Learning objectives. MSc Elective. Structure of the lecture. Entrepreneur cont d. 1/ What is an entrepreneur?

Transcription

1 Learning objectives MSc Elective Entrepreneurial Finance Lecture 1: Context Course leader: Prof. Robert Cressy To understand the nature and characteristics of entrepreneurial businesses To understand how these interact with their finance structure and requirements To understand the financial constraints that small entrepreneurial businesses may face To understand the nature of venture capital and the form of the financial instruments it uses Structure of the lecture To be familiar with the structure of the UK venture capital industry To know the returns to UK venture capital in both absolute and relative terms and by stage, duration and sector 1/ What is an entrepreneur? 2/ Stages of new venture development 3/ The role of equity 4/ Venture capital 5/ The UK venture capital industry 1/ What is an entrepreneur? Typical startup entrepreneur (Cressy, 1993) Objectives Independence Being one s own boss Making money But NOT Fast growth Innovation Internationalisation Ultimate sale of the business Entrepreneur cont d Background of entrepreneurs Low level of education Low skill levels Work experience in the area of the startup Sector of business Services rather than manufacturing Retail Construction Property/Professional/Financial services Personal services e.g. hairdressing, car repairs 1

2 1 9 Finance Entrepreneur cont d Owner s resources (savings) Money from friends and relatives (US: love money ) Bank Outside equity? Highly resistant to relinquishing control and/or profits to outsiders Only 1-2% use venture capital Business survival Very short-lived Most die in the first 2-3 years (See Chart 1) Chart 1. Failure rates and initial capitalisation Probability of failue Figure 2: Initial capitalisation and failure (Source: Cressy,1999) Time trading x=8,mu=2,sigma=5 x=15,mu=2,sigma=5 Exercise 1: Rationale of the failure curve Why do you think the failure curve above Has the shape it does Shifts in the way it does as initial capital increases? Hint: think how startup capital is used by a business Why do they have it? What were Keynes three motives for personal savings? Failure & initial capital cont d (Answer to Exercise 1) Shape of the curves Bell shaped and skewed to the right Failure rates high initial failure rate followed by low long run failure rate Comparison of pink and blue curves Higher initial capital (pink curve) is associated with: Longer honeymoon period (zero failure probability) Lower peak failure rates Lower average failure rates Median value on Pink curve is to the right of that on the Blue Theory of failure The message: Less well-capitalised startups are more failure-prone This affects firms in a dynamic way through the lifecycle Theory of mistakes When entrepreneurs start in business they make mistakes These mistakes are costly (e.g. investing in too large a set of premises by misjudging demand changes) Mistakes increase risk Causing depletion of the initial capital resources Growth reduces risk By adding profits to the business The larger the initial resources the longer the time it takes for the firm to fail for a given growth rate 2

3 Effects of credit market behaviour/imperfections Banks are least likely to lend when the business is in trouble In order to get a bank loan you have to prove you don t need it Failure is therefore more likely the smaller the capitalisation of the business Theory of learning Business is a learning experiment (Jovanovic, 1982) Entrepreneurs have to learn ways of doing things that work and are least cost or most profitable After making mistakes they learn better ways of doing things This means that markets and suppliers for a business take some time to get established During this initial period the business is particularly vulnerable The larger the initial resources the less likely is this to result in failure The sophisticated Entrepreneur (Bhide, 1999) Business ideas Mainly from work experience (see Chart 2) Entrepreneurial objectives Objective 1: A large enduring enterprise Revolutionary idea e.g. Gates and the PC: A PC on every desk Smith and the FedEx global overnight mail delivery system Nokia and the mobile phone Mass market New processes/manufacturing techniques Big money and organisation Inspirational leadership style Skills required: deal-making strategic planning publicity management of overheads etc. Chart 2. Work experience pays dividends: Sources of entrepreneurial ideas (Bhide, 1998) Sophisticated cont d Modified idea from previous employment Discovered through systematic research Swept into the PC revolution Discovered serendipidously Objective 2: A quick profit Market niche Relatively small number of customers not served by existing suppliers Differentiated product rather than a mass market No breakthrough technologies required Skills: Ingenuity in siphoning off customers Appropriate pricing policy to cover high (unit) fixed costs 3

