Samenvatting BF.docx

ENTREPRENEURIAL FINANCE -- SAMENVATTING ======================================= KU Leuven \| TEW MA1 CHAPTER 0: ACCESS TO FINANCE ============================ Financial constraints/credit rationing? --------------------------------------- A firm is financially constrained if it has a need for ex...

ENTREPRENEURIAL FINANCE -- SAMENVATTING ======================================= KU Leuven \| TEW MA1 CHAPTER 0: ACCESS TO FINANCE ============================ Financial constraints/credit rationing? --------------------------------------- A firm is financially constrained if it has a need for external finance, but is unable to obtain it. Lamont et al. (2001; Review of Financial Studies): "by 'financial constraints' we mean frictions that prevent the firm from funding all desired investments." no access while it wants to do investments Afbeelding met lijn, diagram, Perceel, helling Automatisch gegenereerde beschrijving The interest rate clears the market for external funds - If demand \> supply, the interest rate will increase - If demand \< supply, the interest rate will decrease Credit rationing: there exist firms that are willing to borrow at the equilibrium interest rate (or at a higher rate) but are unable to do so, because funding providers don't want to lend to them ### Market failure? Market failure if it is the result of some characteristic that is inherent to the market. It is thus a feature of the long-run equilibrium. For example: - There is typically asymmetric information between demand and supply! Firms have information that finance providers cannot observe. - In the presence of adverse selection or moral hazard asymmetric information can lead to market failure. Models of credit rationing -------------------------- Credit rationing can be rational under asymmetric information. If frictions wouldn't be there, allocations would be different. For example, due to - Adverse selection (Stiglitz & Weiss, 1981; American Economic Review) - Moral hazard (Holmström & Tirole, 1997; Quarterly Journal of Economics) ### ADVERSE SELECTION Banks face borrowers with unknown risk type - Riskiness of firm/projects Banks know the distribution of firm types in the economy, but not the type of each individual firm Firms with risky projects have a low chance of success and thus of repayment, but when they are successful, the return is very high. Firms with safe projects have a high chance of success and thus of repayment. When they succeed, the return is not particularly high. Banks choose their supply (and thus implicitly set the interest rate) such that they maximize their profits! Ceteris paribus, higher interest rates lead to higher profits. Twist in the model: - Safe firms will not accept high interest rates - Only risky firms accept high interest rates This leads to adverse selection if the interest rate is too high! bit of a paradox Safe firms repay with high certainty, but their return is low - High interest rates = high borrowing costs \> return when successful Risky firms repay with low certainty, but their return is very high - High interest rates = high borrowing costs \< return when successful Bank profits no longer monotonically increase with the interest rate! Bank profits increase with the interest rate, up to the point when safe firms start to drop out. From that point onwards, bank profits decrease with the interest rate. It is rational for banks not to lend beyond a certain interest rate. - Even though there are firms with a positive demand for external funding at higher interest rates. The unserved firms are credit rationed in equilibrium. ### MORAL HAZARD Banks face borrowers with same risk type, but different assets - Same riskiness of firms/projects - Different amounts of ex-ante collateral Chance of project success does not depend on firms' collateral. Chance of project success depends on effort of the entrepreneur. - High effort → high likelihood of project success - Low effort → low likelihood of project success Banks choose their supply of external funding to maximize profits. Profits depend on the success of the entrepreneurs and thus on the effort of the entrepreneurs. Twist in the model: - Entrepreneurs also benefit from leisure. - The more effort their exert, the less time they have for leisure. Entrepreneurs might promise to exert high effort but change their effort once they have received the funding and banks can't force you to provide enough effort. Banks cannot observe the effort of the entrepreneur - Firms will need to pledge a minimum level of assets to the bank - This way, firms incur some of the investment risk themselves Only if firms have sufficient "skin in the game," can the bank be sure that entrepreneurs exert the necessary effort. Firms with insufficient assets cannot convince the bank that they will exert effort. They are credit rationed and their projects will not get funded. Importantly, due to moral hazard under asymmetric information, it is rational for banks not to lend to some firms (those with insufficient pledgeable assets). Implications of financial constraints ------------------------------------- Financial constraints have important consequences for - Exports - Investments - Asset growth - Sales growth - Employment growth - Startup formation  Afbeelding met tekst, schermopname, software, scherm Automatisch gegenereerde beschrijving This is only change in 1 year, but there are clear LT effects  Afbeelding met tekst, diagram, schermopname, nummer Automatisch gegenereerde beschrijving example of legal change for Denmark, suddenly a lot of people had more collateral and relaxes constraint - difference between experience and no experience - higher rate of start up formation CHAPTER 1: INTRODUCTION TO ENTREPRENEURIAL FINANCE ================================================== What is Entrepreneurial Finance (EF)? -------------------------------------  Afbeelding met tekst, schermopname, Lettertype, cirkel Automatisch gegenereerde beschrijving we focus on growth firms We can define entrepreneurial finance as the provision of funding to young, innovative, growth-oriented companies - Young: typically \< 10 years - Innovative: technology or business model - Growth-oriented: different from SMEs Investors: great variety that we need to understand Entrepreneurial finance process: long & risky - Need to understand actors & steps - Helpful to define three fundamental principles ### Three fundamental principles Entrepreneurship can be characterized by three fundamental principles *Gathering and recombining resources (Joseph Schumpeter)* Entrepreneurship as a recombination of existing resources to create new sources of value (Schumpeter, 1930s) - Entrepreneurs need to convince resource owners to provide the resources. - Financing is a key resource because money allows the entrepreneurs to acquire other resources (employees, equipment,...). #### Uncertainty (Frank Knight) The entrepreneurial process is inherently uncertain (Knight, 1930s) - "risk" (potential outcomes are known) ↔"uncertainty" (potential outcomes and their probabilities are unknown) - Once outcomes are well-understood, business opportunities are no longer "entrepreneurial" but "managerial." #### Experimentation (James March) Entrepreneurship consists of experimentation & dynamic flexibility (March, 1960s) - "exploration" (entrepreneurial firms) ↔"exploitation" (established firms) - The organizational structure matters for incentives & ability to "pivot" (to respond dynamically to market feedback). if you fix certain things in the beginning, you potentially face high costs when you need to pivot to new markets Why is EF challenging? ---------------------- Entrepreneurial perspective: - Getting funded is often (considered) hard. - Bewildering diversity of investors with different characteristics - often difficult to reach out to Investor perspective: - Swamped with proposals -- most of them bad or a poor fit. - Long and costly investment process Not easy to overcome challenges on both sides at the same time! Why is EF important? -------------------- Entrepreneurial perspective: - Money is a key resource for entrepreneur - Investors impact the company ("money is not green") Investor perspective: - Search for returns, portfolio diversification, or strategic objectives - Pass on knowledge & expertise Broader economic & societal perspective: - Market-driven selection system - Creates jobs, innovation, and economic growth #### Nobel Insights: What drives Growth? We will link to fundamental economic insights occasionally - To better understand them. - To illustrate their practical relevance, including for entrepreneurial finance. [Bob Solow (1987): What drives economic growth?] - Once labor and capital are fully employed, the key driver of economic growth is technological progress or "total factor productivity" (TFP). Economists have investigated the links of (corporate) innovation and entrepreneurship with TFP. #### Drivers of long-term growth Examples of findings from such studies: Chemmanur et al. (2011, Review of Financial Studies): - Start-ups that have received Venture Capital (VC) funding have significantly higher TFP than a control group of start-ups without it. Kortum & Lerner (2000, RAND Journal of Economics): - VC generates more innovative outputs (as measured by patent rates) than corporate R&D spending. Samila & Sorenson (2011, Review of Economics & Statistics): - Increases in local VC funding increase the local start-up rate, employment, and aggregate income. → Entrepreneurial finance contributes to economic growth! #### Which companies create jobs? Several studies investigate who creates lasting jobs: - Young firms make a very significant contribution to net job creation. - Important distinction: The same is not true for small firms! - Only few "Gazelles" (fast growing start-ups) eventually become large companies, as many die out during their growth. Our focus is on start-ups that aim at growing fast into large companies, i.e., on "(entrepreneurial) ventures". In Entrepreneurial Finance (D0O46A), we do not study SME financing. #### Some Data on EF: survival rates A key fact of entrepreneurship is that "death is the rule." Only few start-ups survive. Puri & Zarutskie (2012, Journal of Finance) - After 10 years (from founding), the failure rate of US VC-backed start-ups is about 32%. For comparable non-VC backed start-ups it is about 62%. - In the long-run VC backed companies account for 0.1% of US start-ups, but for 5.5% of US employment US VC Investments are increasing  red line is where previous picture stopped, so funding has not slowed down \--\> growing market Afbeelding met tekst, diagram, schermopname, Perceel Automatisch gegenereerde beschrijving Global VC investments similar trend  Slight slow down, but pick-up immediately after Afbeelding met tekst, schermopname, lijn, Lettertype Automatisch gegenereerde beschrijving HOW CAN WE UNDERSTAND IT? ------------------------- 2 frameworks: Why Frameworks? You should leave with a deep understanding of the entrepreneurial finance process: - Not short-lived facts... -... but long-lived conceptual tools to understand the world. Frameworks are simplified models of reality that help to understand it ### The FIRE framework FIT: - matching process between entrepreneurs & investors INVEST: - process of closing a deal -- money for ownership RIDE: - the path forward, with all the surprises and pivots that are endemic to the entrepreneurial process EXIT: - process by which investors sell some or all of their shares to obtain a return on their investment #### The FIT Step Entrepreneur and