Entrepreneurial Finance Chapter 0: Access to Finance
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Questions and Answers

What can entrepreneurs use the VEM framework to identify and assess?

  • External funding sources
  • Consumer preferences
  • Competitors in the market
  • Strengths and weaknesses of their venture (correct)

    • Financial projections are always accurate, especially for early-stage companies.

    False

    Define financial constraints in the context of entrepreneurial finance.

    Financial constraints refer to the situation where a firm needs external finance but is unable to obtain it.

    In the context of entrepreneurial finance, what can asymmetric information lead to?

    <p>Credit rationing</p> Signup and view all the answers

    Banks facing borrowers with unknown risk type is an example of adverse selection in entrepreneurial finance.

    <p>True</p> Signup and view all the answers

    What drives economic growth according to Bob Solow (1987)?

    <p>Technological progress</p> Signup and view all the answers

    Entrepreneurial finance contributes to economic growth.

    <p>True</p> Signup and view all the answers

    Which costs relate directly to the production & delivery of the product?

    <p>COGS</p> Signup and view all the answers

    Non-operating expenses are recurring costs that relate to maintaining the asset base. (True/False)

    <p>False</p> Signup and view all the answers

    What is the purpose of using preferred stock in companies?

    <p>All of the above</p> Signup and view all the answers

    Founders' stock is typically fully vested from the beginning.

    <p>False</p> Signup and view all the answers

    VCs aim to reduce downside risk while pushing their companies to create a large upside.

    <p>True</p> Signup and view all the answers

    What is one of the main motivations for corporate governance as stated in the content?

    <p>Companies' need for investment return</p> Signup and view all the answers

    Investors under the 3x preferred share deal have no incentive at all.

    <p>True</p> Signup and view all the answers

    What is the purpose of using convertible notes for pre-venture companies?

    <p>Avoiding valuation</p> Signup and view all the answers

    Once converted, ______ notes are usually converted into the same security then issued, which is ______ preferred.

    <p>convertible</p> Signup and view all the answers

    Match the following terms related to deal structuring:

    <p>Lead investors = Perform due diligence, negotiate, sit on boards Followers = Provide capital, expertise, networks ZOPA = Maps sets of admissible deals Outside options = Alternatives to the deal</p> Signup and view all the answers

    Where do investors add value according to the VEM model?

    <p>Networking</p> Signup and view all the answers

    What are the key motivations for staged financing for the Investor?

    <p>staging creates option</p> Signup and view all the answers

    Internal Rate of Return (IRR) takes the level of risk into account.

    <p>False</p> Signup and view all the answers

    What does FAST stand for in the context of founder ownership?

    <p>Founder Allocation of Shares Tool</p> Signup and view all the answers

    Standard valuation models can be easily applied to valuing entrepreneurial companies.

    <p>False</p> Signup and view all the answers

    What is the primary driver of economic growth, according to Bob Solow's Nobel insights?

    <p>Technological progress or total factor productivity (TFP)</p> Signup and view all the answers

    What is the impact of Venture Capital (VC) funding on start-ups, according to Chemmanur et al. (2011)?

    <p>Significantly higher total factor productivity (TFP)</p> Signup and view all the answers

    What is one of the key motivations for entrepreneurs to seek Venture Capital (VC) funding?

    <p>To get access to knowledge and expertise</p> Signup and view all the answers

    What is the primary reason why a firm may face financial constraints?

    <p>The firm is unable to obtain external finance due to frictions</p> Signup and view all the answers

    What is the primary benefit of staged financing for investors?

    <p>Reducing downside risk while pushing for high returns</p> Signup and view all the answers

    What is the main consequence of asymmetric information in the market for external funds?

    <p>Market failure due to credit rationing</p> Signup and view all the answers

    What is the main purpose of corporate governance, according to the content?

    <p>To align the interests of managers and investors</p> Signup and view all the answers

    What is the definition of credit rationing?

    <p>A situation where firms are unable to borrow at the equilibrium interest rate</p> Signup and view all the answers

    What is one of the key benefits of entrepreneurial finance for the broader economy?

    <p>It creates jobs, innovation, and economic growth</p> Signup and view all the answers

    What is the purpose of financial projections in entrepreneurial finance?

    <p>To estimate the firm's future financial performance</p> Signup and view all the answers

    What is the effect of asymmetric information on the market for external funds?

    <p>It leads to credit rationing</p> Signup and view all the answers

    What is the primary role of investors in the entrepreneurial ecosystem?

    <p>To provide funding and expertise to entrepreneurs</p> Signup and view all the answers

    What is the main characteristic of a financially constrained firm?

    <p>It is unable to obtain external finance due to frictions</p> Signup and view all the answers

    What is the primary driver of growth in entrepreneurial companies, according to Kortum & Lerner (2000)?

    <p>Venture Capital (VC) funding</p> Signup and view all the answers

    What is the main consequence of credit rationing in the market for external funds?

    <p>A reduction in the allocation of funds to firms</p> Signup and view all the answers

    What is the main reason why entrepreneurial finance is considered challenging from the entrepreneurial perspective?

    <p>The firm is unable to obtain external finance due to frictions</p> Signup and view all the answers

    What do researchers exploit to observe how VCs manage to bring companies to success?

    <p>Quasi-random events</p> Signup and view all the answers

    What is the primary way VCs add value to companies through networking?

    <p>Connecting companies with potential partners</p> Signup and view all the answers

    What is the goal of pressuring by VCs?

