2,000)
$0
$
$
4,874
2,237
$
$
$
$
1,762
700
1,062
(238)
Portfolio Cash Flows
Expected Cash Flow
Standard Deviation
$
Value of Entrepreneur's Investments
Value of Portfolio
Value of Investment in Market
Value of Interest in Venture
NPV of Interest in Venture
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
Valuing Financial Claims with Equity Shifted to the Entrepreneur
Market Information
Risk-free Rate of Interest
Market Rate or Return
Market Risk Premium
Market Standard Deviation
Correlation Between Venture and Market
Venture Cash Flows
Time
Success Scenario
Failure Scenario
Expected Cash Flow
Standard Deviation
Beta of Venture
21.67%
76.23%
54.57%
44.72%
0.445
$
$
$
$
Investor Interest and Value
Share of Investment
Share of Equity
Cash Flows
Success Scenario
Failure Scenario
Expected Cash Flow
Standard Deviation
Value of Interest
NPV of Interest in Venture
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
0
(2,500)
(2,500)
(2,500)
-
1
2
3
4
$
$
$
$
5
11,000
3,000
7,000
4,000
1.00
$
$
$
$
3,603
983
2,293
1,310
$
$
1,300
100
48.00%
32.75%
$
$
$
$
(1,200)
(1,200)
(1,200)
-
Chapter 13
Valuing Financial Claims with
Equity Shifted to the Entrepreneur (continued)
Entrepreneur Interest and Value
Share of Investment
Share of Equity
Entrepreneur's Wealth
Fraction of Wealth Invested in Venture
Cash Flows of Investment in Venture
Success Scenario
Failure Scenario
Expected Cash Flow
Standard Deviation
52.00%
67.25%
$2,000
65%
$
$
$
$
(1,300)
(1,300)
(1,300)
-
$
$
$
$
7,398
2,018
4,708
2,690
Cash Flows of Investment in Market
Expected Cash Flow
Standard Deviation
$
(700)
$0
$
$
1,234
313
Portfolio Cash Flows
Expected Cash Flow
Standard Deviation
$
(2,000)
$0
$
$
5,941
2,843
$
$
$
$
2,032
700
1,332
32
Value of Entrepreneur's Investments
Value of Portfolio
Value of Investment in Market
Value of Interest in Venture
NPV of Interest in Venture
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
Single-Stage Investment with Discrete Scenarios:
Valuing Financial Claims with the Entrepreneur's Investment Reduced
Market Information
Risk-free Rate of Interest
Market Rate or Return
Market Risk Premium
Market Standard Deviation
Correlation Between Venture and Market
Venture Cash Flows
Time
Success Scenario
Failure Scenario
Expected Cash Flow
Standard Deviation
Beta of Venture
21.67%
76.23%
54.57%
44.72%
0.445
$
$
$
$
Investor Interest and Value
Share of Investment
Share of Equity
Cash Flows
Success Scenario
Failure Scenario
Expected Cash Flow
Standard Deviation
0
(2,500)
(2,500)
(2,500)
-
1
2
3
4
$
$
$
$
5
11,000
3,000
7,000
4,000
1.00
$
$
$
$
5,280
1,440
3,360
1,920
$
$
1,905
100
72.20%
48.00%
$
$
$
$
Value of Interest
NPV of Interest in Venture
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
(1,805)
(1,805)
(1,805)
-
Chapter 13
Valuing Financial Claims with the
Entrepreneur’s Investment Reduced (continued)
Entrepreneur Interest and Value
Share of Investment
Share of Equity
Entrepreneur's Wealth
Fraction of Wealth Invested in Venture
Cash Flows of Investment in Venture
Success Scenario
Failure Scenario
Expected Cash Flow
Standard Deviation
27.80%
52.00%
$2,000
34.75%
$
$
$
$
(695)
(695)
(695)
-
$
$
$
$
5,720
1,560
3,640
2,080
Cash Flows of Investment in Market
Expected Cash Flow
Standard Deviation
$
(1,305)
$0
$
$
2,300
584
Portfolio Cash Flows
Expected Cash Flow
Standard Deviation
$
(2,000)
$0
$
$
5,940
2,397
$
$
$
$
2,478
1,305
1,173
478
Value of Entrepreneur's Investments
Value of Portfolio
Value of Investment in Market
Value of Interest in Venture
NPV of Interest in Venture
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
How Changing the Contract
Affects Value
Investor initially contributes $1.2 million. Entrepreneur contributes $1.3 million,
including $500 thousand of human capital.