investor face a search challenge - Who are the potentially relevant partners? - Involves networking, information gathering, processing,... Entrepreneur and investor also face a selection challenge - Screening and signalling by both parties - Involves deep due diligence: track records, credibility, "clicking",... #### The INVEST Step There are four main forces that typically affect a deal 1. Needs of the entrepreneur - company requirements and own preferences 2. Needs of the investor - own preferences (see FUEL framework) 3. Expectations - about the venture's future 4. Market conditions - e.g., because they affect the parties' relative bargaining power #### The RIDE Step The entrepreneur and the investor jointly grow the company. The process requires: - Learning about the company, the market, and about each other - Involves adjusting the strategy, building/destroying trust - Governance: Who decides when there is disagreement? - Involves, for example, to decide on the composition of the board of directors #### Intermezzo staged financing The FIRE framework encompasses staged financing - Money is provided over several rounds, e.g., every 12/18 months (investor provides cash in different rounds) - The provision is milestone-based - Staging ↔Tranching Staging involves costs and benefits for entrepreneurs and investors, but it is often mutually advantageous. For the entrepreneur: - Staging reduces fundraising cost and dilution - Staging introduces refinancing risk (internal & external) For the investor: - Staging creates "option value of waiting" - Staging increases control through the "power of the purse" Option value of waiting:  During times of uncertainty, this makes the option value to wait for more and better information upon which to base investment decisions extremely high at such times, Terminology may appear confusing, but is rather straightforward: Financing rounds are consecutive and numbered - Each round corresponds to a set of securities, called Series in alphabetical sequence (A, B, C,...) - Pre-VC rounds are called seed, but some VCs call their own first rounds seed round (not so straightforward) Stages reflect venture developments, from seed to late. a round refers to a sequence of investments in the same startup, while a stage refers to the degree of business maturity a startup has reached when raising funds #### The EXIT Stage This is a crucial moment. It is when returns are realized. Key decisions include: - When to exit? - Timing constraints of the different parties matter and may lead to conflicts - How to exit? - A successful exit can be via IPOs, acquisitions, sales to financial buyers (secondary/buyout) - An unsuccessful exit can involve closing down with or without bankruptcy ### The FUEL Framework fire helps you with whole entrepreneurial process, fuel framework should help with categorising the funding possibilities Reflects the investor's nature & approach to the deal Focuses on the investor's defining traits, is there a fit with the entrepreneur? - Fundamental structure \| Who is the investor? - Underlying motivation \| What does she want? - Expertise & networks \| What does she contribute? - Logic & style \| How does she operate? #### The Fundamental structure What is the investor's identity? What are their organizational structures and financial resources? - E.g.: Whose money does she invest and how much? Who makes decisions and how? What are the governance structures? - Think, for example, about the difference between a VC fund and an individual angel investor  structure differences: VC funds have limited partners that don't interact with company, but they have requirements in terms of returns. GPs interact with company \ angel investor only responsible to himself, so more involved. Structure you choose depends on your preferences #### The Underlying motivation What does the investor want? How does she value financial and non-financial returns? - Personal, social, strategic objectives may drive decisions How risk-tolerant and patient is she? - The time horizon is important: it affects the strategy and exit choice Think (again) about the difference between a VC fund and an individual angel investor. #### The Expertise and Networks What does the investor contribute to the venture? What expertise and networks does she possess? - Expertise refers to the investor's own knowledge and skills - Networks refer to the knowledge and skills that become accessible through the investor How is the investor's standing with their peers? - Should be part of (mutual) due diligence and a key validation point Think (again) about the difference between a VC fund and an individual angel investor. #### The Logic and Style How does the investor operate? Logic: How does the investor select companies? - Criteria can include industry, location, stage, amount,... Style: How does the investor interact with companies? - This links to the FIT stage of the FIRE framework Think (again) about the difference between a VC fund and an individual angel investor. Chapter 2: Evaluating Business Opportunities ============================================ Goals ----- - Learn a structured framework for evaluating venture opportunities. - Learn to break down a business' value proposition into its individual components. - Learn to assess the attractiveness, risks, and competitive advantages of a new venture. - Learn to perform due diligence on a new venture's business plan. Evaluating a Business Opportunity --------------------------------- The starting point for any investment is evaluating the proposed business opportunity. Will the opportunity be sufficiently profitable (for a given risk)? - Will the entrepreneur be able to appropriate a fair share? - Will each resource provider be able to do so? Importance of conceptual strength: method vs. "gut feeling" Absolute and relative evaluation. Evaluating an opportunity is (of course) important for the investor. But it is also a key exercise for the entrepreneur e.g., to anticipate the investor's view A structured approach to evaluation can help answer questions like: - Will the opportunity generate the returns an investor seeks (for given risks)? - How can the opportunity be refined and improved? → The VENTURE EVALUATION MATRIX is a useful tool VENTURE EVALUATION MATRIX (VEM) LogicAfbeelding met tekst, schermopname, Lettertype, nummer Automatisch gegenereerde beschrijving --------------------------------------------------------------------------------------------------------------------------------- ### Key actors  ### Key perspectives Afbeelding met tekst, schermopname, Lettertype Automatisch gegenereerde beschrijving ### The VEM The VEM is a tool that helps you to evaluate the strength of an entrepreneurial idea by assessing how it might generate value. - Start with the micro perspective, move to the macro perspective and to the ability to be dynamically sustainable. - Derive the opportunity's competitive advantages and attractiveness - Assess the long-term economic viability of the opportunity - Solid foundations - Comprehensive - Easy to use Incorporates the entrepreneurial and investor perspectives ### VEM CELLS #### NEED Know thy customer! - What exactly is the customer need? - How strong is the need? How well do customers understand it? - How much are customers able & willing to pay? Is the proposition aimed at individual or corporate customers - May, for example, have a different decision process Can we learn something from early adopters? - Iterative exploration #### SOLUTION Know thy product! - Does the proposed solution solve the customer's need? - How does the proposed solution compare to the alternatives? - To what extent can the innovation be protected? Solutions are often found through an iterative process of experimenting across many different possibilities and feedback from multiple sources (not a unique Aha! moment) - Role of product experimentation - Design thinking #### TEAM Talent is the scarce resource! - Do the founders have the required skills and experience? - What are their motivation and commitment? - Is the founder team complementary and cohesive? Investors often "invest in people, not ideas" - Integrity & trustworthiness are important - Solo founder vs. founder teams - Evaluating the team can only be done simultaneously with evaluating the business challenges Micro level: we need to understand the customer, the product and the team #### MARKET How big is the opportunity? - How large is the target market? - How fast will the target market grow? - How will adoption take place? Transformative vs incremental innovation - Transformative: you develop a completely new product - Incremental: you continue to build on an existing product Adaptation process and market timing Product life-cycle: S-curve  #### COMPETITION Know thy competitors! - Who are current and future competitors? - What is the nature of competition? - How can the venture differentiate itself? Cooperation vs. competition Nature of barriers to entry and product longevity #### NETWORK The founders' network can provide access to resources - What is the founding team's reputation? - What network does the team have access to? - How does the team forge and maintain new relationships? Importance of network centrality (Network centrality: your network being central and having access to lots of people) - Quality of network ties: connectedness, diversity, position D is valuable as he opens up 3 other clusters!! easy MC ex question Macro: we value the business opportunity #### SALES How is the product brought to customers? - How does the venture reach its customers? - What are the marketing and distribution strategies? - What are the pricing strategies and the revenue model? Transformative vs incremental products - Natural resistance to adoption #### PRODUCTION How does the company capture value creation? - What is the development strategy? - What are the scope of activities and the partnering strategies? - How efficient are operations? Importance of technical milestones/securing key inputs - Decide on the boundaries of the firm #### ORGANIZATION How to develop and maintain company leadership? - How will the role of the founders evolve? - What is the governance structure? - What is the talent strategy? Develop a cultural imprint Talent recruiting and retention Founder succession ### taking stock The VEM allows to draw conclusions across rows by assessing the attractiveness of the venture in the three perspectives 1. The ability to create value 2. The ability to achieve scale 3. The ability to grow and capture value The VEM allows to draw conclusions across columns by assessing the competitive advantage of the venture in the three domains 1. The ability to gain access to customers 2. The ability to erect and maintain entry barriers 3. The ability to develop key competences The VEM allows to assess a venture's main risks, also across the three vertical dimensions 1. Market risk 2. Technology risk 3. People risk ### How Entrepreneurs can use the VEM The entrepreneur can use the VEM to identify and assess the strengths and weaknesses of her venture. - Is the proposition fully convincing? - Does pursuing the idea require some pivoting? - Should the idea be dropped? More specifically, the VEM provides a framework to - Identify where uncertainty is greatest - Expose the assumptions that underlie the opportunity - Reflect on where the business model is rooted - Decide if the business opportunity is cogent & convincing - Which parts can be improved or might be sinking the project? - The role of the VEM may be different at different development stages If