    <p>To suggest strategic changes</p> Signup and view all the answers

    What is the result of VCs increasing their involvement with companies?

    <p>Companies become more innovative and successful</p> Signup and view all the answers

    What is the level at which mentoring and coaching by VCs takes place?

    <p>Personal level</p> Signup and view all the answers

    What is the purpose of advising by VCs?

    <p>To support decision-making</p> Signup and view all the answers

    What do VCs help companies with through their advising?

    <p>HR and strategy</p> Signup and view all the answers

    What is the outcome of VCs increasing their involvement with companies, which points to a real treatment effect?

    <p>Companies become more successful</p> Signup and view all the answers

    What is the main implication of drag-along rights for investors?

    <p>They can force other shareholders to sell their stock</p> Signup and view all the answers

    What is the purpose of key man insurance in venture capital agreements?

    <p>To provide a financial safety net for the company in case a key person passes away</p> Signup and view all the answers

    What is the main difference between valuation and terms in venture capital agreements?

    <p>Valuation is visible and easy to grasp, while terms are more complex</p> Signup and view all the answers

    What is the implication of having a no-shop clause in a venture capital agreement?

    <p>The entrepreneur cannot shop around for other deals</p> Signup and view all the answers

    What is the purpose of representations and warranties in venture capital agreements?

    <p>To hold the founder or manager responsible for large mistakes or lies</p> Signup and view all the answers

    What is the implication of having a due diligence conditionality clause in a venture capital agreement?

    <p>The investor has the right to back out of the deal if certain conditions are not met</p> Signup and view all the answers

    What is the purpose of information rights in venture capital agreements?

    <p>To provide investors with hard data about the company's performance</p> Signup and view all the answers

    What is the implication of having a legal resolution clause in a venture capital agreement?

    <p>The investor can choose the applicable law in case of disputes</p> Signup and view all the answers

    What is the effect of dilution on the ownership fraction of current shareholders?

    <p>It decreases the ownership fraction of current shareholders</p> Signup and view all the answers

    What is the relationship between risk and return in finance?

    <p>Higher return can be achieved with higher risk</p> Signup and view all the answers

    What is the characteristic of low returns in entrepreneurial finance?

    <p>They are more probable than high returns</p> Signup and view all the answers

    What is the effect of risk-aversion on investor behavior?

    <p>They are willing to pay more for an investment with lower risk</p> Signup and view all the answers

    What is the purpose of distinguishing between realized and expected returns in entrepreneurial finance?

    <p>To assess the performance of an investment</p> Signup and view all the answers

    What is the effect of dilution on the ownership fraction of an investor across rounds?

    <p>It decreases the ownership fraction of the investor across rounds</p> Signup and view all the answers

    What is the primary reason why a firm may face financial constraints?

    <p>Insufficient access to external finance</p> Signup and view all the answers

    What is the result of asymmetric information in the market for external funds?

    <p>Credit rationing</p> Signup and view all the answers

    What is the primary way to address credit rationing in the market for external funds?

    <p>Reducing information asymmetry</p> Signup and view all the answers

    What is the characteristic of a financially constrained firm?

    <p>Having a need for external finance but being unable to obtain it</p> Signup and view all the answers

    What is the purpose of the interest rate in the market for external funds?

    <p>To clear the market for external funds</p> Signup and view all the answers

    What is the consequence of market failure in the context of entrepreneurial finance?

    <p>Credit rationing and reduced economic growth</p> Signup and view all the answers

    What is the primary feature of a market with asymmetric information?

    <p>Firms having information that finance providers cannot observe</p> Signup and view all the answers

    What is the role of credit rationing models in the context of entrepreneurial finance?

    <p>To show how credit rationing can be rational under asymmetric information</p> Signup and view all the answers

    What is the main limitation of the Discounted Cash Flow (DCF) model in entrepreneurial finance?

    <p>It requires detailed assumptions and knowledge of the business</p> Signup and view all the answers

    What is the relationship between ρ and z in the context of venture capital?

    <p>ρ = (d + z)/(1-z)</p> Signup and view all the answers

    What is the main difference between the Venture Capital Method (VCM) and the Discounted Cash Flow (DCF) model?

    <p>The DCF model is more theoretically grounded</p> Signup and view all the answers

    What is the purpose of estimating a terminal value in the Discounted Cash Flow (DCF) model?

    <p>To estimate the present value of future cash flows</p> Signup and view all the answers

    What is the impact of uncertainty on the applicability of the Discounted Cash Flow (DCF) model in entrepreneurial finance?

    <p>The DCF model becomes less applicable</p> Signup and view all the answers

    What is the relationship between the Venture Capital Method (VCM) and the Discounted Cash Flow (DCF) model?

    <p>The VCM is a special case of the DCF model</p> Signup and view all the answers

    What strategic challenge do investors provide expertise on market penetration, customer engagement, and geographic expansion?

    <p>Sales challenge</p> Signup and view all the answers

    What is the primary problem with non-disclosure agreements (NDAs) in the context of venture ideas?

    <p>They are often ineffective in protecting sensitive information.</p> Signup and view all the answers

    What type of culture do investors pressure startups to craft?

    <p>Corporate culture</p> Signup and view all the answers

    Why do problems arise when investors replace underperforming managers?

    <p>Founders are inadequate managers</p> Signup and view all the answers

    What is the main challenge in valuing an idea in isolation?

    <p>It is hard to separate the idea from the assets needed to execute it.</p> Signup and view all the answers

    What is the primary purpose of the MATCH Tool?