4 Sophisticated cont d Entrepreneurial strategy Business opportunities Screen opportunities quickly Analyse ideas parsimoniously Combine research and action Finance Search for appropriate kinds of finance Cheapest/best sources Flexible attitude to control Prepared to relinquish some equity for growth Rational ( instrumental ) attachment to the business Often willing to sell the business after objectives fulfilled Sophisticated cont d Finance constraints Bank financing often unsuitable Collateral required Most assets intangible e.g patents, copyrights, implicit knowledge Most likely to have no or low initial sales Business therefore often loss-making at outset Lack of understanding by banks of high technology Only a constraint for 25% of fast growth businesses Sophisticated cont d Risk Market Overall demand uncertainty Competitors Technology Will the product materialise? E.g. a cure for diabetes or aids Will it sell if it does? Side effects? Small scale initially VCs in Europe often shun small early stage projects Prefer large scale, low risk investment e.g. UK (see later) Hence need to rely on Angel involvement Track record Little or none for startups Judgements of financiers therefore based on people factors 2/ Stages of new venture development Figure 1 shows a stylised graph of returns to a new firm taken from Smith and Smith(2) The firm moves through the following stages Development Startup Early growth Rapid growth Exit Note: This is a stylised picture and one to which many firms will only partially conform. E.g. they may fail at startup. Chart 1 demonstrates this point Stages of New Venture Development Chart 3 Venture development cont d Development stage Dollars Time Revenue Net Income Cash Flow Sales (revenues) None at this stage At most a prototype product Cash flow Funds are initially acquired to develop and test a prototype product or service These may be used up rapidly and the firm is spending more than it receives Net cash flow is negative Development Start-up Early Growth Rapid Growth Exit 2, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2 4

5 Venture development cont d Startup stage Sales None initially but sometime into startup Customers are attracted Sales start to grow Cash-flow Still negative as investments need to be made in: Short term assets (NWC) Trade debtors: often large firms who are slow payers Trade creditors: suppliers demand early payment Wages need to be paid despite these lags in cash payments (see Figure ) Hence overdraft facilities (short term borrowing) taken on board When net cash flow becomes positive the overdraft is paid off Venture development cont d Long-term assets (FA) Fixed capital is being purchased rather than sold Long-term loans may be required or equity must be raised Factory premises, machinery, computers, laboratories etc. need to be purchased Such investments involve net cash outflows Equity investments may be necessary to fund these Venture development cont d Early & rapid growth Sales The market has been identified Eventually demand takes off Exponential growth of sales Cash-flow Eventually becomes positive as Trade credit is managed better Trust is built up with customers and suppliers Unit operating costs fall with output As experience accumulates Good suppliers identified Venture development cont d Exit Sales Growth rate levels out Firm has an established track record of Profitability Growth Dividends to shareholders Entrepreneur is willing to sell shares to the public She may personally cash in and allow control to be taken by the Board appointed by the shareholders Form of exit IPO Trade sale Exercise 2: Cash flow and profits Describe the situation in the next Figure Where is the breakeven point? In profit terms In cash flow terms Over what period will the firm have to borrow to fund its operations? Startup Figure 1: Cashflow & profits after startup Sales(t) Purchases(t) Net Cash flow(t) Cash outflow from Purchases (t) Cash inflow from Sales(t) Wages(t) Time(t) 5

6 Cash-flow breakeven (Answer to exercise) The firm s sales and purchases occur immediately it starts up E.g. a pure arbitrage business such as used cars The period of trade credit is the same for sales and purchases and is t* (see next figure) Cash needs to be paid in wages from the outset Only after the period of trade credit (t*=9 days) is net cash flow positive The profits breakeven point is at t= The cash flow breakeven point is t=t* Startup k-w -w Figure 2: Cash-flow breakeven (Answer to Exercise 2) Wages(t) t* Net Cash flow(t) Cash outflow from Purchases (t) Cash inflow from Sales(t) Time(t) 3/ The role of equity The firm would have to borrow e.g. on overdraft, until t* is reached Then it could start to pay off its debts Finance problems affect the early stages of the business: Survival (see chart 1) Growth NB. Problems may have their origins in causes other than finance e.g. management deficiencies Equity cont d Broad types of funding available Debt Advantages No loss of control Larger share of profits to owner Disadvantages increases financial risk requires collateral Equity cont d Private equity Definition: long term finance provided by outsiders for a share in the ownership of the firm Advantages Long-term funds Reduction in financial risk D/E ratio declines: Allows more debt to be taken on board if required No commitment to fixed payments (as with debt): dividends not compulsory 6

7 Case study: Equity rationing? There is a growing body of evidence suggesting that small firms may not get enough funds according to NPV criteria This applies to equity as well as debt Small firms are considered by some as having lower return and higher risk Rationing cont d Carpenter and Petersen (21) Sample of some 2,5 US firms that went public in the period Measures of size and financing recorded At time of IPO After IPO Findings At time of IPO Average (median) firm makes little use of long-term debt (5-8% total assets) Larger firms make more use of it (4-5% total assets) Rationing cont d Post-IPO use of equity New equity (from IPO) is extremely important in financing assets Median ratio of new equity to TA is th percentile ratio is Hence IPO permits big increase in firm assets But little equity is raised subsequent to IPO (see Fig. ) Despite significant employment growth $bn equity Use of equity by hi tec firms post IPO, US, New equity issues ($bn) Ratio of new equity to total assets 4 Interpretation The authors argue that this is evidence of financing constraints What interpretation would you place on the findings? 2 t t+1 t+2 t+3 t+4 t+5 Years from IPO date (t) Definition: 4/ Venture capital Venture capital is the purchase by outsiders of shares in an unquoted company The objective is primarily for the purpose of capital gain Cumulative convertible preference shares (CCP) VCs typically initially supply funds in the form not of common stock (ordinary equity) but in Preference shares Cumulative Dividends can be delayed until IPO (or 6-8 years, whichever is the sooner) Cumulated unpaid dividends can then be paid in one sum Convertible They can be converted into equity at the behest of the shareholder This is more likely if the firm is perceived to be doing well 7