Allocation of
Returns
Proportional
Sharing
Increased Share
to Entrepreneur
Reduce
Investment of
Entrepreneur to
27.80% from
52%
Investor
Share of
Equity
48.00%
Investor
NPV
Entrepreneur
Share of
Equity
$705,000
52.00%
32.75%
$100,000
48.00%
$100,000
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Entrepreneur
NPV
Total
NPV
-$238,000
$467,000
67.25%
$32,000
$132,000
52.00%
$478,000
$578,000
Chapter 13
Outside Investment Staged, but not Optional:
Valuing Financial Claims with Equity Shifted to the Entrepreneur
Market Information
Risk-free Rate of Interest
Market Rate or Return
Market Risk Premium
Market Standard Deviation
Correlation Between Venture and Market
Venture Cash Flows
Time
Success Scenario
Failure Scenario
Expected Cash Flow
Standard Deviation
Beta of Venture
$
$
$
$
Investor Interest and Value
Share of Investment
Share of Equity
Cash Flows
Success Scenario
Failure Scenario
Expected Cash Flow
Standard Deviation
8.16%
25.44%
17.28%
28.28%
0.3174
0
(1,500)
(1,500)
(1,500)
-
1
$
$
$
$
2
(1,082)
(1,082)
(1,082)
-
21.67%
76.23%
54.57%
44.72%
0.445
3
4
$
$
$
$
5
11,000
3,000
7,000
4,000
1.00
53.67%
48.00%
100.00%
(805)
(805)
(805)
-
$ (1,082)
$ (1,082)
$ (1,082)
$
-
$
$
$
$
5,280
1,440
3,360
1,920
-1000
$
$
1,905
100
$
$
$
$
Value of Interest
NPV of Interest in Venture
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
Valuing Financial Claims with Equity Shifted to the
Entrepreneur (continued)
Entrepreneur Interest and Value
Share of Investment
Share of Equity
Entrepreneur's Wealth
Fraction of Wealth Invested in Venture
46.33%
52.00%
$2,000
34.75%
0.00%
Cash Flows of Investment in Venture
Success Scenario
$
Failure Scenario
$
Expected Cash Flow
$
Standard Deviation
$
(695)
(695)
(695)
-
$
$
$
$
5,720
1,560
3,640
2,080
Cash Flows of Investment in Market
Expected Cash Flow
$
Standard Deviation
(1,305)
$0
$
$
2,300
584
Portfolio Cash Flows
Expected Cash Flow
Standard Deviation
(2,000)
$0
$
$
5,940
2,397
$
$
$
$
2,478
1,305
1,173
478
$
Value of Entrepreneur's Investments
Value of Portfolio
Value of Investment in Market
Value of Interest in Venture
NPV of Interest in Venture
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
How Staging with Mandatory
Investment Affects Value
Investor contributes $1.2 million. Entrepreneur contributes $1.3 million, including $500
thousand of human capital.
Allocation of
Returns
Single-Stage
Investment of
Investor at
72.2%
Multi-Stage
Investment of
Investor at
72.2%, not
optional
Investor
Share of
Equity
48.00%
Investor
NPV
Entrepreneur
NPV
$100,000
Entrepreneur
Share of
Equity
52.00%
48.00%
$478,000
$578,000
$100,000
52.00%
$478,000
$578,000
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Total
NPV
Chapter 13
Game Tree for Staged Investment
Terminal nodes show NPV (entrepreneur, investor)
Good state:
Success is
likely
NPV
Investor
accepts offer (1000,100)
Entrepreneur
offers
multi-stage
investment
Nature
chooses
Investor
rejects offer
NPV
Do not
invest
NPV
(1800,500)
(400,-200)
NPV
(0,0)
Bad state:
Success is
unlikely
NPV
Investor
accepts offer (90,10)
Entrepreneur
offers
single-stage
investment
Investor
rejects offer
Invest in
second
stage
Invest in NPV
second (-200,-1800)
stage
Do not
invest
NPV
(200,-300)
NPV
(0,0)
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
Valuation Template 8
Investor Valuation of Discrete Scenarios with Second-Stage Investment Optional:
Value Is Conditional on Good State Occurring, Investor Is Assumed to Exercise Option
Market Information
Risk-free Rate of Interest
Market Rate or Return
Market Risk Premium
Market Standard Deviation
Correlation Between Venture and Market
Venture Cash Flows
Time
Success with Success Forecasted
Failure with Success Forecasted
Conditional Expected Cash Flow
Conditional Standard Deviation
12.49%
40.49%
28.01%
34.64%
0.445
Probability at
0
2
0.5
0.9
0.5
0.1
1
0.9
1
0.1
0
1
$
$
$
$
Assumptions: Good State - Second-Stage Investment Made
Share of Equity Received for Second-Stage Investment
Terminal Share of Equity from First-Stage Investment
Initial Share of Equity from First-Stage Investment
Total Share of Equity if both Stage Investments Made
Total Cash Flows
Success with Success Forecasted
Failure with Success Forecasted
Conditional Expected Cash Flow
Conditional Standard Deviation
3
4
$
$
$
$
5
11,000
3,000
10,200
2,400
18.00%
25.36%
30.93%
43.36%
1.0
1.0
Conditional Net Value of Total Interest at Time of Second-Stage Investment
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
2
(1,082)
(1,082)
(1,082)
-
0.9
0.1
$
2,518
$
$
$
$
(1,082)
(1,082)
(1,082)
-
$
$
$
$
4,770
1,301
4,423
1,041
$
(1,082)
$
3,599
Chapter 13
Investor Valuation of Two-Stage Investment with Discrete Scenarios:
Comparison of Alternative States of the World and Second-Stage Investment Decisions
Assumptions: Good State - Second-Stage Investment Made
Share of Equity Received for Second-Stage Investment
Terminal Share of Equity from First-Stage Investment
Initial Share of Equity from First-Stage Investment
Total Share of Equity if both Stage Investments Made
Total Cash Flows
Success with Success Forecasted
Failure with Success Forecasted
Conditional Expected Cash Flow
Conditional Standard Deviation
18.00%
25.36%