    <p>To evaluate the fit between investor and entrepreneur.</p> Signup and view all the answers

    What do investors help startups with during the exit challenge?

    <p>Building a profile expected by acquirers</p> Signup and view all the answers

    How many business plans do VC investors examine on average per year?

    <p>200</p> Signup and view all the answers

    What type of relationships do investors help startups establish?

    <p>All of the above</p> Signup and view all the answers

    What do investors provide to help startups with the production challenge?

    <p>Support for identifying suppliers and strategic partners</p> Signup and view all the answers

    What is the primary outcome of Arrow's information paradox?

    <p>The buyer only pays if the quality of the idea can be seen.</p> Signup and view all the answers

    Why are NDAs suitable for project-specific, non-patentable information?

    <p>Because they can protect soft information.</p> Signup and view all the answers

    What is the outcome of investors increasing their involvement with startups?

    <p>A real treatment effect is observed</p> Signup and view all the answers

    What do investors provide to help startups with the organization challenge?

    <p>Support for professionalizing startups</p> Signup and view all the answers

    What is the primary reason why valuing an idea is different from valuing a venture?

    <p>The idea reflects a more basic level of option value.</p> Signup and view all the answers

    What is the main concern when assessing the value of an idea?

    <p>The uniqueness of the idea.</p> Signup and view all the answers

    What is the primary motivation for entrepreneurs to use staged financing?

    <p>To reduce the cost of fundraising and the associated dilution</p> Signup and view all the answers

    What happens to the number of rounds in staged financing as the venture matures?

    <p>The number of rounds decreases</p> Signup and view all the answers

    What is the primary motivation for investors to use staged financing?

    <p>To create option value</p> Signup and view all the answers

    What is the trend of the amount raised in successive rounds of staged financing?

    <p>The amount raised increases</p> Signup and view all the answers

    What is the impact of staged financing on entrepreneurs' ownership?

    <p>It decreases their ownership</p> Signup and view all the answers

    What is the primary driver of growth in entrepreneurial companies, according to Kortum & Lerner (2000)?

    <p>Research and development</p> Signup and view all the answers

    What is the primary benefit of staged financing for entrepreneurs?

    <p>Reduced cost of fundraising</p> Signup and view all the answers

    What is the main characteristic of staged financing?

    <p>It involves raising successive rounds of funding</p> Signup and view all the answers

    What is the primary purpose of using preferred securities in venture capital investments?

    <p>To provide incentives to founders and align investor and entrepreneur expectations</p> Signup and view all the answers

    What happens to the investor's shares if the exit value is above XCOM?

    <p>The investor's shares are converted into common stock</p> Signup and view all the answers

    What is the primary benefit of using preferred securities in venture capital investments?

    <p>Aligning investor and entrepreneur expectations</p> Signup and view all the answers

    What is the typical maturity of a convertible note?

    <p>12-24 months</p> Signup and view all the answers

    What happens to the investor's shares if the exit value is between XCAP and XCOM?

    <p>The investor receives the preferred terms at the capped valuation</p> Signup and view all the answers

    What is the appeal of convertible notes?

    <p>They have a simple, standardized structure</p> Signup and view all the answers

    Why do entrepreneurs prefer to use common stock instead of preferred stock?

    <p>Because it gives them more control over the company</p> Signup and view all the answers

    What is the main purpose of a valuation cap in a convertible note?

    <p>To put a maximum price per share that investors will pay</p> Signup and view all the answers

    What is the primary reason why entrepreneurs accept preferred stock?

    <p>Because they are confident in the company's success</p> Signup and view all the answers

    What happens to a convertible note when a company raises its first qualified funding round?

    <p>It is automatically converted into stock</p> Signup and view all the answers

    What is the result of using preferred securities in venture capital investments?

    <p>It aligns investor and entrepreneur expectations</p> Signup and view all the answers

    What is the conversion rate of a convertible note determined by?

    <p>A pre-determined price discount</p> Signup and view all the answers

    What is the primary benefit of using preferred securities for investors?

    <p>Reducing the risk of investment</p> Signup and view all the answers

    What is the main benefit of using convertible notes for pre-venture companies?

    <p>They delegate and postpone the valuation and negotiation</p> Signup and view all the answers

    What is the formula for the conversion price of a convertible note (PCN)?

    <p>P<del>CN</del> = (1-DIS)*P<del>INV</del></p> Signup and view all the answers

    What is the formula for the number of shares received by a convertible note investor (SCN)?

    <p>S<del>CN</del> = I<del>CN</del>/P<del>CN</del></p> Signup and view all the answers

    What percentage of deals are typically syndicated?

    <p>50-80%</p> Signup and view all the answers

    Why do investors syndicate deals?

    <p>To reduce commitment and diversify their portfolios</p> Signup and view all the answers

    What is the role of lead investors in a syndicate?

    <p>To perform due diligence and negotiate</p> Signup and view all the answers

    What is the impact of syndication on deal performance?

    <p>It has a positive impact on deal performance</p> Signup and view all the answers

    What is the purpose of John Nash's bargaining theory?

    <p>To understand how two parties make deals in a general setting</p> Signup and view all the answers

    What is the benefit of syndication for entrepreneurs?

    <p>It allows them to access complementary expertise and networks</p> Signup and view all the answers

    What is the main reason why angel and seed investors are not often syndicated?

    <p>They are too small to be syndicated</p> Signup and view all the answers

    What is the implication of syndication for venture capital firms?