the entrepreneur decides to proceed with contacting investors, she can use the VEM to structure her business plan (BP). The business plan has two meanings - It provides a strategic framework for guiding the venture - It describes the venture to outside parties The VEM can contribute to both. Our focus is on the second meaning. A BP needs a simple but convincing structure. - It requires an overview of the business opportunity - It should provide a detailed, yet concise, analysis of the main challenges - It should contain a set of financial projections A possible configuration of a business plan, guided by the VEM, could look as follows:  What role for the business plan? - structured narrative along the VEM logic What role for financial projections? - Verify the assumptions underlying the business plan - Focus on operational viability & profitability. The bottom-line matters! - Focus on timing & milestones. What financial resources are needed when? Financial projections reflect the underlying business plan - P&L statements identify the underlying profitability - Balance sheet statements identify the growth pattern - Cash flow statements identify the timing and extent of funding needs, and allow for testing alternative financial plans Important to crystalize the entrepreneur's expectations. #### Nobel Insights: Signaling your Venture [George Akerlof ] introduced the concept of adverse selection as a consequence of asymmetric information: - Markets may break down if sellers cannot credibly communicate to buyers the quality of their goods - The same happens when entrepreneurs aim to sell shares in their ventures, whose quality is difficult to tell - Pitching the business plan and engaging in due diligence help to reduce asymmetric information and ideally to make markets for new ventures viable [Michael Spence ] showed that costly signalling can help one party to convince the other of the veracity of their claim. - To be credible the signal must be costly! - E.g.: an entrepreneur must work hard to rack up initial sales, rather than just promising them Costly signalling: door moeite te doen voor iets, geef je aan dat je er alles voor doet Je kan investors makkelijker overtuigen van je idee of BP als je aantoont dat je er veel moeite in hebt gestoken dat het 'costly' voor je was ### How Investors can use the VEM Investors can use the VEM on two levels 1. For a first screening 2. For guiding due diligence (DD) - DD is a time-consuming activity that is undertaken only when the investor is already inclined to invest and has negotiated a preliminary deal structure (term sheet). The VEM Tool on the book's companion website makes the VEM operational (https://www.entrepreneurialfinance.net/courseware). Try it out The investment decision will depend on a careful assessment of the BP strengths and the financial appeal of the deal. Different investors have different decision processes and rules, but the quality of the BP is always at the heart of the decision! Afbeelding met tekst, schermopname, Lettertype, nummer Automatisch gegenereerde beschrijving Chapter 2.5: Why financial planning? ==================================== Why financial planning? ----------------------- - To predict how much financing is needed and when - Amount and timing of the external funding you need - To be in a better position to negotiate the terms of external financing - To choose between different project/policy options - To avoid surprises ### 2 HORIZONS 1. Medium/long term financial planning (machines you have to buy,...) - About growth planning - About growth financing - About financial policy/stability 2. Short term financial planning - About cash management - About working capital management  - Working Capital (WC) = Equity + LT loans -- fixed assets - Healthy when WC \> 0 - Working Capital requirement (WCR) = inventories + Customer credit -- Supplier credit - If WCR \> WC, need to rely on ST loans #### Growth management - If a company grows it requires investments in production facilities, buildings, equipment,... - Not every industry needs large investments in fixed assets to grow - Trade - Services Growing also affects: - Inventories: In practice often too much inventory: avoid delivery delays - Customer credit: Outputs ↑ = outgoing bills ↑ = customer credit ↑ - Supplier credit: Inputs ↑ = incoming bills ↑ = supplier credit ↑ #### What happens when a company grows? Afbeelding met tekst, schermopname, Lettertype, nummer Automatisch gegenereerde beschrijving Increase in profits and increase in WCR but WCR grows faster than profits! #### Working Capital Management - Let's look at the production and sales cycle  Chapter 3: The Financial Plan ============================= Goals ----- - How to build a financial plan to illustrate the financial attractiveness of a venture and to determine its financing needs. - Learn about key forecast metrics (revenues, costs, cash flows). - How to identify milestones that can be used to provide salient information about the venture's progress. - How to pitch a financial plan to investors. ### Two key questions 1. How financially attractive is the venture? Financial goals: Where to get to. 2. What financial resources does the venture need? Financial means: How to (financially) get there. Financial projections are managerial accounting tools that look forward, rather than financial accounting tools that report past facts. The financial plan's configurations change with the venture's stage of development: - From skimpy cost structures & revenue hopes... -... to increasingly precise, internally generated estimates. Do ventures always need a financial plan? - It should be appropriate for the stage and nature of the venture (balance detail/analysis and realism) - Early stage: quarterly/monthly up to two years forward - Later stage: lower frequency but further into the future ### Role of financial projections Afbeelding met tekst, schermopname, Lettertype, nummer Automatisch gegenereerde beschrijving ### Financial projections as a mirror Financial projections can be thought of as reflections 1. They force entrepreneurs to reflect on their business model - Analyze, motivate, and discuss strategic choices 2. They reflect the business plan - Set expectations and translate the business plan into numbers 3. They reflect something about the entrepreneurs themselves - Reveal their approach to business / shows who you are ### Limitations The nature of the entrepreneurial process implies that: - Financial projections are always inaccurate especially for early stage companies - Financial projections quickly become outdated - Financial projections are always optimistic ### The structure of financial projections Financial projections consist of three main accounts: 1. Income Statement (IS): business model & profitability - Costs, revenues, profitability measures (flows) 2. Balance Sheet (BS): size, asset base structure, financing - Assets & financing (types); net income links to IS (stocks) 3. Cash Flow Statement (CF): cash changes from IS and BS - Financing needs, their amount and timing ### Sources of information Financial projections reflect information about the company, the market(s), and the entrepreneur's plans. Four main sources of information: 1. Primary data research: directly from the market 2. Secondary data research: filtered & prepared 3. Learn from the experience of similar companies 4. Use own past performance, when available ### How to build financial projections The process requires an analytical approach and comprises five steps 1. Define a timeline 2. Estimate the revenues of the company 3. Estimate the costs of the company 4. Build the three financial statements 5. Formulate the financial plan #### Step 1: Define a timeline Identify the relevant business milestones - Can be reflected into a Gantt chart Define the appropriate time horizon (across milestones) - From 2 years (apps) to 20 (nuclear) -- typical is 5-6 years Set the level of account detail (between milestones) Set the time intervals across the horizon Milestones are particularly important, they are also used to define funding-relevant targets - Milestone: salient event whose achievement reveals important information in a discontinuous way - Milestones represent different types of business achievements, from technical, to commercial, to managerial #### Step 2: Estimating revenues Revenue = Price x Quantity 1. Define the unit: good/service, customer, contract 2. Estimate the price: focus on the net average price but don't forget about the price distribution (over time, units, regions,...) 3. Estimate the quantity: top-down vs. bottom-up Revenues are the "Top Line" -- their timing is important. [Top-down revenue projections] Based on demand-side logic and supported by secondary data sources. In steps: 1. Size of the relevant target market (section 2.2.4. in the book) 2. Segmentation, if any 3. Market share (captured share of the addressable market) You size the market the company is in and assess the company's market share to get an idea of the amount of revenue one should expect. No assumptions, you take the total market size and you then draw conclusions upon the revenue one should expect It is also important how and how fast the market share is acquired. Works well when the target market share is well-defined and can be well-approximated, can be done very quickly. It is less convincing when - The target market is much larger than the venture can achieve ('restaurants in New York') - The target market does not exist yet because the venture introduces something completely new ('space flights') [Bottom-up revenue projections] - Based on supply-side logic and the company's ability to develop and deliver the product. Supported by company data. - Necessary for very large markets or new markets. - Requires estimating a realistic growth rate of the production capacity. - Complementary to top-down. - Need for realism (consider returns, discounts, fulfilment,...) Bottom-up forecasts begin with the individual business drivers, and build up to a forecast revenue figure, but don't really factor in market conditions.  [Combining Top-Down & Bottom-Up] Estimated market share S = C/M - C = bottom-up capacity - M = Top-down market size Case 1: small share (S \< 5%) - Market segment defined too broadly? - Bottom-up strategy too conservative? Case 2: normal share (5% \< S \< 25%) - Is the market share realistic? Case 3: aggressive share (S \> 50%) - Can you really be the largest player? Case 4: impossible share (S \> 100%) - Stop dreaming! - The market doesn't support the growth strategy #### Step 3: Estimating costs Three types of costs: - Costs of goods sold (COGS): delivering the product - Operating expenses: running the business - Development costs: creating & maintaining the venture Economic interpretation: fixed vs variable costs - COGS relate directly to the production & delivery of the product - COGS are lowest in services - Bottom-up: unit costs by looking at inputs - Top-down: learn from existing competitors - Operating expenses (OEs) are the costs that relate indirectly to the production & delivery of the product - incurred irrespective of sales - Salaries and stock options are very important OEs for new ventures - Capital expenses are non-recurring costs of acquiring long-lived assets. - Side note: whether it is best to rent or to purchase (also) depends on the strategic importance of an asset. - Development costs are one-off costs related to the creation of the venture and its product. For innovative companies they are relatively recurring (by definition). - Non-operating expenses are recurring costs that relate to maintaining the asset base: - Depreciation & amortization - Interest expenses - Asset revaluations/devaluations #### Step 4: *Build* the financial model The financial model consists of the three accounts: 1. Income statement (or Profit & Loss, P&L): - Projects revenues, in particular their timing and growth - Projects costs, in particular their timing and growth - Derives bottom line measures of profits: - Gross margin = Revenues -- COGS - EBITDA = gross margin -- Oes - Net income = EBITDA -- ITDA 2. Balance Sheet: - Short-term (current) and long-term (fixed) - Assets: tangible and intangible - Liabilities: debt and equity 3. Cash Flows Statement: - Operating cash flow: reverses D&A - Investing activities (tangible and intangible) - Financing activities The financial model can help to interpret and assess a venture's potential financial upsides and downsides, - by considering different profitability measures and benchmarking them to competitors and other startups (Income Statement) - by interpreting the needs for working capital and long-term capital goods (Balance Sheet) - NWC = Cash, inventory, accounts receivables \[CA\] -- accounts payables \[CL\]) - by identifying funding needs (Cash Flow Statement) - early-stage ventures: cash flows from operations & investing are typically negative Income vs. Cash Flow: start-ups need to focus first on retaining strictly positive cash balances, then on becoming profitable Positive net income may be insufficient to ensure a positive cash flow [Cash flow forecasting] [Testing financial projections] Financial projections only consider a single path for the venture, which is often too restrictive -- especially for early-stage ventures. To test the realism of the assumptions: - Scenario analysis: construct alternative sets of assumptions - Sensitivity analysis: understand which assumptions are crucial & how much they matter Simplifications to make (analyzing) the financial plan more manageable - not always advisable, but can provide useful shortcuts For example: - Build a unit model (express all accounts in product units) and vary the scale of production. - Limit analysis to key industry metrics (e.g., "eyeballs" for websites) - Restrict the time horizon to the experimentation period #### Step 5: Formulate the financial plan The financial plan builds on the financial projections and addresses the two key questions of interest to the investor: 1. How financially attractive is the venture? - Can be argued, using the three statements. 2. What financial resources does the venture need? - Largely relies on the cash flow statement - Current and future funding needs ### Pitching the financial plan Pitching the financial plan can take many different forms, depending for example on investor preferences. - Presentations can differ with respect to the medium (pdf vs power point), the account details, the type of interaction (personal vs impersonal),... But: - the two key questions need to be answered convincingly, and - some key points need to be covered #### Key points Need to be covered in a pitch, independent of the exact format: - Discussion of underlying assumptions - Revenues: level, growth, timing,... - Costs: nature, level, growth,... - Profitability: drivers and timing - Funding needs and cash flow analysis #### Nobel Insights: Behavioral Biases [Daniel Kahnemann (Nobel 2002) ] showed the importance of behavioural biases in "fast" thinking: - Investors may well fall in this trap when choosing ventures, as this is a standardized activity for them - Framing of information may determine which ventures get funded - The sunk cost fallacy can lead investors to keep pouring money into ailing ventures just because they had already invested. - For entrepreneurs, over-optimism is a common bias #### Behavioral Biases and the Pitch Richard Thaler (Nobel 2017) argues that behavioural biases can be amplified or reduced by nudging, which is a form of framing. - Nudging: Positieve keuzes worden op een subtiele manier naar voren geschoven, zonder de andere keuzeopties weg te nemen of te benadelen. Elk individu behoudt zijn keuzevrijheid, maar door subtiele beïnvloeding worden we met zijn allen onbewust naar het gewenste gedrag geleid.  All these behavioural biases apply closely to financial projects, which reflect judgement over future possibilities rather than objective facts. See Toledo for examples of pitches of different quality. Chapter 4 Ownership and Returns =============================== Goals ----- - Understand the relationship between investment amount, ownership shares, valuation, dilution, and returns. - Derive the allocation and prices of shares, as well as a company's pre- and post-money valuations. - Analyze investor returns using alternative measures. - Understand how founders allocate ownership shares within a team. OWNERSHIP --------- ### The Meaning of Ownership Determining ownership stakes and valuing the company are a central part of structuring an investment. Valuation has two important effects: 1. It determines what percentage of the company's equity the investor receives for contributing the investment. 2. It allows the investor to estimate the returns they expect to make on their investment. ### Mechanics of Ownership & Valuation Implied valuation: valuation reflects (is implied) by the investor's willingness to pay a certain sum for the ownership stake she gets: Investment = Ownership x Valuation Which can be written as: Valuation = Investment / Ownership Pre- & Post-money valuations are valuations prior to or upon receiving the investment: Pre-money val. = Post-money val. -- Investment (4.3) Which we can write as: Post-money val. = Pre-money val. + Investment #### Notation I = investment F = ownership share V = valuation S = number of shares Implied valuation: V~POST~ = I / F~INV~ Pre- and Post-money: V~POST~ = V~PRE~ + I INV = new investors ### Price & number of shares For the first investment round, we can choose the number of shares freely, as they are purely a scaling factor. Afterwards, the number of shares is given by S~POST~ = S~PRE~ + S~INV~ (S~PRE~ = pre-deal owners, S~PRE~ = post-deal owners, S~INV~ = new investors) For a given price P: I = P x S~INV~ and V~POST~ = P x S~POST~ & V~PRE~ = P x S~PRE~ Ownership shares are thus: F~PRE~ = S~PRE~ / S~POST~ and F~INV~ = S~INV~ / S~POST~ ### The Stock Options Pool Stock compensation is used for attracting & retaining talent and to defer cash payments to key employees and board members. Stock can be granted directly or through stock options. Stock options are issued in a pool, typically at the first round and often amount to 10%-20% of total ownership. A Stock Options Pool (SOP) creates a new category of owners, so we need to adjust our formulas: S~POST~ = S~PRE~ + S~INV~ + S~SOP~ V~PRE~ = P x (S~PRE~ + S~SOP~) F~PRE~ = S~PRE~ / S~POST~ F~INV~ = S~INV~ / S~POST~ F~SOP~ = S~SOP~ / S~POST~ With a SOP, we express share numbers on a "fully diluted" base. That means, all shares in the pool are assumed to eventually be converted (option exercised) into common stock. With a SOP, V~PRE~ represents the valuation of founders and option holders' shares. Founders need to be aware of this when negotiating. ### The Capitalization Table The "Cap Table" is a spreadsheet table that, for each shareholder, keeps track (at each round) of: - The number of shares owned - The amount invested - The ownership fraction It is organized in blocks corresponding to funding rounds, with each row reporting data for one owner. - Next slide: the WorkHorse example from the book  ### Ownership Dilution Over Multiple Rounds Ventures typically raise funds over multiple rounds. When investors buy newly issued shares, this affects current shareholders' ownership. Dilution: reduction in the ownership fraction of current shareholders due to the issuance of new shares at any new financing round Notation: - Index financing rounds by r = 1, 2,..., R - Label the round in which the investor contributes by i - F~i~(r) is then the ownership fraction at round r, of an investor who invested in round i In each round, the new valuation is implied by VPOST(r) = I(r) / Fr(r) Furthermore: - V~PRE~(r) = V~POST~(r) -- I(r) - S~POST~(r) = S~POST~(r-1) + S~r~(r) - I(r) = P(r) x S(r) - V~POST~(r) = P(r) x S~POST~(r) - V~PRE~(r) = P(r) x S~POST~(r-1) - F~i~(r) = S~i~(r)/ S~POST~(r) We can thus compute the dilution of ownership across rounds as: - F~i~(r) = F~i~(r-1) x (1 -- F~r~(r)) Investor Returns ---------------- When considering investor returns, we distinguish between - Realized returns: backward-looking objective measure(s) of what an investment has yielded - Need the value, for investors, of the company at exit: X~INV~ = F~INV~ x X - Expected returns: forward-looking expectations #### Skewness Low returns are more probable than high returns ### Risk & Return A basic principle of finance is that one can achieve higher return by taking more risk - For example, consider two investments that each need \$40 of capital - Investment A yields \$50 for sure - Investment B yields \$100 with 60% probability, or 0\$ with 40% probability - The expected outcomes are \$50 and \$60 respectively. - Which investment is preferable depends on the investor's degree of risk-aversion. Investors are typically risk averse; they 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, which would in turn reduce the return on the safer asset. There are two important differences wrt. the risk-return trade-off between entrepreneurial and standard corporate finance: 1. Risk in entrepreneurial finance is often extreme ("skewed" in statistical terms). Most projects fail, few generate a moderate return, and only very few generate very high returns. 2. Investing in ventures also carries "liquidity risk". Selling company shares can take time and one may find buyers only at a very low price. This is in stark contrast to the liquidity of traded stock. Venture investors are not risk lovers! - They typically diversify their risk across several ventures. - They (try to) actively reduce risk by becoming involved in their portfolio companies. It is better to think of them as risk tolerant investors who work towards reducing the risk of their companies. ### Three Measures of Return Three standard measures of investor return are: 1. The Net Present Value 2. The Internal Rate of Return 3. Cash on cash #### Intermezzo time value of money: How much is \$1 worth at different points in time? - \$1 today \> \$1 tomorrow because we could invest it and earn a return overnight; the difference in value is called the time value of money Notation: - FV = future value; PV = present value - I = investment - d = rate of return, also called discount rate Then (over T years): FV(I) = I x (1 + d)^T^ and PV(I) = I/ (1+d)^T^ #### Net Present Value (NPV) NPV = X~INV~ / (1+d)^T^ -- I Where T, if we think of this as a return measure, is the time to exit. - NPV is the main tool for capital budgeting decisions. - In an entrepreneurial finance context, d may be difficult to find because of a lack of benchmark companies. #### Cash on cash Multiple (CCM) The CCM counts how many times the invested capital is returned at exit CCM = X~INV~ / I - Appeal: simplicity - Weakness: does not account for the time value of money, or for the investment risk #### Internal Rate of Return (IRR) The IRR is the most common measure among practitioners. It is defined as the discount rate that sets an investment's NPV to zero. I x (1 + IRR)^T^ = X~INV~ - IRR takes the time value of money into account, and thus implicitly the timing of cash flows. - It does not take into account