30.93%
43.36%
1.0
1.0
0.9
0.1
Conditional Net Value of Total Interest at Time of Second-Stage Investment
$
2,518
$
$
$
$
(1,082)
(1,082)
(1,082)
-
$
$
$
$
4,770
1,301
4,423
1,041
$
(1,082)
$
3,599
Assumptions: Good State - Second-Stage Investment Not Made
Share of Equity Received for Second-Stage Investment
Terminal Share of Equity from First-Stage Investment
Initial Share of Equity from First-Stage Investment
Total Share of Equity if both Stage Investments Made
Total Cash Flows
Success with Success Forecasted
Failure with Success Forecasted
Conditional Expected Cash Flow
Conditional Standard Deviation
0.00%
30.93%
30.93%
30.93%
1
1
Conditional Net Value of Total Interest at Time of Second-Stage Investment
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
0.9
0.1
$
1,478
$
$
$
$
-
$
$
$
$
1,856
928
1,763
278
$
-
$
1,478
Chapter 13
Investor Valuation of Two-Stage Investment with
Discrete Scenarios (continued)
Assumptions: Bad State - Second-Stage Investment Made
Share of Equity Received for Second-Second Investment
Terminal Share of Equity from First-Second Investment
Initial Share of Equity from First-Stage Investment
Total Share of Equity if both Stage Investments Made
Total Cash Flows
Success with Failure Forecasted
Failure with Failure Forecasted
Conditional Expected Cash Flow
Conditional Standard Deviation
18.00%
25.36%
30.93%
43.36%
1
1
0.1
0.9
Conditional Net Value of Total Interest at Time of Second-Second Investment
$50
Assumptions: Bad State - Second-Stage Investment Not Made
Share of Equity Received for Second-Stage Investment
Terminal Share of Equity from First-Stage Investment
Initial Share of Equity from First-Stage Investment
Total Share of Equity if both Stage Investments Made
Total Cash Flows
Success with Failure Forecasted
Failure with Failure Forecasted
Conditional Expected Cash Flow
Conditional Standard Deviation
$
$
$
$
4,770
1,301
1,648
1,041
-$1,082
$
1,132
0.00%
30.93%
30.93%
30.93%
1
1
Conditional Net Value of Total Interest at Time of Second-Stage Investment
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
-$1,082
-$1,082
-$1,082
$0
0.1
0.9
$818
$
$
$
$
-
$
$
$
$
1,856
928
1,021
278
$
-
$
818
Chapter 13
Investor Second-Stage Investment
Decisions
Expected
Outcome
Success
Success
Failure
Failure
Investor’s StageTwo Decision
Invest
Do Not Invest
Invest
Do Not Invest
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Total Equity
Share
43.36%
30.93%
43.36%
30.93%
Present
Conditional
Value
NPV at Time 2
$3,599
$2,518
$1,478
$1,478
$1,132
$50
$818
$818
Chapter 13
Valuation Template 9
Entrepreneur Valuation of Discrete Scenarios with Second-Stage Investment Optional:
Investor's Second-Stage Investment Decision is Assumed to be Rational
Market Information
Risk-free Rate of Interest
Market Rate or Return
Market Risk Premium
Market Standard Deviation
Correlation Between Venture and Market
Venture Cash Flows
Time
Success with Success Forecasted
Failure with Success Forecasted
Success with Failure Forecasted
Failure with Failure Forecasted
Expected Cash Flow
Standard Deviation
8.16%
25.44%
17.28%
28.28%
0
Probability at
0
2
0.5
0.9
0.5
0.1
0.5
0.1
0.5
0.9
$
$
$
$
$
$
Investor Interest and Value
Share of Investment
Share of Equity Received for Second-Stage Investment
Terminal Share of Equity from First-Stage Investment
Initial Share of Equity from First-Stage Investment
Total Share of Equity if both Stage Investments Made
Cash Flows
Success with Success Forecasted
Failure with Success Forecasted
Success with Failure Forecasted
Failure with Failure Forecasted
Expected Cash Flow
Standard Deviation
Present Value of First-Stage Interest
NPV of Option to Invest in Second Stage
NPV of Interest in Venture
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
0
(1,500)
(1,500)
(1,500)
(1,500)
(1,500)
-
1
$
$
$
$
$
$
53.67%
0.9
0.1
0.1
0.9
3
4
$
$
$
$
$
$
5
11,000
3,000
6,000
3,000
6,750
3,897
100.00%
18.00%
25.36%
30.93%
43.36%
30.93%
0.5
0.5
0.5
0.5
2
(1,082)
(1,082)
(541)
541
21.67%
76.23%
54.57%
44.72%
0.445
$
$
$
$
$
$
(805)
(805)
(805)
(805)
(805)
-
$
$
$
$
$
$
(1,082)
(1,082)
(541)
541
$
$
$
$
$
$
4,770
1,301
1,856
928
2,722
1,864
$
905
$
(500)
$
1,405
$
100
Chapter 13
Entrepreneur Valuation of Discrete
Scenarios with Second-Stage Investment
Optional (continued)
Entrepreneur Interest and Value
Share of Investment
Terminal Share of Equity with Second-Stage Investment
Share of Equity with no Second-Stage Investment
Success with Success Forecasted
Failure with Success Forecasted
Success with Failure Forecasted
Failure with Failure Forecasted
Expected Cash Flow
Standard Deviation
46.33%
0.00%
56.64%
$
$
$
$
$
$
69.07%
(695)
(695)
(695)
(695)
(695)
-
$
$
$
$
$
$
6,230
1,699
2,780
1,390
4,028
2,043
Cash Flows of Investment in Market
Expected Cash Flow
Standard Deviation
$
$
(1,305)
-
$
$
2,300
584
Portfolio Cash Flows
Expected Cash Flow
Standard Deviation
$
$
(2,000)
-
$
$
6,328
2,362
NPV of Interest in Venture
$
833
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
0.5
0.5
0.5
0.5
1
1
0.9
0.1
0.1
0.9
0.9
0.1
Chapter 13
Staged Investment with
Abandonment Option
Investor contributes $1.2 million. Entrepreneur contributes $1.3 million, including $500
thousand of human capital.
