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Literature: Chapter 1, and 2

The lecture started with a little discussion:

Q: If you think about entrepreneurial finance, where do you think off?

Om 3enture capital
Om Jngel investors (which are informal investors which provide many seed capital)
Om Ôusiness proposal
Om Jsymmetric information
Om Ôank financing
Om „inancial forecasting, where cash flow management is by far the most important
Om Capital structure in general
Om c it strategy

Later on the teacher showed us a video about Jli G who was thinking to become an
entrepreneur. The video showed all kinds of jokes, but the main point was that to become a
successful entrepreneur a lot of factors are important.

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Q: What should happen in between? i
 
 




 



 
 


 

 

 
 
 
 

Om ou need to have a business model






  


Om J sponsor who sees the opportunity
Om J patent to have some protection   











  


Om Capital
Om J successful
 consisting of technicians and business man.

This course will be covered around five main themes:

1.m ÿaising and sourcing entrepreneurial finance

2.m „inancial forecasting/management of entrepreneurial firms
3.m Sources of entrepreneurial finance: business angels, corporate, venture capital
4.m Deal structuring: due diligence, valuation, term sheets, negotiation
5.m Deal management: investor involvement and e it

.
` 
  



Thousands of business ventures are started every year. Most fail within a short period. Of
those that survive, most achieve only meager success, some achieve rates of return high
enough to justify the initial investment, and a few achieve phenomenal success.

What distinguishes the successes from the failures? There is not just one answer. J new
venture based on a good idea can fail because of poor implementation or bad luck. One that is
based on a bad idea can fail despite e cellent implementation. Many that survive, but do not
thrive, should not have been undertaken. Sometimes even when a venture is hugely
successful, early financing mistakes prevent the entrepreneur from sharing in the rewards.

This course is a book on the financial decision making for new ventures. Our goal is to help
students, prospective entrepreneurs, and investors think more clearly about the conditions
under which an idea is worth pursuing and about how to apply the tools of financial economic
theory in ways that add to the e pected value of an undertaking.

1.1m The cntrepreneur

cntrepreneurial finance concerns financial decision making by entrepreneurs who are

undertaking new ventures. To understand the distinctions between the responsibilities
between the decisions managers of public corporations and entrepreneurs face, lets first
e amine the word entrepreneur.

cntrepreneur comes from the „rench word µ¶undertaker¶¶. In the sense of one who undertakes
to do something. Today entrepreneurship is most often described as the pursuit of
opportunities to combine and re-deploy resources, without regard to current ownership or
control of those resources.

Thinking of entrepreneurship in this way suggests a multistep process. „irst, the entrepreneur
must perceive an opportunity to create value by re-deploying society¶s resources. Second, the
entrepreneur must devise a strategy for marshaling control of the necessary resources. Third,
he or she must implement a plan of action to bring about the change. Jnd fourth, the
entrepreneur must harvest the rewards that accrue from the innovation.

To be successful an entrepreneur needs to maintain a clear focus on how strategic choices and
implementation decisions are likely to affect rewards.

1.2m „inance and the cntrepreneur

ÿegardless of their desires or their lack of interest in accumulating personal wealth (since
entrepreneurs are often seen as visionaries), few entrepreneurs can afford to ignore financing.
In fact, being caught up in the vision and ignoring the details of implementation is a danger
sign to prospective investors.

To quote a successful venture capitalist: µ¶good ideas and good products are a dime a
dozen. Ôut good e ecution and management ± in a word good people ± are rare¶¶
The entrepreneurial focus on finance will be on financial decision making. The domain of the
financial decision-making paradigm is resource allocation. The range of decisions that can be
approached using the finance paradigm is much broader as they might appear at first glance.

„or e ample: The organizational form (partnership, corporation, proprietorship) can be

construed as a financial investment decision. Is the e pected value higher for the entrepreneur
if the venture is organized as a proprietorship or a corporation? Similarly issues like the
choices of scale and scope of a business venture can be analyzed as financial investment
decisions.

1.3m The „inance Paradigm

The guiding principles of financial decision making can be stated as follows:

Om More of a good is preferred to less

Om Present wealth is preferred to future wealth
Om Safe assets are preferred to risky assets

Ôesides that we consider two kinds of decisions.

1)m Investment decisions concern acquisition (or sale) of assets. It refers to the left hand
side of the balance sheet. The worth or value of an investment depends on the ability
to generate cash flows for the investors in the future and on the riskiness of those cash
flows

2)m The other decision we consider is financing. It is the right hand side of the balance
sheet. „or e ample, given the decision to acquire an assets what will be the most
desirable way to finance it? Or, capital structure decisions?

The objective of entrepreneurial finance is to learn you to master the financial approach to
entrepreneurship. We think you will see that the tools of finance are powerful and can
contribute substantially to the value of a new venture.

1.4m What makes entrepreneurial finance different from corporate finance?

The difference is that the focus on entrepreneurship and early-stage ventures dramatically
changes the ways in which the essential features of the finance paradigm must be applied. In
the ne t section we will show you an e planation of the differences.