the level or the risk taken. ### Comparing the Return Measures Combining the definitions yields CCM = (1 + IRR)^T^, which implies  Notice that CCM does not vary with the time horizon; the IRR does. Yet, it is difficult to compare two projects with the same IRR but two different horizons - Consider, for example, the projects with an IRR of 41% in the table - A common approach is to assume that the shorter project can be extended, but this is only viable if the IRR could be achieved for more years. NPV is a conceptually stronger measure - It accounts for the time horizon and thus allows to compare projects with a different time to exit - The important downside, especially in entrepreneurial finance, is the need for an appropriate discount rate. In the end, it is advisable to use NPV for decision-making - But: the common use of IRR and CCM, especially for reporting purposes has its justification Two final remarks: - Discussing returns for entrepreneurs makes conceptually little sense -- they generally do not contribute any investment. - Returns for the entire company can be computed using X instead of X~INV~. ### Valuation and Returns If we use the company-level exit value and valuation, we have, for example, CCM = X / V~POST~ (results are general to all return measures). X = exit value - Insight 1: for a given valuation, a higher exit value leads to a higher realized investor return - Insight 2: for a given exit value, a higher valuation leads to lower realized investor return If we consider total monetary gains of the entrepreneur, we can express X~EN~T as X~ENT~ = X x (1 -- (I / V~POST~)) - Insight 3: for a given valuation (V~POST~), a higher exit value (X) leads to higher entrepreneurial gains - Insight 4: for a given exit value (X), a higher valuation (V~POST~) leads to higher entrepreneurial gains Incentives are aligned with respect to the exit value, but not with respect to the valuation! The investor prefers a low post money valuation while the entrepreneur likes a high post money valuation! Furthermore, if we restate V~POST~ in expected terms as Xe / CCM^e^, we obtain: - Insight 5: for a given required return (CCM^e^), a higher expected exit value (X^e^) leads to a higher valuation - Insight 6: for a given expected exit value, a higher required return leads to a lower valuation ### Economic Determinants of Valuation There are four main determinants of a venture valuation: 1. The opportunity itself: the better, the more courted 2. The market context: hot vs cold market 3. Deal competition: more competition, higher valuation 4. Investor quality: good investors achieve higher valuations ### Founder Agreements Founders (may) need to share ownership with external investors, but also internally within their group. They need to agree on the internal split before reaching out to investors. - There are different approaches to decing these splits (early vs. late, different criteria related, for example, to skills or expected involvement). - Splits are decided in Founder Agreements. Founder agreements address five main issues: 1. Who are the founders? 2. Salaries and other forms of compensations 3. Obligations and rights of the company towards founders 4. Ownership allocation 5. Contingencies under which some founders obtain stronger or weaker rights (e.g., vesting of stock) ### Determinants of Founder Ownership How ownership is allocated is an important and far-reaching decision. Egalitarian approach: equal split - but crucially requires the same perceptions by all involved Rewarding differential contributions, instead, would generally imply an unequal split - Need to keep incentives for everyone intact Principles to adopt, could be - Backward-looking - More objective - Take stock of who contributed what (idea, funding, other resources) - Forward-looking - Keep in mind who should/needs to contribute what as the venture develops - Takes incentives into account #### Nobel Insights: Team Incentives [Bengt Holmström (Nobel, 2016) ] one fathers of the economics of incentives - He emphasized the importance of incentives within teams - Relative productivity within the team should guide the share allocation, as it rewards & motivates those most valuable to the venture - But: incentives should be balanced to keep everybody on board ### The FAST Tool FAST = Founder Allocation of Shares Tool The tool is based on the following steps: - Define team members and their roles - Define time periods and their weights - Allocation of points to founders for their contributions - Identify net transfers across founders - Recommend ownership stakes & contingencies Chapter 5: Valuation Methods ============================ Valuing entrepreneurial companies --------------------------------- So far, we determined ownership fractions and investor returns, taking valuation as given. The next step is to understand how to arrive at a valuation. In the EF context, uncertainty is a fundamental feature surrounding the venture's futures. If valuation of entrepreneurial companies is so difficult and time consuming: Why should we bother? An informed opinion is essential for both parties to enter into the negotiation (and know how flexible they can be price-wise): - For investors, valuation is part of the decision-making process - For entrepreneurs, valuation helps becoming "investor-ready" Valuation Challenges -------------------- Why is valuation of entrepreneurial venture difficult? - High degree of (Knightian) uncertainty - Lack of value-relevant objective information - Asymmetric information - Inadequate accounting for intangible assets -- including human capital Standard valuation models cannot be simply applied. Key trade-off: simplicity vs. complexity - Uncertainty calls for a simple, reasonable approach - Uncertainty may also require a precise, complex methodology Different people have different views on this. We consider 4 main approaches to valuing entrepreneurial companies 1. Venture Capital Model - From practice - simple, consistent 2. Discounted Cash Flow Model - From theory & practice - Can become complicated and relies on demanding assumptions - Generates "intrinsic", "absolute" valuation 3. Comparables Method - From practice - Uses market information to generate "extrinsic", "relative" valuation 4. Probabilistic approaches with model uncertainty ### The Venture Capital Method/Model (VCM) Very popular in practice. It models investor cash flows, which are relatively simple - Contribute money at the start and wait for the exit event Simple logic: - Estimate a likely exit value - Discount it back in time - Use it as a post-money valuation to derive ownership fractions Recall: - V~POST~ = X^e^/ (1+ρ)^T^ - V~PRE~ = V~POST~ -- I - F~INV~ = I/ V~POST~ Or, for multiple periods: - V~POST~(r) = V~PRE~(r+1) / CCM~r~ ^e^, with CCM~r~ ^e^ = (1+ρ)^Tr(r+1)^ - V~PRE~(r) = V~POST~(r) -- I(r) - F~INV~(r) = I(r) / V~POST~(r) These three equations contain the logic of the VCM The VCM requires estimating four inputs: - The investment amount: I - The time-to-exit: T - The exit value: Xe - The hurdle rate or required rate of return: ρ #### The investment amount: - Requires knowledge of the venture's business model & financial plan - Requires an understanding of the economics of the sector and the venture's operations - Is recovered from the financial plan - How much money is needed, and when? #### The time to exit: - Requires knowledge of exit markets (acquisition opportunities, IPOs,...), but cannot really be planned in advance - Different investors (and entrepreneurs) may have different time horizons and expectations - Should be discussed at the time of the deal! #### The (expected) exit value: - Exit value estimate, not "expected value" in a statistical sense - This is the value in case of a successful company outcome - Mainly results from an acquisition or an IPO - Two main estimation approaches: - A discounted cash flow estimate - An estimate based on exits of comparable companies #### The required rate of return consists of five elements - Financial (fairly standard) - The riskless rate of return (time value of money) - The financial risk-premium (systematic risk -- CAPM) - The illiquidity premium (long-term investments, almost no secondary market) - Non-financial (less obvious) - The failure rate premium (reflects the high mortality of new ventures) - The "service" premium (reflects investor services: monitoring, advice, mentoring,...) #### Nobel Insights: the CAPM [Harry Markowitz & William Sharpe (Nobel, 1990) ] helped to create modern finance in the 1960s. A central contribution was the CAPM. Key intuition: - investors can eliminate the risk that is specific ("idiosyncratic") to each company by investing in many companies. Gains in some companies will offset the losses of others. - Risk that affects all companies ("systematic") cannot be diversified away. - The financial risk premium measures the return investors require to bear systematic risk - Required rate = riskless rate + β\*(market rate -- riskless rate) Two approaches to calculating the failure risk premium - Relying on past experience and putting in a "large number" - Developing a model that tries to capture the specific underlying uncertainty We will discuss an intermediate approach. Notation: z = failure probability (if you want to take into account a failure premium, d = discount rate Probability of surviving until exit at T = (1-z)^T^; thus: - Expected exit value: X^e^ (1-z)^T^ - discounted value: V~POST~ = X^e^ (1-z)^T^ /(1+d)^T^ From before, we can also express V~POST~ as X^e^/ (1 + ρ)^T^, so that: (1-z)^T^/(1+d)^T^ = 1/(1+ρ)^T^ and thus ρ = (d + z)/(1-z) Three possible variations: 1. Time varying ρ - ρ will decrease as the venture matures and becomes less risky 2. CCM instead of ρ - from CCM^e^ = (1+ρ)^T^ 3. Forecast to the next round - Pushes the need to estimate X^e^ down the road ### The Discounted Cash Flow (DCF) Model Theoretically grounded, but less popular in practice. Models company cash flows, which require detailed assumptions & knowledge of the business. Simple logic: - Estimate a terminal value some years ahead & discount it back in time - Do the same for all other cash flows and add up all discounted values DCF is the main model used in corporate finance Uncertainty of entrepreneurial ventures makes it less applicable - except at later stages, when historical information about the company becomes available But: the EF context makes it plausible to abstract from debt financing, which simplifies the use of the DCF. The DCF model can be written as: #### Differences with the VCM: - The time horizon corresponds to the point from which the company reaches stable growth. This is often (but not always) similar in length to the time-to-exit. - Free Cash Flow - The terminal value (TV\* = FCF~T~\* [\$\\frac{1 + g}{d - g}\\ \$]{.math.inline} , with g = growth rate of FCF~T~ is the main component of a DCF valuation - interim cash flows are mostly negative (investments) - The discount rate (d\ CT The conversion treshold is now larger as the PT earns a higher return  This increases the CF claims by the investor Afbeelding met tekst, lijn, diagram, schermopname Automatisch gegenereerde beschrijving This reduces the CF claims by the entrepreneur. A higher cashflow needs to be obtained in order to actually start getting anything #### Participating Preferred Participating preferred terms combine debt and equity features by adding a (multiple) liquidation preference to the preferred dividend ("double dip") The investor then gets the PT and at exit also shares into common equity. If the company's exit value is X, this implies: PT is the fixed return (X-PT) \* F INV = The ownership share of the investor after exit which entitles him to a part of the company's cashflows. This part is relative to his ownership stake  Investor payoff is higher because of the double dip #### #### #### #### #### #### #### #### #### #### Participating Preferred with Cap A cap may be imposed on the participation in order to preserve incentives for the entrepreneurs (As the additional conversion into common equity materially decreases the entrepreneur's cashflows, there is a cap on this.) - Participation vanishes if X \> X^CAP^ preferred shares are turned into common equity - This implies: CF~INV~ = PT + (X -- PT)\*F~INV~ The drop in the cap is usually smoothed out to avoid providing perverse incentives at the time of exit.  