    <p>It decreases their risk and increases their returns</p> Signup and view all the answers

    What is the typical duration of a Convertible Note (CN)?

    <p>12-24 months</p> Signup and view all the answers

    What is the benefit of using Convertible Notes (CN) for pre-venture companies?

    <p>It delegate/postpone the valuation and negotiation</p> Signup and view all the answers

    What is the conversion rate of a Convertible Note (CN)?

    <p>(1-DIS)*P_INV</p> Signup and view all the answers

    What is the purpose of a valuation cap in a Convertible Note (CN)?

    <p>To limit the maximum price per share that CN investors have to pay</p> Signup and view all the answers

    What is the appeal of Convertible Notes (CN)?

    <p>They are simple, standardized structures</p> Signup and view all the answers

    What is the advantage of Convertible Notes (CN) in terms of ownership?

    <p>They involve virtually no control and other protective rights</p> Signup and view all the answers

    What happens to a Convertible Note (CN) at the first 'qualified' fundraising (Series A)?

    <p>It is automatically converted into stock</p> Signup and view all the answers

    What is the formula to calculate the amount of shares (S-CN) of a Convertible Note (CN)?

    <p>I_CN / (1-DIS)*P_INV</p> Signup and view all the answers

    What is the purpose of using preferred stock in companies?

    <p>To provide incentives to founders and screen out weaker projects</p> Signup and view all the answers

    What happens to the investor's shares for exit values above XCOM?

    <p>They get converted into common stock</p> Signup and view all the answers

    Why do entrepreneurs accept preferred shares?

    <p>Because they are willing to give up their cash flows in case of failure</p> Signup and view all the answers

    What is the effect of using preferred stock on the entrepreneur's incentives?

    <p>It increases the entrepreneur's incentive to work hard</p> Signup and view all the answers

    What is the purpose of preferred stock in aligning investor and entrepreneur expectations?

    <p>To provide a mutually beneficial structure for cash flows</p> Signup and view all the answers

    What happens to the entrepreneur's shares when the company fails?

    <p>They become worthless</p> Signup and view all the answers

    What is the effect of preferred stock on the company's cash flows?

    <p>It reduces the company's cash flows</p> Signup and view all the answers

    Why do investors use preferred stock?

    <p>To reduce their risk</p> Signup and view all the answers

    What is the primary purpose of syndication in venture capital investments?

    <p>To obtain second opinions and reduce commitment</p> Signup and view all the answers

    What is the role of lead investors in a syndicate?

    <p>To perform due diligence and negotiate</p> Signup and view all the answers

    What is the effect of syndication on deal performance?

    <p>It has a positive impact on deal performance</p> Signup and view all the answers

    Who is the Nobel laureate who pioneered the mathematical study of non-cooperative games?

    <p>John Nash</p> Signup and view all the answers

    What is the purpose of involving investors with complementary skills and networks in a syndicate?

    <p>To leverage expertise and networks</p> Signup and view all the answers

    What is the main motivation for VCs to syndicate deals?

    <p>To reduce risk and diversify their portfolio</p> Signup and view all the answers

    What is the primary benefit of syndication for entrepreneurs?

    <p>Access to more capital</p> Signup and view all the answers

    What is the primary purpose of survey evidence in the context of syndication?

    <p>To understand the motivations behind syndication</p> Signup and view all the answers

    Which of the following is NOT a reason why investors syndicate deals?

    <p>Increase their ownership share</p> Signup and view all the answers

    What is the main benefit of syndication for investors?

    <p>To improve their investment choices</p> Signup and view all the answers

    According to the Nash bargaining solution, how many variables do we need to know to understand what deal two parties would strike?

    <p>3</p> Signup and view all the answers

    What is the main driver of economic growth, according to Bob Solow's Nobel insights?

    <p>Technological progress</p> Signup and view all the answers

    What is the purpose of syndication in venture capital?

    <p>To reduce the commitment of each investor</p> Signup and view all the answers

    What is the outcome of VCs increasing their involvement with companies?

    <p>A real treatment effect</p> Signup and view all the answers

    What is the main characteristic of a financially constrained firm?

    <p>It faces capital constraints</p> Signup and view all the answers

    What is the primary role of investors in the entrepreneurial ecosystem?

    <p>To provide capital and networking opportunities</p> Signup and view all the answers

    What is the main advantage of using convertible notes in the seed stage?

    <p>They allow entrepreneurs to defer valuation negotiations</p> Signup and view all the answers

    What is the purpose of the valuation cap in convertible notes?

    <p>To protect investors from paying a high price per share</p> Signup and view all the answers

    What is the conversion rate of convertible notes determined by?

    <p>A pre-determined price discount</p> Signup and view all the answers

    What is the benefit of using a standardized structure for convertible notes?

    <p>It reduces the complexity of the deal</p> Signup and view all the answers

    What is the main purpose of structuring deals in entrepreneurial finance?

    <p>To provide a buffer to sustain the deal</p> Signup and view all the answers

    What is the relationship between the conversion rate and the valuation cap in convertible notes?

    <p>The conversion rate is inversely proportional to the valuation cap</p> Signup and view all the answers

    What is the primary advantage of using convertible notes in pre-venture companies?

    <p>They provide a simple and standardized structure</p> Signup and view all the answers

    What is the typical maturity period of convertible notes?

    <p>12-24 months</p> Signup and view all the answers

    What is the purpose of preferred stock in companies?

    <p>To incentivize founders to work hard and align investor and entrepreneur expectations</p> Signup and view all the answers

    What happens to the investor's shares if the exit value is above XCOM?