Allocation of
Returns
Single-Stage
Investment of
Investor at
72.2%
Multi-Stage
Investment of
Investor at
72.2%, not
optional
Multi-Stage
Investment of
$1.5 million
and $1.0
million, with
entrepreneur
investing $695
thousand in
first stage
Investor
Share of
Equity
48.00%
Investor
NPV
48.00%
30.93% if
no second
stage
investment,
43.36% if
both stages
Entrepreneur
NPV
$100,000
Entrepreneur
Share of
Equity
52.00%
$478,000
$578,000
$100,000
52.00%
$478,000
$578,000
$833,000
$933,000
$100,000
69.07% if no
second stage
investment,
56.64% if both
stages
Total
NPV
Figures 13-11, 13-12
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
New Venture Simulation with Conditional Second-Stage Investment
Example Iteration of the Model (Dollar figures in thousands, except unit price)
Year
0
Market Potential
Price (dollars)
Potential Revenue
Total Investment
Investment
Cum. Investment
$2,500
$2,500
Total Income
Sales Revenue
Cost of Sales
Gross Profit
Operating Expenses
Interest Expense
Interest Income
Net Profit
Total Cash Flow
Beginning Cash
Operating Cash Flow
NWC Required
Free Cash
Borrowing
Repay Loan
Ending Free Cash
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
1
2
3
4
5
92.41
$100
$9,241
113.95
$100
$11,395
155.20
$100
$15,520
219.55
$100
$21,955
263.35
$100
$26,335
$2,500
$0
$2,500
$2,500
$2,500
$2,500
$15,520
$12,416
$3,104
$2,242
$382
$0
$862
$21,955
$17,564
$4,391
$2,756
$633
$0
$1,635
$26,335
$21,068
$5,267
$3,107
$778
$0
$2,160
$0
$862
$2,062
($1,200)
$1,200
$0
$0
$0
$1,635
$3,218
($1,583)
$1,583
$0
$0
$9,241
$7,393
$1,848
$1,739
$73
$0
$109
$0
$109
$924
($815)
$815
$0
$0
$11,395
$9,116
$2,279
$1,912
$211
$0
$367
$0
$367
$1,077
($709)
$709
$0
$0
$0
$2,160
$2,190
($30)
$30
$0
$0
Chapter 13
Simulation: Conditional Stage-2 Investment
(cont.) (Note: figures do not relate to prior slide
Total Cash Flow
Beginning Cash
Operating Cash Flow
NWC Required
Free Cash
Borrowing
Repay Loan
Ending Free Cash
$0
$178
$982
($804)
$804
$0
$0
Loan Balance
$0
Total Ending Value
Continuing Value
Plus: Free Cash
Less: Loan Balance
Value
$1,299
$0
$817
$1,774
($958)
$958
$0
$0
$0
$1,660
$3,514
($1,854)
$1,854
$0
$0
$0
$2,092
$1,799
$293
$0
$293
$0
$2,256
$4,110
$3,817
$16,734
$0
$3,817
$12,916
Total Investment
Investor's First-Stage Investment
Investor's Second-Stage Investment
Entrepreneur's First-Stage Investment
Total Equity Share and Return
Investor's Share in First Stage
Investor's Share in Second Stage
Investor's Total Share
Entrepreneur's Total Share
$804
$0
$391
$886
($495)
$495
$0
$0
$2,000
$0
$500
10.00%
0.00%
10.00%
90.00%
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
$1,292
$11,625
Chapter 13
Abbreviated Example: Iteration of New Venture Simulation Model
With Incremental Effects of Second-Stage Investment Identified
Year
0
Potential Revenue
Total Investment
Investment
1
2
3
4
5
$9,192
$10,912
$15,895
$22,727
$32,784
$15,895
$907
$22,727
$1,727
$30,000
$2,600
$2,500
Total Income
Sales Revenue
Net Profit
$0
$9,192
$103
$10,912
$309
Total Ending Value
Value
$15,402
Total Equity Share and Return
Investor's Total Share
Entrepreneur's Total Share
10.00%
90.00%
Investment - No Second Stage
Investment
$2,500
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
$1,540
$13,862
$0
Chapter 13
Abbreviated Example (continued) (note: figures do
not relate to prior slide)
Income - No Second Stage
Sales Revenue
Net Profit
$10,091
$211
$18,815
$1,258
$30,000
$2,600
$30,000
$2,600
Ending Value - No Second Stage
Value
Equity Share and Return - No Second Stage
Investor's Total Share
Entrepreneur's Share
$30,000
$2,600
$22,366
10.00%
90.00%
Incremental Investment - Second Stage
Investment
$2,237
$20,129
$0
Incremental Income - Second Stage
Sales Revenue
Net Profit
$5,000
$0
$0
$0
$0
$5,228
$627
$20,758
$2,491
$32,610
$3,913
Incremental Ending Value - Second Stage
Value
$18,771
Incremental Equity Share and Return - Second Stage
Investor's Incremental Share
27.00%