Afbeelding met tekst, lijn, schermopname, Perceel Automatisch gegenereerde beschrijving Here, smoothing out in order to reduce wrong incentives. for all exit values between X~CAP~ and X~COM~ the investor gets the preferred terms at the capped valuation, and for all exit values above X~COM~, the investor's shares get converted into common stock. For exit values above the cap (X \> X~CAP~). the investor gets either his preferred terms held constant at the 'capped' valuation (PT + F~INV~ \* (X~CAP~ - PT)) or the common terms at the actual valuation (F~INV~ \* X) #### Why Preferred Securities? There are three main rationales for using preferred stock: 1. Provide incentives to founders (need for balance): When the company fails, most of the cash flows go to the investor (X \< PT), so this incentivizes the entrepreneur to work hard in order to make the company successful. 2. Screen out weaker projects: An entrepreneur that knows he has a weak project, will not accept preferred shares as he knows he has a low chance of getting any money out of it. This deals with the 'lemon' problem as well. Good entrepreneurs will continue and bad entrepreneurs will be removed. 3. Align investor and entrepreneurs' expectations: The entrepreneur is likely more positive about his project than investors and is willing to give up his CF's in case of failure because he knows the company is going to succeed. In this way, it is mutually beneficial if they structure the cashflow in the way that the entrepreneur gets a big part if the company succeeds and the investors get the biggest part in case of failure. ### Compensation & Employment Upon funding, founders become employees. Main implications of founder employment agreements: - They can be fired - They are subject to non-compete laws - They confer to the company their IP Founders receive compensation that may include: - Salary (typically below market) - Performance bonus - Stock options (at later stages, to restore incentives) Two guiding principles: 1. Defer pay as much as possible to save cash 2. Provide incentives for long-term value creation Most of the compensation derives from future sales of common stock Founders' stock is "vested" (earned back) with two criteria: - Time vesting (linear, with/out cliff, acceleration) - Performance vesting (accelerated upon IPO/acquisition), by defining targets, if they achieve them-\> more shares Its main purpose is to assure the continued commitment of the founders to the company. The value of early-stage companies is embodied in their founders' ability to execute their plans. Investors need protection from the possibility that founders leave after the venture has been funded. Vesting is lost in case of dismissal with cause. Example*:* "the founder obtains 60% ownership; vesting is at 6% quarterly rate with a cliff of one year" - Each quarter, the founder vests 6% of its whole allotted common stock (i.e., 60%) =\> Vesting completes after 10 quarters - Vesting requires one year of employment to start kicking in, so after 9 months, the founder has not vested any stock, but after 12 months the vested part jumps to 24% #### Stock option pool Stock options come from an "Option Pool" that is typically set up at the first funding round and replenished when needed. - The pool is 10%-20% of the fully diluted stock base and many companies "consume" 2%-5% per year, depending on the type of talent they need to recruit - Stock options are also subject to vesting, unless they come from a hiring or yearly bonus - They have a strike price, often very small or linked to the last round's price - Exercise may require a (short-term) loan from the company - Importance of granting liquidity to employees (see Chapter 11) Term sheet ---------- ### Control Rights & Future Fundraising The company charter & by-laws provide 4 main types of control rights: 1. Shareholders' voting rights 2. Board of directors 3. Contractual rights: additional right which could be given to certain investors ( to appoint the new CEO, to veto certain decisions) 4. Informal control, (more on all four types in Chapter 8) Term sheets at all rounds set some rules that affect future fundraising and future investors. We examine these rights (e.g., anti-dilution) & obligations (e.g., pay-to-play) in Chapter 9. ### Investor Liquidity Investors need to sell their shares at some point. This can occur under diverse circumstances: - Redemption rights allow investors to "redeem" his/her shares after a reasonably long period - Tag-along rights imply that investors can sell their shares along with founders. Drag-along rights imply that investors can force other shareholders to sell their stock - Registration rights (right to start process of IPO) & piggy-back (if shares are sold to the public, you have the right to sell your shares as well) imply that right holders can force a listing ### Additional clauses - Information rights allow investors to obtain hard data (particularly useful at early stages) - Key Man Insurance: the company is the founder(s) Insurance for investors in case a key person (founder, manager etc) passes away - Legal resolutions: applicable law and disputes investors retain the right to sue the company in a specific country when something bad has happened. Whenever the company operates in a different country, investors usually want to sue in a 'sound' country - Representations and warranties: key to close the deal investors can hold the founder or manager responsible for large mistakes or lies - Negotiation: - no shop clause: the entrepreneur cannot shop around for other deals - exploding offer: offer is canceled after a certain date - due diligence conditionality: investors' offer is only valid after due diligence shows there are no problems - co-investors: investors demand that the founder looks for a co-investors and condition their offer on this - milestones ### Valuation vs Terms - You cannot "have your cake and eat it", i.e., you cannot negotiate all terms. What should you focus on? - Valuation is the most visible term, and also the easiest to grasp for entrepreneurs. - However, Cash Flow rights for example can undo a generous valuation. - Some trade-offs make clear that negotiation is not a zero-sum game: - Valuation vs. control rights (protecting yourself) - Valuation vs. Compensation and future payoffs - Valuation in upside and downside For many entrepreneurs, valuation is the most important, but this means that investors can make use of this by giving a high valuation, but writing very favourable terms for themselves without the entrepreneur really caring about them #### Example of the upside/downside trade-off (Box 6.6):  First example: only common shares and no investor downside protection. Investors need to invest 20 mil for 25% of the shares. Investors get an expected return of 60 Afbeelding met tekst, schermopname, Lettertype, nummer Automatisch gegenereerde beschrijving Second offer: Include a 2x multiple liquidation preference. Investment of 20 million 2x multiple means that the first 40 mil earned goes to the investor. Additionally, he only takes 20% of the company. In the bad outcome, he already gets more but in the good outcome, he now earns 80. But this means that his expected return is still the same  Another example: here you take a 3x preferred multiple so you get the first cashflows until you have earned back your investment 3 times, no matter what happens. In the good case, you have 15% equity which in total gives the investor the same 60 expected outcome. The only thing that changes for the entrepreneurs here are the post and pre money valuation. The valuation goes up when the equity % drops. Afbeelding met tekst, schermopname, Lettertype, nummer Automatisch gegenereerde beschrijving The founders now looked past the valuation and focused on the exit value. Now: one founder is an optimist and one is a pessimist. Optimists give 60% of success and 40% of failure and pessimist give the opposite. As we can see, optimists prefer the liquidation preference deal as this gives the investor more protection on the downside but in case of the good outcome, the investor takes a lower equity stake which leaves more upside for the entrepreneurs  Now we look at the difference in exit value for the founders and investors between the good and bad situation. We see that in the 3x preferred share deal, investors have no incentive at all and don't care about the company as they will get the same return in the good and the bad case. This is because their investment will be returned 3 times from the first cash flows. Investors care the most when they don't have preferred shares as there is no guaranteed cash coming to them. They need the company to do well in order to get the highest return. Furthermore, the 3x preferred deal gives the founders the most incentive as the investor takes a lower equity stake which means that the entrepreneurs are left with a higher equity stake in case of the good outcome. However, higher preferred deals are not always beneficial for the investor because in the good case, the investor has a lower equity stake which means lower returns. ### Convertible Notes For pre-venture companies, it is much more difficult to put a valuation on it. This is why they make use of convertible notes as there is no need to value them, this is a debt-like instrument that converts into equity at the first following round. As there is no valuation needed for rewarding convertible notes, investors don't know how many shares they will get. At the first following round, they will get a discount on the share price. Term sheets are different for the seed ("pre-venture") stage, i.e., for cases characterized by: - Low funding amounts (\< \$100,000) - Unsophisticated investors - Most likely outcome: the company fades away Convertible Notes (CN) are debt-like claims that address these issues - They are automatically converted into stock at the first "qualified" fundraising (Series A) - They are converted into the same security then issued (convertible preferred) - The conversion rate is pre-determined by a price discount (10-20%) - The maturity is typically 12-24 months The appeal of CNs: - Their simple, standardized, structure - Allows to save on legal costs - Involve virtually no control and other protective rights - Delegate/postpone the valuation and negotiation - Conversion rate: P~CN~ = (1-DIS)\*P~INV~ - Ownership: S~CN~ = I~CN~/P~CN~ = I~CN~/(1-DIS)\*P~INV~ - Valuation cap to avoid "paying for success" P~CN~ = the price of the shares for convertible note owners P~INV~ = the price that next round investors pay for shares S~CN~ = the amount of shares you get = investment into CN / P~CN~ If the company does well, share price will rise and when the first round comes, CN investors have to pay a high price per share they would rather have a low price