    <p>The shares are converted into common stock</p> Signup and view all the answers

    What is the benefit of using preferred stock in companies?

    <p>It incentivizes founders to work hard and aligns investor and entrepreneur expectations</p> Signup and view all the answers

    What is the purpose of using preferred stock in deal structuring?

    <p>To incentivize founders to work hard and align investor and entrepreneur expectations</p> Signup and view all the answers

    What is the benefit of preferred stock for investors?

    <p>It provides a higher return on investment</p> Signup and view all the answers

    What is the benefit of preferred stock for entrepreneurs?

    <p>It incentivizes them to work hard</p> Signup and view all the answers

    What is the implication of using preferred stock for weaker projects?

    <p>It screens out weaker projects</p> Signup and view all the answers

    What is the purpose of using preferred stock in deal structuring, according to the content?

    <p>To incentivize founders to work hard and align investor and entrepreneur expectations</p> Signup and view all the answers

    Study Notes

    Chapter 0: Access to Finance

    • Financial constraints/credit rationing occur when a firm needs external finance but is unable to obtain it.
    • Causes of credit rationing:
      • Adverse selection: banks face borrowers with unknown risk types, and safe firms may not accept high interest rates.
      • Moral hazard: banks cannot observe the effort of entrepreneurs, and firms with insufficient assets cannot convince banks to lend.

    Market Failure

    • Market failure occurs when there is asymmetric information between demand and supply, leading to credit rationing.
    • Examples of market failure:
      • Adverse selection (Stiglitz & Weiss, 1981)
      • Moral hazard (Holmström & Tirole, 1997)

    Adverse Selection

    • Banks face borrowers with unknown risk types, and safe firms may not accept high interest rates.
    • High interest rates lead to higher profits for banks, but safe firms drop out, reducing bank profits.
    • It is rational for banks not to lend beyond a certain interest rate, leading to credit rationing.

    Moral Hazard

    • Banks face borrowers with the same risk type, but different amounts of ex-ante collateral.
    • Entrepreneurs may promise to exert high effort but may not do so, and banks cannot observe effort.
    • Firms need to pledge a minimum level of assets to convince banks to lend, and those with insufficient assets are credit rationed.

    Implications of Financial Constraints

    • Financial constraints have important consequences for:
      • Exports
      • Investments
      • Asset growth
      • Sales growth
      • Employment growth
      • Startup formation

    Chapter 1: Introduction to Entrepreneurial Finance

    • Definition of Entrepreneurial Finance (EF): provision of funding to young, innovative, growth-oriented companies.
    • Key characteristics of EF:
      • Focus on growth firms (not SMEs)
      • Entrepreneurial finance process is long and risky
      • Three fundamental principles:
        • Gathering and recombining resources (Schumpeter)
        • Uncertainty (Frank Knight)
        • Experimentation (James March)

    Challenges of EF

    • Entrepreneurial perspective:
      • Getting funded is difficult
      • Diversity of investors with different characteristics
    • Investor perspective:
      • Swamped with proposals, most of which are bad or not a good fit
      • Long and costly investment process

    Importance of EF

    • Entrepreneurial perspective:
      • Money is a key resource for entrepreneurs
      • Investors impact the company
    • Investor perspective:
      • Search for returns, portfolio diversification, or strategic objectives
      • Pass on knowledge and expertise
    • Broader economic and societal perspective:
      • Market-driven selection system
      • Creates jobs, innovation, and economic growth

    And so on...### Entrepreneurial Venture Management

    Solution

    • The proposed solution should solve the customer's need.
    • It should be compared to alternatives.
    • The innovation should be protected to some extent.

    Team

    • Talent is a scarce resource.
    • Founders should have required skills and experience.
    • Motivation and commitment are important.
    • Integrity and trustworthiness are essential.
    • Solo founder vs. founder teams should be evaluated.

    Market

    • The size of the opportunity should be determined.
    • The target market size and growth rate should be assessed.
    • The adoption process should be understood.
    • Transformative and incremental innovations should be considered.

    Competition

    • The competition should be known.
    • Current and future competitors should be identified.
    • The nature of competition should be understood.
    • The venture should differentiate itself.

    Network

    • The founders' network can provide access to resources.
    • The team's reputation and network should be evaluated.
    • The quality of network ties should be assessed.

    Sales

    • The product should be brought to customers.
    • The venture should reach its customers.
    • Marketing and distribution strategies should be outlined.
    • Pricing strategies and revenue models should be determined.

    Production

    • Value creation should be captured.
    • Development strategies should be outlined.
    • The scope of activities and partnering strategies should be determined.
    • Operational efficiency should be assessed.

    Organization

    • Company leadership should be developed and maintained.
    • The role of the founders should evolve.
    • Governance structure should be established.
    • Talent strategy should be outlined.

    Venture Evaluation Model (VEM)

    • The VEM assesses a venture's attractiveness across three perspectives:
      1. Ability to create value.
      2. Ability to achieve scale.
      3. Ability to grow and capture value.
    • The VEM identifies a venture's main risks, including market, technology, and people risks.

    How Entrepreneurs can use the VEM

    • The VEM helps identify strengths and weaknesses.
    • It exposes assumptions underlying the opportunity.
    • It reflects on where the business model is rooted.
    • It helps decide if the business opportunity is convincing.

    How Investors can use the VEM

    • The VEM helps identify if the business plan is convincing.
    • It guides due diligence.
    • Different investors have different decision processes and rules.