Entrepreneur's Incremental Share
-27.00%
$12,984
$5,787
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
Valuation Template 10
Valuing the Second-Stage Option Claims
by Discounting the Conditional Cash Flows
Market Information
Risk-free Rate of Interest
Market Rate or Return
Market Risk Premium
Market Standard Deviation
Correlation Between Venture and Market
0.00%
0.00%
0.00%
0.00%
0
12.49%
40.49%
28.01%
34.64%
0.2
Investor Interest and Value - Conditional Second-Stage Investment Only
Cash Flows
Expected Cash Flow
Standard Deviation
Present Value of First-Stage Interest
NPV of Option to Invest in Second Stage
NPV of Interest in Venture
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
$
$
-
$
$
(5,000)
-
$
$
14,312
4,187
$
7,121
$
(5,000)
$
12,121
$
7,121
Chapter 13
Valuing the Second-Stage Option Claims by
Discounting the Conditional Cash Flows (continued)
Entrepreneur Interest and Value
Entrepreneur's Wealth
$
Cash Flows of Investment in Venture
Expected Cash Flow
Standard Deviation
$
$
(300)
-
$
$
7,824
5,429
Cash Flows of Investment in Market
Expected Cash Flow
Standard Deviation
$ (1,700)
$
-
$
$
2,388
589
$ (2,000)
$
-
$
$
$
10,212
5,577
3,811
$
$
$
5,071
1,700
3,371
$
$
$
6,340
1,700
4,640
Portfolio Cash Flows
Expected Cash Flow
Standard Deviation
Maximum Achievable Leverage (MAL)
Value of Entrepreneur's Investments - CAPM-based
Present Value of Portfolio
Present Value of Investment in Market
Present Value of Interest in Venture
NPV of Interest in Venture
$
Value of Entrepreneur's Investments - MAL
Present Value of Portfolio
Present Value of Investment in Market
Present Value of Interest in Venture
NPV of Interest in Venture
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
$
2,000
3,071
4,340
Chapter 13
Valuation Template 11
Valuing Financial Claims by Discounting All Expected Cash Flows
Market Information
Risk-free Rate of Interest
Market Rate or Return
Market Risk Premium
Market Standard Deviation
Correlation Between Venture and Market
8.16%
25.44%
17.28%
28.28%
0
21.67%
76.23%
54.57%
44.72%
0.2
Investor Interest and Value
Cash Flows
Expected Cash Flow
Standard Deviation
Present Value of First-Stage Interest
NPV of Option to Invest in Second Stage
NPV of Interest in Venture
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
$
$
(2,000)
-
$
$
(2,475)
2,501
$
$
9,112
8,483
$
3,500
$
(2,288)
$
5,788
$
1,500
Chapter 13
Valuing Financial Claims by Discounting All
Expected Cash Flow (continued)
Entrepreneur Interest and Value
Entrepreneur's Wealth
$
Cash Flows of Investment in Venture
Expected Cash Flow
Standard Deviation
$
$
(500)
-
$
$
19,505
10,842
Cash Flows of Investment in Market
Expected Cash Flow
Standard Deviation
$
$
(1,500)
-
$
$
2,644
671
$
$
(2,000)
-
$
$
$
22,149
10,996
4,919
$
$
$
7,177
1,500
5,677
$
$
$
13,271
1,500
11,771
Portfolio Cash Flows
Expected Cash Flow
Standard Deviation
Maximum Achievable Leverage (MAL)
Value of Entrepreneur's Investments - CAPM
Present Value of Portfolio
Present Value of Investment in Market
Present Value of Interest in Venture
NPV of Interest in Venture
Value of Entrepreneur's Investments - MAL
Present Value of Portfolio
Present Value of Investment in Market
Present Value of Interest in Venture
NPV of Interest in Venture
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
$
$
2,000
5,177
11,271
Chapter 13
Valuing Financial Claims by Discounting All
Expected Cash Flow (continued)
Decision Tree
Simulation Results
Max. Trials = 1000
Statistics provided for:
Output
WHEN
Decision Tree Node
IS
Value
1
Investor's Second Stage Investment
No Condition
>
0
2
Investor's Total Share
No Condition
>
0
3
Entrepreneur's Total Share
No Condition
>
0
4
Investor's Incremental Share
Second Stage Investment Made
>
0
5
Entrepreneur's Incremental Share
Second Stage Investment Made
>
0
Percentiles
Average
Median
Standard
Deviation
Skewness
Successful
Trials
Minimum
25%
50%
75%
Maximum
2525
5000
2501