Interdependence between investment and financing decisions

In corporate finance you learn that investment and financing decisions are largely   
 Off course they
are not completely independent (think of the ta shield on debt financing that increase the
P3) but decisions
can be made separately.

Jmong other things appropriate application of the finance paradigm implies that the value placed on a new
venture will be very different for the entrepreneur that for many outside investors. This difference in value arises
because of differences in required rates of return between entrepreneurs and outside investors.
More generally, some investment choices are only possible if certain financing choices are made. „or e ample,
rapid growth may only be possible with substantial outside financing, whereas if the same project were
undertaken by an established large corporation it might be possible to finance the project with internally
generated funds.

The link between investment choices and financing choices creates comple ity that does not arise in corporate
finance.

Giversifiable Risk and Investment Value

Within corporate finance portfolio theory assumes that the cost of capital depends on the component of project
risk that cannot be avoided through diversification.

This assumption does not hold for the entrepreneur. Js a result project value between investors and
entrepreneurs is different.

In corporate finance
  
  

 implies that allocation of financial claims does not affect
the decision to accept a project. Ôut for new ventures, because entrepreneurs and outside investors view risk
differently, they ascribe different values to the same risky asset. So value additivity does not hold.

Œanagerial Involvement of Outside Investors

In public corporations investors generally are passive, while outside investors in new ventures do provide
services that contribute to venture success.

Information Problems and Contract Gesign

In the normal public corporations outside investors have little control over investment decisions. The managers
act accordingly and do not have to ask permission from the investors. This situation is much different in the case
of a startup firm that requires outside financing.

In the latter case outside investors are seeking in the venture to realize a return. Consequently, the entrepreneurs
bear a heavy burden of trying to convince outsiders of the value of the project.

Incentive Alignment and Contract Gesign

Incentive contracting (stock options and performance bonuses) to align interest of management and investors or
covenants with respect to debt financing play a crucial role in the public corporation.

The issues are similar for start-up business, but incentive contracting is in some respects more compelling. The
entrepreneurs namely do often not have an interesting C3 or track record. The result is that outside investors use
a variety of contractual devices to improve upon their abilities to identify high -quality entrepreneurs and
motivate them.

So they use staging, termination options, and other contractual devices transfer substantial control over ultimate
success to the outside investors.

The importance of real options

Projects are often valued by using the
P3 approach and the value of real options is often of secondary
importance. The value of real options is highest when uncertainty is high surrounding the investment.

owhere is the importance of option values more central than for a start -up business. In fact, a new venture can
be viewed most accurately as a portfolio of real options, some controlled by the entrepreneur and others
controlled by outside investors.
†arvesting the Investment

Investing in new ventures is totally different from investing in a public corporation.
ew venture investments are
not liquid and often do not generate any significant free cash flow for several years. To realize the returns on
their investments a liquidity event must occur. Such liquidity events are the main ways in which investors in new
ventures harvest and realize the returns on their investments.

While with respect to the purchase of stock in public markets the investors realize returns from dividends and
capital gains.

Value to the Entrepreneur

In the public corporation the main focus is ma imizing shareholder value. While in a start-up business, the true
residual claimant is the entrepreneur. The objective of the entrepreneur in deciding whether to pursue the venture
and how to structure the financing, is to ma imize the value of the financial claims and other benefits that the
entrepreneur is able to retain as the business grows.

1.5m The objective: ma imum value for the entrepreneur

Schumpeter makes clear that the entrepreneur¶s motivation is not so much to make society
better off as it is to make the entrepreneur better off. This is our orientation as well. We
e pect that the entrepreneurial function will create value for society, but we assume that
prospective entrepreneurs are driven by self-interest.

1.6m The process of new venture formation

See „igure 1.2 in the book

The diagram traces the process of new venture formation from perception of the opportunity
to harvesting, with an emphasis on key financial decisions.
` 
      

   

In this chapter we will introduce the ta onomy of new venture development and provide an
overview of the new venture financing sources.

2.1 The ÿocket Jnalogy

Practitioners often compare undertaking a venture with launching a rocket. Just as with
comple rockets, the venture will be in stages. cach stage offers the opportunity to terminate
or make minor mid-course corrections.

Ôecause most new ventures do not generate sufficient cash to cover operating costs or provide
for future growth, they must be µ¶fueled¶¶ by an initial supply of cash. The normal intent is to
fuel the venture with enough cash at each stage of development so that it is able to reach the
ne t stage.

The rocket analogy is not perfect, since a new venture does not raise all of the necessary
capital up-front. Jnd another difference between rockets and new ventures concerns the
specificity of the objective.

2.2 Choosing the Organizational form

One of the earliest decisions the entrepreneur must make concerns the organizational form of
the venture. The choice has important implications for a variety of factors, including ta es,
liability, succession, and ability to attract financing and employees.

The choice of organizational form can be addressed most effectively by using criteria such as
those in    to e clude alternatives. ou might for e ample begin whether or not the
venture is intended to generate profits for investors (for profit vs. not for profit).