    Financial Planning

    • Financial planning predicts financing needs and timing.
    • It helps negotiate terms of external financing.
    • It chooses between different project/policy options.
    • It avoids surprises.

    Two Horizons of Financial Planning

    • Medium/long-term financial planning (machines, growth planning, and financial policy).
    • Short-term financial planning (cash management and working capital management).

    Growth Management

    • Growing companies require investments in production facilities, buildings, equipment, etc.
    • Not every industry needs large investments in fixed assets to grow.
    • Growing affects working capital requirements.

    Working Capital Management

    • Let's look at the production and sales cycle.
    • Increase in profits and increase in working capital requirement.

    The Financial Plan

    • The financial plan should illustrate the financial attractiveness of a venture and determine its financing needs.
    • Learn about key forecast metrics (revenues, costs, cash flows).
    • Identify milestones that can be used to provide salient information about the venture's progress.
    • Pitch a financial plan to investors.

    Two Key Questions

    1. How financially attractive is the venture?
    2. What financial resources does the venture need?

    Building Financial Projections

    • Define a timeline (milestones, time horizon, level of detail).
    • Estimate revenues (unit, price, quantity).
    • Estimate costs (cost of goods sold, operating expenses, development costs).
    • Build the three financial statements (income statement, balance sheet, cash flow statement).
    • Formulate the financial plan.

    Limitations of Financial Projections

    • Financial projections are always inaccurate, especially for early-stage companies.
    • Financial projections quickly become outdated.
    • Financial projections are always optimistic.

    Structure of Financial Projections

    • Income Statement (IS): business model and profitability.
    • Balance Sheet (BS): size, asset base structure, and financing.
    • Cash Flow Statement (CF): cash changes from IS and BS.

    Sources of Information

    • Primary data research (directly from the market).
    • Secondary data research (filtered and prepared).
    • Learn from the experience of similar companies.
    • Use own past performance (when available).

    How to Build Financial Projections

    • Step 1: Define a timeline.
    • Step 2: Estimate revenues (unit, price, quantity).
    • Step 3: Estimate costs (cost of goods sold, operating expenses, development costs).
    • Step 4: Build the three financial statements.
    • Step 5: Formulate the financial plan.Here are the study notes for the text:

    Pitching the Financial Plan

    • A financial plan should answer two key questions convincingly:
      • What funding does the venture need, and when?
      • How will the venture generate returns for investors?
    • Key points to cover in a pitch:
      • Discussion of underlying assumptions
      • Revenues: level, growth, timing
      • Costs: nature, level, growth
      • Profitability: drivers and timing
      • Funding needs and cash flow analysis

    Behavioral Biases and the Pitch

    • Behavioral biases can affect investment decisions, e.g.:
      • Framing of information can influence investment choices
      • Sunk cost fallacy can lead investors to pour more money into failing ventures
      • Over-optimism is a common bias among entrepreneurs
    • Nudging can be used to reduce the impact of behavioral biases

    Ownership and Returns

    • Ownership is central to structuring an investment
    • Valuation determines the percentage of equity received for an investment and expected returns
    • Pre-money and post-money valuations are important concepts:
      • Pre-money valuation: valuation before investment
      • Post-money valuation: valuation after investment
    • The capitalization table (Cap Table) tracks ownership stakes and investments across funding rounds
    • Dilution occurs when new shares are issued, reducing current shareholders' ownership fractions

    Investor Returns

    • Three measures of investor return:
      • Net Present Value (NPV)
      • Internal Rate of Return (IRR)
      • Cash on Cash Multiple (CCM)
    • Each measure has its strengths and weaknesses
    • NPV takes into account the time value of money, but requires an appropriate discount rate
    • IRR is a common measure, but does not account for risk or the level of investment
    • CCM is simple, but does not account for the time value of money or risk

    Valuation Methods

    • Four main approaches to valuing entrepreneurial companies:
      1. Venture Capital Method (VCM)
      2. Discounted Cash Flow Model (DCF)
      3. Comparables Method
      4. Probabilistic approaches with model uncertainty
    • The VCM is a popular method, but requires estimating four inputs:
      • Investment amount (I)
      • Time to exit (T)
      • Exit value (Xe)
      • Required rate of return (ρ)

    The Venture Capital Method (VCM)

    • The VCM estimates post-money valuation as Xe / (1 + ρ)^T^
    • VCM requires an estimate of the exit value, time to exit, and required rate of return
    • The required rate of return consists of five elements:
      • Financial risk-premium
      • Illiquidity premium
      • Failure rate premium
      • Service premium
      • Systematic risk premium (β)

    Nobel Insights: Behavioral Biases, CAPM, and Failure Risk Premium

    • Behavioral biases can affect investment decisions
    • CAPM helps estimate the required rate of return
    • Failure risk premium can be estimated using past experience or a model
    • Approaches to calculating the failure premium include using a "large number" or developing a model to capture uncertainty

    Access to Finance

    • A firm is financially constrained if it has a need for external finance but is unable to obtain it.
    • Financial constraints prevent a firm from funding all desired investments.
    • The interest rate clears the market for external funds, and credit rationing occurs when firms are willing to borrow at the equilibrium interest rate but are unable to do so.

    Market Failure

    • Market failure occurs when there is a characteristic inherent to the market, leading to a feature of the long-run equilibrium.
    • Examples of market failure include asymmetric information between demand and supply, adverse selection, and moral hazard.

    Credit Rationing

    • Credit rationing can be rational under asymmetric information, leading to different allocations.
    • Frictions in the market can lead to credit rationing.