-0.020
1000
0.000
0.000
5000
5000
5000
8925
6716
8281
0.363
1000
2.80
1190
6716 16441
26227
19421
15982
10559
0.451
1000
25.18 10707 15982 27994
44658
14237
14140
4114
-0.008
505
4593 11427 14140 16952
23185
7540
7441
5401
-0.052
505
-4644
3779
7441 11379
18033
Results of Simulating the Decision Tree
Variable
Investor’s Second Stage Investment
Investor’s Total Share
Entrepreneur’s Total Share
Investor’s Incremental Share
Entrepreneur’s Incremental Share
Mean
Standard
Deviation
-$2,475
$9,112
$19,505
$14,312
$7,824
$2,501
$8,483
$10,842
$4,187
$5,429
Number of
Cases Where
Condition is
Satisfied
1000
1000
1000
495
495
Source: Results generated by Venture.SIMTM decision tree simulation routine
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
Search Results for Contract Terms that are Most Attractive for Entrepreneur
First Round
Shares
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
20%
20%
20%
20%
20%
Assumptions
Second
Round
Shares
5%
5%
5%
5%
5%
10%
10%
10%
10%
10%
20%
20%
20%
20%
20%
30%
30%
30%
30%
30%
5%
5%
5%
5%
5%
Simulation Results
Exercise
12,500
15,000
17,500
20,000
22,500
12,500
15,000
17,500
20,000
22,500
12,500
15,000
17,500
20,000
22,500
12,500
15,000
17,500
20,000
22,500
12,500
15,000
17,500
20,000
22,500
Probability of
Exercise
0.68
0.50
0.40
0.23
0.09
0.68
0.50
0.40
0.23
0.09
0.68
0.50
0.40
0.23
0.09
0.68
0.50
0.40
0.23
0.09
0.68
0.50
0.40
0.23
0.09
Investor
Conditional
NPV
-$1,588
-$745
-$404
-$66
$30
-$551
$187
$364
$388
$256
$1,175
$1,766
$1,901
$1,363
$663
$3,045
$3,561
$3,302
$2,293
$1,090
-$923
$48
$333
$472
$270
Investor
Entrepreneur
Total NPV
Total NPV
-$2,550
$3,497
-$1,802
$4,174
-$1,613
$3,066
-$1,231
$2,420
-$935
$3,321
-$1,491
$4,538
-$1,229
$4,005
-$905
$3,602
-$915
$2,618
-$996
$3,842
-$172
$4,071
-$371
$4,930
-$36
$4,781
-$183
$4,180
-$864
$4,389
$1,274
$4,124
$1,500
$5,177
$932
$5,507
$229
$5,258
-$666
$5,390
-$489
$3,258
$261
$4,447
$540
$3,259
$283
$1,912
$434
$2,667
Entrepreneur
Conditional
NPV
$3,065
$5,403
$5,033
$3,819
$2,019
$2,298
$4,165
$4,488
$3,636
$1,771
$811
$3,148
$3,272
$2,775
$1,349
-$407
$1,536
$1,940
$1,803
$1,018
$2,585
$4,399
$4,712
$3,388
$1,713
Simulation Tree Results Under Alternative
Market Potential Assumptions
Simulation Results Under Alternative Market Potential Assumptions:
Investor Receives 10% of Round 1 Equity and 30 percent of Total
Equity for Round 2 Investment
$6,000
Net Present Value ($000)
$5,000
$4,000
Investor Conditional NPV
Investor Total NPV
Entrepreneur Total NPV
Entrepreneur Conditional NPV
$3,000
$2,000
$1,000
$0
12,500
15,000
17,500
20,000
22,500
-$1,000
Potential Second Year Revenue ($000)
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 13
Chapter 8
Venture Capital
Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of
the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information
should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations
contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of
these programs or from the use of the information contained herein.
Historical Development of
Venture Capital as an Institution
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 14
Venture Capital New Commitments
Venture Capital New Commitments
$50,000
$45,000
Millions of Dollars
$40,000
$35,000
$30,000
$25,000
$20,000
$15,000
$10,000
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
1973
1971
$0
1969
$5,000
Year
Sources: Statistical Abstract of the U.S. (various issues), Venture Economics Investor Service, Sahlman (1990).
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 14
of Venture Capital
Funds
Sources Sources
of Venture
Capital
Funds
100%
90%
80%
Percent of Total
70%
Foreign Investors
60%
Individuals
50%
Corporations
Endowments
40%
Insurance Companies
30%
Pension Funds
20%
10%
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
0%
Year
Sources: Statistical Abstract of the U.S. (various issues), Gompers and Lerner (1996, 1997).