per share so they put a cap on the price this is the maximum price per share that CN investors will have to pay. (If the normal price is below the cap, obviously the normal price will have to be paid) Chapter 7: Structuring Deals ============================ The Art of Structuring Deals ---------------------------- Deals rely on hard elements (valuation, term sheet) - These elements are summarized in quantitative relationships (e.g., pricing) and hard legal constraints However, it is necessary to also have some soft elements that provide a buffer to sustain the deal and allow the parties to work productively. - Buffers go into effect when (contingent) contracts are not enough for effective solutions. - For instance: How do you elicit interest into the venture? How do you choose a commercial partner? How do you react if a key employee leaves? A competitor appears? A key supplier goes bankrupt? The entrepreneur and the investor contribute to structuring the deal - The entrepreneur typically gets the process started - The investor designs the term sheet, valuation Given the presence of both and hard & soft elements, deal structuring is more art than science. We can roughly divide the structuring process into five steps: 1. Fundraising/ Pitching (to investors): business & financial planning before pitch 2. Screening (business opportunities) 3. Syndicating (with other investors) 4. Negotiating (between parties) 5. Closing (feedback guest lecture: purpose more to illustrate, strategy of KU Leuven in investing is cool. examQ: examrelevant primarily for illustrationpurposes, for example describe in which way asymmetric information and entrepreneurship is important \--\> you can use an example of this lecture) ### fundraising Fundraising is a long process that requires preparation - Using the VEM to prepare a strong business case - Building a financial plan - Negotiating share splits amomg founders - Preparing to negotiate a valuation Fundraising also requires engaging potential investors - Early contacts facilitate interaction & trust building - Later stage companies want to keep good relations with investors & attract competing bids - Timing the fundraising campaign trading of traction with expectation Executing the fundraising campaign has its own challenges: - Cold-calling vs being introduced - Need to involve many investors to get an offer ("right investor at the right time") - Prepare a good pitch: domain knowledge and confidence. The key relevant dimensions change with the venture stage Disclosure dilemma: - Non-disclosure agreements (NDAs) are a largely useless tool -- the information is largely common knowledge, what is key is the execution - Arrow's information paradox: you only pay if you can see the quality of the idea, but that requires that this is disclosed! Two solutions to the disclosure dilemma: 1. Patenting as a way to protect ideas even with disclosure 2. NDAs suitable for objective, project-specific, non-patentable information, often soft (e.g., client lists) Do business ideas have a value? - Valuing an idea is different from valuing a venture, because it reflects a more basic level of option value. - Valuing an idea is only necessary if some financial transaction depends on it. What is an idea's theoretical value? - Financially an asset is worth the discounted value of its future cash flow. An idea itself does not generate cash flow, so can only be valued together with the assets needed to make it profitable. - The key question is whether the idea can improve the profitability of alternative uses of the necessary assets. This means asking how unique the idea is. Conclusion - An idea is not worth much in isolation! - Asking where the value of the venture lies is key. ### Screening Once the proposals for investment opportunities are in, they need vetting by investors. Survey evidence suggests, VC investors... - Examine on average 200 BPs/year in depth - Meet 50 management teams - Have 20 BPs reviewed by each partner (12 with due diligence) - Made 5.5 offers (had 4 accepted) - Require 83 days to for deal closing and 118 hours of due diligence The MATCH Tool represents a way to assess the fit between investor & entrepreneur, sifting through several questions that can be adjusted to each specific situation. - Should we consider working together? (geography, industry, stage,...) - Could we strike a deal? (size, security type, board of directors,...) - How would we get on with each other? (Customers & markets, technology & operations, leadership & organization,...) - Can we trust each other? (Implemented as a spreadsheet on the companion website + instructions for use) ### Syndication Syndication is common (50-80% of deals), you get more investors on board, you invest alongside other investors Investors syndicate deals to: - Obtain second opinions - Reduce commitment/diversify/keep "dry powder" - Reciprocate invitations (giving up cherry-picking) - Involve investors with complementary skills and/or networks Survey evidence - Capital constraints (39%) - Complementary expertise (33%) - Risk sharing (24%) - Access to future deals (3%) Afbeelding met Perceel, lijn, diagram, schermopname Automatisch gegenereerde beschrijving Angel/Seed are often not syndicated. The later the rounds get, the more likely deals are syndicated as the amounts involved becomes larger as well. How are syndicates structured? - Lead investors perform due diligence, negotiate, and sit on boards of directors - Followers provide capital, on-demand expertise and networks Does syndication affect performance? - Studies show that syndicated deals tend to perform better - VCs with better record tend to be better networked and syndicate more - Past success breeds future success by accessing better deals through others - Syndication also allows to make better investment choices, improve diversification, attract co-investors that are a good fit #### Nobel Insights: Bargaining Theory [John Nash (Nobel, 1994) ] pioneered the mathematical study of noncooperative games with the "Nash bargaining solution". His goal was to understand what deal two parties would strike in a general setting. He managed to show that this complex problem can be made simple. Nash specifically showed that all we need to know is three variables: 1. Each party's outside option of walking out of the deal 2. The joint value that the two parties can achieve by cooperating 3. A rule for splitting the surplus between joint value and the sum of the outside options ### Negotiation Nash bargaining theory can be made operational by using three concepts: 1. Each party's outside option of walking out of the deal 2. The Zone of Possible Arrangements (ZOPA) 3. The actual final agreement Outside options are alternatives to the deal - They give each party the power to threaten to walk out, so they are very important - They are often build over time by cultivating alternative employment/investment possibilities - For later stage deals, the cash flow situation is an important factor in this respect For example the entrepreneur can sell their company for 2 million, or it can seek an investor to further grow the company. The outside option for the entrepreneur is the 2 million sale. Outside options for investors are usually just preserving their cash instead of investing it. The ZOPA (Zone Of Possible Arrangements) maps the respective sets of admissible deals, i.e., for each party those deals that are more attractive than the outside options. A ZOPA will exist if the investor's maximum valuation is higher than the entrepreneur's minimum valuation. This means that there is some common ground on which both parties would be happy. Next slide: a simple, bi-dimensional example focusing on the trade-off between downside protection and valuation  On this graph we see the entrepreneurs minimum valuation, it is steady as he does not care or doesn't get influenced by the amount of downside protection the investor wants. (for simplicity). However, the more downside protection the investor has, the higher he is willing to pay for shares. The investor is unwilling to make a deal if there is no protection, lets say in a common equity deal. However by introducing convertible notes for example, more downside protection is offered. As an investor you want low valuation, or you want downside protection with a higher valuation (orange line). As an entrepreneur you have a minimum valuation (flat line) Which specific deal is chosen within the ZOPA depends on deal-specific conditions, including factors that are not accounted for in the diagram. - The negotiation ability, for example, comes into play. We can express this formally: - Notation: SV = surplus, JV = joint value of cooperation, OO = outside option, BV = bargaining value, BS = bargaining strength, E = entrepreneur, I = investor - SV = JV -- OO~E~ -- OO~I~ - BV~E~ = OO~E~ + BS~E~ \* SV - BV~I~ = OO~I~ + BS~I~ \* SV Surplus value of the joint venture = the value of the joint venture -- both outside options. This shows what the total added value of the deal is. To see what the bargaining value for each party is, we must consider the bargaining strength to see what piece of the surplus each party is able to capture. ### Deal Closing Closing the deal requires coordinating various activities (like the interests of different investors) - Entrepreneurs typically take initiative. Founders need to agree on a common position on bargaining. - Investors contribute experience and a balancing hand A constant threat is to get agreement/commitment by external parties - For example: funding might be conditional on hiring a senior manager, who will accept conditional on funding being secured,... - Good negotiators can make a huge difference in these circumstances Carefully read the Brill Power Case in the book for illustration Both sides of the deal benefit from creating competition - Building better outside options reduces the ZOPA - "no shop" clauses Competition for the investor: if there are multiple ventures which could be funded, this puts them in a strong negotiating position. Competition for the Entrepreneur: when he has multiple investors, he can create competition in order to get the best deals. Market conditions also affect how "hot" a certain deal is - When "money chases deals" getting better conditions is easier for entrepreneurs BUT: a deal is part of a set of repeated interactions, whose goal is the success of the venture. Both parties have to "live with the deal". - Two soft elements are particularly important as buffers: trust & a long-term perspective #### Trust Firm belief in the reliability, truth, or ability of someone - Allows one party to let the other take actions without direct control or limitations - Allows parties to make decisions when contracts cannot help and there is a need to absorb bumps - Starts out as generalized trust among two sets of people and grows (or vanishes) as personalized trust between two individuals - The dissipation of trust quickly leads to a formal relationship that is costly for all parties and harmful for the venture. #### A long-term perspective Allows to compensate for inter-temporal imbalances. (Trade-offs between long-term and short-term gains.) - A higher valuation now may cause a "down round" later - There needs to be room for future investors (hard to give better terms to later investors, so you can\'t promisee too much to current investors the higher your valuation today, the lower your growth) A long-term perspective moves beyond the deal and can create future value-creating opportunities. Chapter 7: Corporate Governance =============================== The