    Entrepreneurial Perspective

    • Getting funded is often considered hard, and entrepreneurs face a bewildering diversity of investors with different characteristics.
    • It is difficult to reach out to investors and overcome challenges on both sides.

    Investor Perspective

    • Investors are swamped with proposals, most of which are bad or a poor fit, and the investment process is long and costly.
    • Investors search for returns, portfolio diversification, or strategic objectives, and pass on knowledge and expertise.

    Importance of Entrepreneurial Finance

    • Entrepreneurial finance is important because money is a key resource for entrepreneurs, and investors impact the company.
    • Investors search for returns, portfolio diversification, or strategic objectives, and pass on knowledge and expertise.
    • Entrepreneurial finance creates jobs, innovation, and economic growth.

    Nobel Insights: What Drives Growth?

    • Economic growth is driven by technological progress or "total factor productivity" (TFP) once labor and capital are fully employed.
    • Studies have investigated the links between corporate innovation, entrepreneurship, and TFP.

    Drivers of Long-term Growth

    • Venture capital (VC) funding leads to higher total factor productivity (TFP) than corporate R&D spending.
    • Increases in local VC funding increase the local start-up rate, employment, and aggregate income.

    Dilution

    • Dilution is the reduction in the ownership fraction of current shareholders due to the issuance of new shares at any new financing round.
    • The ownership fraction can be calculated across rounds.

    Investor Returns

    • Realized returns are backward-looking objective measures of what an investment has yielded.
    • Expected returns are forward-looking expectations.
    • Skewness in returns indicates that low returns are more probable than high returns.

    Risk and Return

    • A basic principle of finance is that one can achieve higher return by taking more risk.
    • Risk-averse investors want a higher return to be compensated for additional risk.
    • A risk-averse investor would be willing to pay more for an investment that has lower risk for a given return.

    Additional Clauses

    • Drag-along rights imply that investors can force other shareholders to sell their stock.
    • Registration rights and piggy-back rights imply that right holders can force a listing.
    • Information rights allow investors to obtain hard data.
    • Key Man Insurance provides insurance for investors in case a key person passes away.
    • Legal resolutions, representations, and warranties, and negotiation clauses are important in investment agreements.

    Valuation vs Terms

    • Valuation is the most visible term, but cash flow rights and other terms can undo a generous valuation.
    • Some trade-offs make clear that negotiation is not a zero-sum game.

    How Investors Add Value

    • Investors add value through four types of activities: mentoring and coaching, advising, networking, and pressuring.
    • Investors help entrepreneurs cope with challenges, provide guidance, networking opportunities, and monitoring to suggest strategic changes.

    Financial Constraints and Credit Rationing

    • A firm is financially constrained if it cannot obtain external finance despite having a need for it.
    • Credit rationing occurs when firms willing to borrow at the equilibrium interest rate are unable to do so due to funding providers' reluctance to lend.

    Market Failure

    • Market failure occurs when a characteristic inherent to the market prevents it from functioning efficiently.
    • Asymmetric information between demand and supply can lead to market failure.

    Models of Credit Rationing

    • Credit rationing can be rational under asymmetric information.
    • Notation: z = failure probability, d = discount rate.
    • Probability of surviving until exit at T = (1-z)^T.
    • Expected exit value: X^e^ (1-z)^T.
    • Discounted value: VPOST = X^e^ (1-z)^T / (1+d)^T.

    The Discounted Cash Flow (DCF) Model

    • Theoretically grounded, but less popular in practice.
    • Models company cash flows, requiring detailed assumptions and knowledge of the business.
    • The DCF model can be written as: VPOST = X^e^ (1-z)^T / (1+d)^T.
    • Uncertainty of entrepreneurial ventures makes the DCF model less applicable, except at later stages.

    Disclosure Dilemma

    • The disclosure dilemma arises when entrepreneurs need to disclose their idea to attract investors, but fear that the idea will be stolen.
    • Two solutions to the disclosure dilemma: patenting and using non-disclosure agreements (NDAs) for objective, project-specific, non-patentable information.

    Valuing an Idea

    • Valuing an idea is different from valuing a venture, as it reflects a more basic level of option value.
    • An idea is only worth something if it can improve the profitability of alternative uses of the necessary assets.

    Screening

    • Investors vet proposals for investment opportunities, examining an average of 200 business plans per year.
    • The MATCH Tool assesses the fit between investor and entrepreneur, considering geography, industry, stage, and other factors.

    Investor Value-Adding

    • Investors provide strategic advice, expertise, and support in various areas, such as market penetration, supplier identification, and professionalizing start-ups.
    • Investors help entrepreneurs build a profile that acquirers or stock markets expect.

    Modelling Agency Conflicts

    • Agency conflicts arise when the interests of entrepreneurs and investors diverge.

    Staged Financing

    • Most start-ups only raise one round of financing, but those that survive typically raise additional rounds.
    • Staged financing reduces the cost of fundraising and the associated dilution for entrepreneurs.
    • Staged financing creates options for investors.
    • Key features of staging include:
      • The number of rounds decreases as the venture matures.
      • The raised amount increases over the rounds.
      • Later stages raise more money than early stages.

    Term Sheets

    • Low funding amounts (< $100,000) and unsophisticated investors characterize the seed ("pre-venture") stage, where most companies likely fade away.
    • Convertible Notes (CN) address these issues by being automatically converted into stock at the first "qualified" fundraising (Series A) with a pre-determined price discount (10-20%) and maturity of 12-24 months.