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 14
The Organizational Structure of a
Venture Capital Fund
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 14
Organizational Structure of
Venture Capital Investment
General Partners
– Generate deal flow – Negotiate deals
– Screen opportunities – Monitor and advise
– Harvest investments
Effort and
1% of
capital
Annual
Management
Fee 2-3%
Carried
Interest 2030% of Gain
Venture Capital Fund
99% of Investment
Capital
Capital Appreciation
70-80% of Gain
Investment
Capital and
Effort
Financial
Claims
Portfolio
Companies
–Value creation
Limited Partners
– Pension plan
– Corporations
– Endowments
– Individuals
– Life insurance companies
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 14
Summary of Terms:
Venture Capital
Limited
Partnership
Summary of Terms:
Venture Capital Agreement
Limited Partnership Agreement
Venture.com VC Fund, L.P. (the “Fund”)
Terms and Provisions
Purpose
General Partner
Limited Partnership Interests
General Partner’s Investment
Minimum for Closing
Payment of Subscriptions
Term
Allocation of Profit and Loss
Distributions
Service Fee
Organizational Expenses
Conflicts of Interest
Other Restrictions and Limitations
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 14
Managing the Investment
Portfolio
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 14
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Exiting
Assisting in Outside
Relationships
Recruiting Management
Consulting
Directing and Monitoring
Negotiating Deals
Analyzing Business Plans
Selecting Opportunities
Soliciting Business
Percent of time
Allocation Allocation
of Venture
Capitalist
Time
of Venture Capitalist
Time
25%
20%
15%
10%
5%
0%
Activity
Source: Zider (1998)
Chapter 14
The Venture Capital Investment
Process
Development of Fund Concept
Secure Commitments
from Investors
Closing of Fund
Year 0
2-3 years
Generate Deal Flow
First Capital Call
Screen
Business
Plans
Evaluate and
Conduct Due
Diligence
Negotiate
Deals and
Staging
Additional
Capital
Calls
Invest
Funds
Value Creation and Monitoring
4-5 years
2-3 years
or more
– Board service
– Assist with external relationships
– Performance evaluation and review – Help arrange additional financing
– Recruitment management
Harvesting Investment
Distributing Proceeds
– IPO
– Acquisition
– Cash
– Public Shares
7-10 years plus extensions
– LBO
– Liquidation
– Other
Incentive Conflicts and Structures
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 14
Key Covenant
Classes
of Venture
Key Covenant
Classes
of Venture
Limited
Partnerships
CapitalCapital
Limited
Partnerships
Overall Fund Management
Investment in a single firm
Use of debt
Coinvestment by Venture Capitalist’s Other Funds
Reinvestment of profits
Activities of General Partner
Personal investing in portfolio companies
Sale of interest by General Partner
Fund-raising
Outside activities
Addition of General Partners
Types of investments
Restrictions on asset classes
Based on Gompers and Lerner (l997).
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 14
Chapter 9
Choice of Financing
Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of
the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information
should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations
contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of
these programs or from the use of the information contained herein.
A Partial List of Financing Sources for
New Ventures and Private Business
• Asset-based Lending
• Business Angels
• Capital Leasing
• Commercial Bank Lending (various forms)
• Corporate Entrepreneurship
• Customer Financing
• Direct Public Offering
• Economic Development Program
Financing
• Employee-provided Financing
• Equity Private Placement
• Export/Import Bank Financing
• Factoring
• Franchising
• Friends and Family
• Public Debt Issue
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
• Registered Initial Public Offering
• Research and Development Limited
Partnerships
• Relational Investing or Strategic
Partnering
• Royalty Financing
• Self (bootstrapping)
• Small Business Administration
Financing
• Small Business Investment
Company Financing
• Term Loan
• Vendor Financing
• Venture Capital
Chapter 15
Factors That Affect the
Choice of Financing
• Financial needs of the venture
• Stage of Development
• Financial Condition
• Product-market Considerations
• Organizational Considerations
• Track Record/Reputation/Relationships
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 15
Financial Needs of the Venture
• Immediacy of the need
• Size of the immediate need
• Duration of the immediate need
• Cumulative need
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 15
Stage of Development
• Completeness of the management team
• Ease of communicating the venture’s merit
• Value of managerial/consulting services
• Importance of flexibility/adaptability
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 15
Financial Condition
• Risk/Return characteristics of the venture
• Taxable income status
• Operating cash flow status
• Time to a liquidity event
• Transferability of tax benefits to investors
• Available collateral
• Cash flow cycle
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 15
Product-market and Organizational
Considerations
• Importance of rapid growth
• Importance of relationship with a supplier or
distributor
• Dedication of distributors to the product
• Value of centralization of control
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 15
Track Record/
Reputation/Relationships
•
•
•
•
•
•
Track record of the venture
Importance of future financing needs
Past failure or financial distress
Likely failure in the near future
Reputation of the entrepreneur
Relationships with financing sources
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 15
Some Financing Choices
•
•
•
•
•
•
•
•
•
•
•
•
Securitization
Strategic investing
Franchising
Venture capital
Angel investing
Corporate venture investing
SBA programs
Direct public offering
Factoring
R&D Limited Partnerships
Vendor financing
Public offering
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 15
Comparison of Business Angel and Venture Capital Financing
Panel (a)
Size of Financing Round
<$250,000
$250,000-$499,999
$500,000-$1,000,000
>$1,000,000
Total
Panel (b)
Stage of Financing
Seed
Startup
First stage
Second stage
Third stage
Bridge
Total
Number of Deals
with Individual
Financing
102
43
15
17
177
Percent of Deals
with Venture
Capital
Financing
8
14
31
120
173
with Individual
Financing
57.63%
24.29%
8.47%
9.60%
100.00%
with Venture
Capital
Financing
4.62%
8.09%
17.92%
69.36%
100.00%
Number of Deals
Percent of Deals
with Venture
with Venture
with Individual
Capital
with Individual
Capital
Financing
Financing
Financing
Financing
52
11
29.38%
6.36%
55
38
31.07%
21.97%
29
56
16.38%
32.37%
26
46
14.69%
26.59%
10
19
5.65%
10.98%
5
3
2.82%
1.73%
177
173
100.00%
100.00%
Source: Freear and Wetzel (1990)
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 15
Estimates of Financing to Small Businesses and New
Ventures as of 1992.