Need for Corporate Governance --------------------------------- Investors provide two main resources to their portfolio companies 1. Money 2. Corporate governance Corporate Governance: a set of actions through which investors (try to) ensure to receive a return from their investment There are two motivations for corporate governance: 1. Companies' need for guidance 2. Investors' need to protect their investment ### Companies' need for guidance: - Entrepreneurial drive rarely comes with (business) experience - Early-stage companies mostly need mentoring and connections - Later-stage companies mostly need strategic advice and monitoring + benchmarking of strategies ### Investors' need to protect their investment: - VCs want to reduce downside risk while pushing their companies to create a large upside - Company vs. entrepreneur: conflicts of interest, exit, firing a founder Corporate Governance Structures ------------------------------- Main governance rules are defined in the company's charter and other legal documents: bylaws, shareholder agreements, etc. There are typically three main control structures: - Voting rights - Board of directors (BoD) - Informal control ### Voting Rights - Shareholders decide on actions set by law or bylaws (e.g., when and how to sell the company). - Votes are by simple or super majority. - Standard: equal voting power ("one share, one vote"), but there is also "share class voting" (series of shares) and there are "dual-class shares" (which deviate from the "one share, one vote"-rule. #### Example: "Vote by share class" Afbeelding met tekst, schermopname, Lettertype, nummer Automatisch gegenereerde beschrijving different kind of shares influence the vote, In every share class, there needs to be a majority in yes for every share class in order to take a decision. #### Example: "Dual class and non-voting shares"  Some shares can have double voting rights and some shares have no voting rights ### Board of Directors - BoDs make most key strategic decisions (products, market, executive hires/firings, alliances, fundraising). - They are nominated under different rules: majority, super majority, unanimity, even nominating rights - Has different roles - Boss (decisions) - Monitor (oversees on behalf of shareholders) - Coach (advice to CEO) - Promoter (forge new relationships) - Board members have a fiduciary duty to all shareholders: they have to put the general interest of shareholders first - Role of observer status: no voting rights but active involvement - Sometimes the law requires a dual board structure: a supervisory board and a management board (small companies may be exempted) - Start-Ups' BoDs are small: - Typically, an odd number; 3 or 5, growing to 9 (or more) - Frequent meetings (often monthly) - Directors spend time advising the company; committees (audit, compensation, etc.) only at a later stage - Composition includes three categories - Entrepreneurs/management - Investors - Independent directors: bring industry expertise and networks - BoD members change over time, also reflecting investor additions/turnover. - The BoD becomes larger and more formal over time. - Outside directors have different roles than in public companies - Balance: pivotal role if investors and management disagree - Promoter: experience & industry knowledge ### Informal control Decisions are often made outside of the framework of formal control rights - Power of the purse: staged financing gives substantial power - Power of personality: comes from credibility and respect (entrepreneurside) - Power of persuasion: comes from experience and strength of arguments #### Power of the purse (belongs to the investors) - "the golden rule is that who has the gold makes the rules" - Entrepreneurs depend on investors for future funding - Current investors wield great power also through their ability to signal to outsiders as investors control the influx of money, they can have considerable power and influence. For example, they decide on future funding and furthermore they can signal their confidence in the company by participating in equity rounds. #### Power of personality (belongs mainly to management) - Stems from having the trust & respect of employees and directors - E.g., a founder can persuade employees to leave the company if it is sold, which may make the company unattractive without key people and can overturn an investor decision A founder with a lot of trust and respect from his employees may have the power in case the investors want to sell the company. The founder has the power to take all the employees with him in case he leaves the company which makes the sale of the company go bust. #### Power of persuasion (belongs to investors & entrepreneurs) - Some decisions are ambiguous and hard - BoD votes, especially swing votes kept by outside directors, can be gained by the persuasion of good arguments - Knowledge and expertise are therefore important for influencing the decision process The one who is the best in convincing or persuading certain people in favor of a decision, has great power as they can guide the company in a certain direction by being able to persuade thr BoD for example. #### Nobel Insights: Selection vs Treatment [Clive Granger (Nobel, 2003) ] studied the co-evolution of variables over time, allowing to understand, for example, how interest rates affect house price movements. This approach becomes limited when, for example, expectations drive decisions before an event occurs: - E.g., Christmas tree purchases and Christmas happening - In our context: VCs may invest in anticipation of success. [James Heckman (Nobel, 2000) ] contributed fundamental insights into how to deal with "selected" data samples. Selection comes from (good) investors being able to choose good companies, which have a higher chance of success, and vice-versa, which is different from investors being able to affect the growth of companies (treatment). - The first effect is "selection", the second "treatment" Question here: are VC's more succesful because they pick good companies with a high chance of success or do they rather have a big influence on the growth of a company which leads to success? [David Card and Joshua Angrist & Guido Imbens (Nobel, 2021) ] contributed fundamental insights on how to exploit "natural experiments" to identify real ("causal") treatment effects. - Methodology from medical trials and popularized in economic in the context of studying labour market effects, for example of minimum wages, immigration, or education. - For causal inference, the idea is to find a way to mimic what happens when companies are randomly assigned to VC investors -- like with the random assignment of drug treatments to patients. Researchers look for ways to observe investments that are "quasi-random" due to exogenous events. Example: new flight routes decrease the distance from companies [Bernstein et al. (2016, Journal of Finance)] - Quasi-randomly allows VCs to spend more time with founders - Researchers can exploit this to see how VCs manage to bring to success companies in which they already invested before the change - Result: companies become more innovative and successful, which points to a real treatment effect (on top of any selection) Companies have a higher chance of success if the VC is more involved There is a treatment effect at play here How do investors add value? --------------------------- In general, through four types of activities: ### Mentoring & coaching - Takes place at the personal level - Founders need to learn how to cope with entrepreneurial & personal challenges - Investors have seen this various times over ### Advising - Takes place at the company level - Companies need guidance in areas where founders are not prepared enough - Investors can support decision-making in strategy, marketing, and HR - Some VC investors maintain permanent staff for these tasks and use information from past deals for benchmarking their companies ### Networking - Takes place at the industry level - "entrepreneurship is the pursuit of opportunities, regardless of the resources one currently controls" (Howard Stevenson, HBS) - Networking allows getting in touch with potential employees, industry leaders, governments, potential funders - VCs also help companies forge strategic alliances ### Pressuring - Takes place at the company level - IP protection strategy - Monitoring to suggest when strategic change needs to happen - Push managers to rethink their strategies under changed circumstances (e.g., cut costs due in recessions, in response to global events,...) Where do investors add value? ----------------------------- To answer this, we can draw on the VEM to identify the relevant strategic challenges (3rd row): 1. Sales challenge 2. Production challenge 3. Organization challenge ### Sales challenge: Investors provide... - Strategic advice building on their experience - Expertise on market penetration, customer engagement, geographic expansion,... - Contracts and validation for hiring key commercial figures - Support in establishing relationships with key customers (large companies, government-owned, etc.) ### Production challenge: Investors provide... - Support for identifying suppliers and strategic partners - Credibility and certification towards third parties - Connections to professional service providers - Connections to regulators and local government officials ### Organization challenge: Investors provide... - Support for professionalizing start-ups - Pressure to craft a functional corporate culture - Credibility towards potential employees - Network of contacts for managerial hiring - Performance benchmarking Investor Value-Adding --------------------- An additional important dimension of value-adding is helping with the exit challenge: investors help by - pressuring companies to build a profile that acquirers or stock markets expect (e.g., a focus on a limited set of products, or a more developed corporate structure) - Instilling a corporate culture of transparent communication, consistent financial reporting,... Replacing Managers ------------------ Investors obtain and retain rights to allow replacing underperforming managers. They often use these rights. Why do problems arise? - Founders are often inadequate managers. - Entrepreneurial skills and managerial skills may be uncorrelated - Some founders welcome a changing role, other resist it MODELLING AGENCY CONFLICTS -------------------------- - See slides, clear explanation Chapter 9: Staged Financing =========================== Financing growth ---------------- - Most start-ups only raise one round because they fail to develop. - Those which survive typically raise additional rounds. - The investor could just provide all the needed money at once, and wait for the results -- the same way a banker would do. This does not happen. Let's understand why. - Raising successive rounds is called 'staged' financing. - Rounds are called pre-seed, seed, Series A, B, C,... - The following graphs describe the main features of staging: - The number of rounds decreases as the venture matures. - The raised amount increase over the rounds. - Later stages raise more money than early stages. Afbeelding met lijn, Perceel, schermopname, helling Automatisch gegenereerde beschrijving Number of deals that use staged financing The later the series, the less staged financing is used.  The later the series, the higher the amount raised Key motivations for staged financing are: For the Entrepreneur: - staging reduces the cost of fundraising and the associated dilution For the Investor: - staging creates option