    Convertible Notes (CN)

    • CNs are debt-like claims with a simple, standardized structure that saves on legal costs and involves virtually no control or protective rights.
    • They delegate/postpone valuation and negotiation, allowing for a conversion rate of PCN = (1-DIS) * PINV.
    • Ownership is calculated as SCN = ICN/PCN = ICN/(1-DIS) * PINV.
    • A valuation cap is used to avoid "paying for success".

    Structuring Deals

    • Deals rely on hard elements (valuation, term sheet) and soft elements (size, security type, board of directors) to provide a buffer for a productive partnership.
    • Soft elements include considering how parties work together and whether they can trust each other.

    Syndication

    • Syndication is common (50-80% of deals) and involves getting more investors on board, investing alongside other investors.
    • Investors syndicate deals to:
      • Obtain second opinions
      • Reduce commitment and diversify
      • Reciprocate invitations
      • Involve investors with complementary skills and networks
    • Lead investors perform due diligence, negotiate, and sit on boards of directors, while followers provide capital, on-demand expertise, and networks.
    • Syndication tends to improve deal performance, allow for better investment choices, and attract co-investors that are a good fit.

    Nobel Insights: Bargaining Theory

    • John Nash's (Nobel, 1994) "Nash bargaining solution" shows that understanding deal-making can be simplified to three variables.

    Why Preferred Securities?

    • Three main rationales for using preferred stock:
      1. Provide incentives to founders (need for balance)
      2. Screen out weaker projects (dealing with the "lemon" problem)
      3. Align investor and entrepreneurs' expectations

    Term Sheets

    • Low funding amounts (< $100,000) and unsophisticated investors characterize the seed ("pre-venture") stage, where most companies likely fade away.
    • Convertible Notes (CN) address these issues by being automatically converted into stock at the first "qualified" fundraising (Series A) with a pre-determined price discount (10-20%) and maturity of 12-24 months.

    Convertible Notes (CN)

    • CNs are debt-like claims with a simple, standardized structure that saves on legal costs and involves virtually no control or protective rights.
    • They delegate/postpone valuation and negotiation, allowing for a conversion rate of PCN = (1-DIS) * PINV.
    • Ownership is calculated as SCN = ICN/PCN = ICN/(1-DIS) * PINV.
    • A valuation cap is used to avoid "paying for success".

    Structuring Deals

    • Deals rely on hard elements (valuation, term sheet) and soft elements (size, security type, board of directors) to provide a buffer for a productive partnership.
    • Soft elements include considering how parties work together and whether they can trust each other.

    Syndication

    • Syndication is common (50-80% of deals) and involves getting more investors on board, investing alongside other investors.
    • Investors syndicate deals to:
      • Obtain second opinions
      • Reduce commitment and diversify
      • Reciprocate invitations
      • Involve investors with complementary skills and networks
    • Lead investors perform due diligence, negotiate, and sit on boards of directors, while followers provide capital, on-demand expertise, and networks.
    • Syndication tends to improve deal performance, allow for better investment choices, and attract co-investors that are a good fit.

    Nobel Insights: Bargaining Theory

    • John Nash's (Nobel, 1994) "Nash bargaining solution" shows that understanding deal-making can be simplified to three variables.

    Why Preferred Securities?

    • Three main rationales for using preferred stock:
      1. Provide incentives to founders (need for balance)
      2. Screen out weaker projects (dealing with the "lemon" problem)
      3. Align investor and entrepreneurs' expectations

    Term Sheets

    • Low funding amounts (< $100,000) and unsophisticated investors characterize the seed ("pre-venture") stage, where most companies likely fade away.
    • Convertible Notes (CN) address these issues by being automatically converted into stock at the first "qualified" fundraising (Series A) with a pre-determined price discount (10-20%) and maturity of 12-24 months.

    Convertible Notes (CN)

    • CNs are debt-like claims with a simple, standardized structure that saves on legal costs and involves virtually no control or protective rights.
    • They delegate/postpone valuation and negotiation, allowing for a conversion rate of PCN = (1-DIS) * PINV.
    • Ownership is calculated as SCN = ICN/PCN = ICN/(1-DIS) * PINV.
    • A valuation cap is used to avoid "paying for success".

    Structuring Deals

    • Deals rely on hard elements (valuation, term sheet) and soft elements (size, security type, board of directors) to provide a buffer for a productive partnership.
    • Soft elements include considering how parties work together and whether they can trust each other.

    Syndication

    • Syndication is common (50-80% of deals) and involves getting more investors on board, investing alongside other investors.
    • Investors syndicate deals to:
      • Obtain second opinions
      • Reduce commitment and diversify
      • Reciprocate invitations
      • Involve investors with complementary skills and networks
    • Lead investors perform due diligence, negotiate, and sit on boards of directors, while followers provide capital, on-demand expertise, and networks.
    • Syndication tends to improve deal performance, allow for better investment choices, and attract co-investors that are a good fit.

    Nobel Insights: Bargaining Theory

    • John Nash's (Nobel, 1994) "Nash bargaining solution" shows that understanding deal-making can be simplified to three variables.

    Why Preferred Securities?

    • Three main rationales for using preferred stock:
      1. Provide incentives to founders (need for balance)
      2. Screen out weaker projects (dealing with the "lemon" problem)
      3. Align investor and entrepreneurs' expectations

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    Description

    This quiz covers the concept of financial constraints and credit rationing in entrepreneurial finance, including the definition and implications of financial constraints for firms.

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