Later you might ask the ne t question with respect to long run capital needs ( C corporations,
and limited partnerships can raise very large amounts of money from passive investors).

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2.3 Information Problems „acing the cntrepreneur and the Investor

There are three basic information problems that characterize the market for financing new
ventures.
 1.m The entrepreneurs information about the value of the opportunity may be incomplete
and uncertain
2.m Information about the value of the idea and the ability of the entrepreneur is held
asymmetrically.
3.m The asymmetric information will lead to a third problem namely the risk of
appropriation of intellectual property.

These problems gave rise to some unique features in the market for entrepreneurial finance.
„irst, since information is highly uncertain and asymmetric, outside investors want to see
tangible evidence that both reduces uncertainty about the market potential and reveals the
entrepreneur¶s abilities. Milestones are specific and verifiable performance benchmarks.
c amples are production of a prototype, initiation of sales, the completion of clinical tests.

The second feature, closely related to milestones is staging of financing. Staging of financing
reflect the common sense idea of µ¶ wait and see¶¶.

2.4 Measuring progress with Milestones

ÿaising capital at a very early stage is difficult. ÿeliance on milestones enables the parties to
postpone financial commitments until they are needed, and to base infusions on the levels of
risk and e pected return that e ist at the time of the investment.

cach milestone also functions as a working hypothesis about the venture. Understanding the
reasons for failing to meet a milestone is important.

In either case milestones enable the entrepreneur and outside investors to sharpen their
e pectations about ultimate success or failure. Milestones help identify ways to enhance the
e pected benefits of the project.

„or an overview of milestones see    .

2.5 Stages of
ew 3enture Development

Jlthough there is no typical µ¶life cycle¶¶ for a new venture, firms do go through stages of
development.

„igure 2-2 offers a representation of the stages of new venture development.

If cash flow available to investors is negative, the venture must finance the shortfall. If cash
flow available to investors is positive, the firm can use the surplus to pay returns to investors,
including interest payments on debt, debt redemption, dividends, and share repurchase.

The figure reflects five fundamentally distinct stages of new venture development.

1.m Development Stage

2.m Start-up
3.m carly Growth
4.m ÿapid Growth (the stage where e ternal financing is required)
 5.m c it (C„ available to investors positive, no need to increase outside
financing and an obvious point for investors to harvest)

2.6 Sequence of
ew 3enture „inancing

It should be evident that the stages in „igure 2-2 correspond roughly to measurable
milestones. J correspondence also e ists between the milestones and the opportunities to
attract outside financing.

Jt an early stage, the entrepreneur looks for ways to finance the venture from personal
savings and borrowing where repayment does not depend on success. Many successful
ventures have been bootstrapped with very little financial capital. Ôootstrap techniques
include for e ample, drawing down saving accounts, taking out second mortgages, using the
credit lines of multiple credit cards, and borrowing on life insurance policies. Ôut also by
thinking and operating as efficient as possible.

Jlthough bootstrapping can work as short-run financing tactic, it normally cannot be a source
of permanent financing (it has to be paid back). The more likely scenario is that the
entrepreneur must turn to outside financing that is based on the merits of the venture.

Depending on the stage of development outside investors may include family members,
friends, business angels, banks, venture capitalists, and a variety of others.

The earliest e ternal financing is known as seed financing. Seed financing consists of
relatively small amounts of money to support e ploration of a concept. Primary risk is the risk
of discovery.

Start up financing covers activities from later research and development to initiation of sales.
Generally, start-up financing is provided when a concept appears to be worth pursuing, key
members of the team are in place, and most of the risks related to development have been
resolved.

„irst stage financing is provided to a company that has initiated production and is generating
revenues but normally has not yet achieved profitability.

Second stage financing supports continuing growth of a venture that is operating around the
breakeven point of profitability.

Mezzanine financing is used to support major e pansion of a profitable business.

Ôridge financing is temporary financing, particularly between later-stage financing rounds

and harvesting.

2.7 Sources of
ew 3enture „inancing

Om Self, „riends, and „amily

Om Jngel „inancing
 Om 3enture Capital Investors > distinguish between general partners and limited
partners
> In innovative and high growth firms
> mostly in the high growth stages
Om Corporate 3enturing
Om Small Ôusiness Investment Companies (SÔIC) > subsidy on financing,
stimulated by the Small Ôusiness Jdministration (SÔJ)
Om Small Ôusiness Innovation ÿesearch Program (SÔIÿP)
Om c-IM bank > finance the purchase orders of the firm, so
making working capital guarantees.
Om Trade Credit > for e ample cJSJcT
Om „actoring > with and without (factor absorbs the loss) resource
Om Jsset Ôased Lenders
Om Mezzanine Capital

Common type is subordinated debt with an equity sweetener or warrants. J warrant is a long
term call option issued by the firm.

Om Private Placements
Om IPOs
Om Public Debt

'/   /  
      

     
 
  

2.8 The Deal

- Term Sheet

- Pre and Post Money 3aluation

- Investment Jgreement

In addition understand the slides with respect to the:

„irm as a cash converter

3alue

Survival period with financing