Source
Principal owner
Angel finance
Venture capital
Other equity
Total equity
Commercial banks
Finance companies
Other institutions
Trade credit
Other business financing
Government
From principal owner
Credit cards
Other individuals
Total debt
Total
Amount
524.3
60
31
215.2
830.6
313.8
82.1
50.1
264.1
82.1
8.1
68.5
2.4
24.5
842.9
1673.4
Percent
31.33%
3.59%
1.85%
12.86%
49.64%
18.75%
4.91%
2.99%
15.78%
4.91%
0.48%
4.09%
0.14%
1.46%
50.37%
100.00%
Note: Includes all non-farm, non-financial, non-real estate small businesses
Source: Berger and Udell (1998).
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 15
Chapter 10
Harvesting
Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of
the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information
should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations
contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of
these programs or from the use of the information contained herein.
Harvesting Alternatives
• Initial public offering
• Private placement / private sale
• Roll-up IPO
• Management buy-out
• Employee stock ownership plan
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 16
The Underwritten IPO Process
• The role of the underwriter
– Issue pricing
– Due diligence
– Certification
– Distribution
– Market making
• Harvesting by going public
– In the IPO
– After the IPO
• Cost of public offering
• Cost of harvesting by going public
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 16
The IPO Issue Pricing Process
for a Firm Commitment Underwriting
Figure 16-1
Comparable
Firm Values
New
Information
from
Market
Comparable
Transactions
and IPOs
Discounted
Cash Flow
Valuation
Information
from Issuer
New
Information
from
Market
Preliminary
Estimate of
Value
New
Information
from Due
Diligence
Filing
Range
reported in
Preliminary
Prospectus
Issue Price
reported in
Final
Prospectus
Indications of
Interest from
Roadshow
“Take down”
Due Diligence
IPO Cost
• Underwriter fee: 5-7 percent of proceeds
• Direct issuing cost: 1-5 percent of proceeds
• Underpricing: 10-15 percent of proceeds
• Total : 16-27 percent of gross proceeds
17-31 percent of net proceeds
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 16
Cost of Harvesting by Going Public
• IPO usually is a small fraction of total value.
• Selling shareholders normally harvest in the aftermarket.
• Selling shareholders bear their share of the dollar-valued
cost of the IPO.
• Percentage cost of IPO is less important than percentage
cost of harvesting.
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 16
Private Placement / Private Sale
• Exchange modes
– Equity for cash
– Assets for cash
– Equity or assets for equity
• Valuation
– Discounts compared to public market value
– Cost of private sale
• Choice of public or private sale
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 16
Roll-up IPO
• The underlying theory of value creation
• The off-setting costs
• Structural solutions
• Net benefit (cost v. share value)
• Examples
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 16
Roll-up IPO
Figure 16-3
Owner of
Private
Company A
Owner of
Private
Company B
Exchange of
shares for
new shares,
cash, and
employment
contracts
New
Company
IPO
Public
Market
Investors
Owner of
Private
Company C
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 16
Family-owned Businesses
and ESOPs
• Leveraged v. unleveraged ESOPs
• Advantages and disadvantages of ESOPs
• Valuation of ESOP shares
– to owners
– to employees
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 16
Structure of a Private Leveraged
ESOP
Owner/
Entrepreneur
Figure 16-2
Panel (a) ESOP Initiation
Sell shares to ESOP
trust for cash
Company
Evaluation
of equity
for fee
Valuation
Service
Establish
ESOP Plan
ESOP
Trust
Cash loan
secured by
Company shares
Bank
Structure of a Private Leveraged
ESOP
Panel (b) Annual Retirement Contribution Funding
Company
Annual
retirement
contribution
Evaluation
of equity
for fee
Valuation
Service
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
ESOP
Trust
Loan
repayment/
Release of
shares
Funding of
employee
retirement
Employees
Bank
Chapter 16
Structure of a Private Leveraged
ESOP
Panel (c) Share Redemption at Employee Retirement
Company
Annual
Retirement
contribution
Evaluation
of equity
for fee
ESOP
Trust
Share
redemption
by Trust
Employees
Valuation
Service
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 16