Entrepreneurial Finance Chapter 0: Access to Finance

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