8 CCP cont d Preference shares These are shares without voting rights but which have more senior claims if the firm is Liquidated Sold to another party Why the preference for Preference? (Taken from Gompers and Sahlman, 21) Consider the following business situation: An entrepreneur Joe Flash sells 5% of his startup business Surfit, for 1.5 to Rex VC, a venture capitalist a 5.5/49/95 split to be exact leaving Joe with a majority stake and control over decisions This values the business at 3m Rex paid 1.5m for half of Surfit Surfit s Assets: Tangible: 1.5m cash Why? Cont d Intangible: Joe s Powerpoint slides and business plan Another businessman John Terrific offers Joe 2m for Surfit Joe accepts giving 1m to Rex (his 5%) 1m to Joe (his 5%) Why? Cont d Note what has happened to Rex s investment: It has instantly fallen in value by 5k or 33%! Note that John Terrific has been able to recruit Joe and his business idea for a mere 5k! He has acquired a business for 2m with cash assets of 1.5m Hence his net price for the deal is only 5k Why? Cont d How does Rex VC avoid this problem? By use of one of the following: Preferred stock Vesting of founder, management and key employee shares Covenants and supermajority provisions We examine only the first: preference shares Preferred stock has liquidation preference over common stock (=ordinary shares) Why? Cont d It gets paid before common stock does in the event of liquidation sale of the business to another party Hence in our example, if Rex VC had invested 1.5m in preference shares under the sale to John Terrific Rex would have had this sum returned to him on sale before any payment to ordinary shareholders What about the remaining 2m- 1.5m= 5k from the sale? It depends on the type of preferred stock used: Redeemable preferred Convertible preferred 8

9 Why? Cont d Redeemable preferred (RP) Cannot be converted into equity Carries a negotiated term specifying when it must be redeemed by the company, typically smaller of: IPO date 5-8 years Agreement might have been: Rex pays 1.5m for RP with face value 1.5m And Rex gets 49.95% of common equity = 25k Joe gets 5.5% of common equity = 25k Why? Cont d Convertible preferred (CP) Can be converted to common equity at the shareholder s option Forces the shareholder to decide whether to take her returns through Liquidation option (e.g. at IPO) Conversion option (before IPO) What are the choice criteria? Looking back, we can see that Rex VC would not have converted his preference shares in to common stock: In so doing his wealth would have fallen Why? Cont d Thus the criterion is rather simple: if the current value of the firm exceeds the initial value (I.e. the value immediately after the initial investment) then convert else, do not convert For example, if the offer Joe had received was 4m and Rex VC converted his preference shares into equity he would receive 5% of 4m or 2m This is > 1.5m Rex had initially invested. Trester s data Financial structure of venture capital deals, USA, 1998 Table 1 All deals, Early stage, # venture firms =8, percentages Mean(95%) Confidence interval (n=8) Min Max Preferred Common Debt Table 2 All deals, Later stage, # venture firms=8, percentages Mean(95%) Confidence interval (n=8) Min Max Preferred Common Debt Table 3 Preferred deals where preferred is convertible (%), # venture firms=8 Mean(95%) Confidence interval (n=8) Min Max Source: Trester(1998) The inference from Trester s data is: Most venture capital deals involve a majority of preferred stock rather than ordinary equity It is more common in Early stage deals than Later stage ones The vast majority (almost 9%) of preferred is convertible 5/ Context: UK formal venture capital industry Our definition of venture capital includes Informal venture capital: Business Angels Investments: Small sums of money (< 1m) Investors: high net worth individuals (e.g. successful entrepreneurs) with a hands-on approach to investment play a role in managing firm usually live and invest locally Formal or Institutional venture capital Investors: Large financial institutions Investments: Large sums of money 9

10 Context cont d Context cont d VC Fund types 1. Captive funds Source of money Own-money Big organisations Clearing banks Big VC firms e.g. 3is Investment Stage: MBO/MBI Size: Large Horizon: Short 2-4 years Exit route: Flotation, London Stock Exchange Management style Hands-off Transaction-based Practitioner profile Age Young: 2s-3s Qualifications Profession: accountant Education: graduate, highly numerate, computer-literate, financerelated 2. Non-captive ( Active ) funds Source of money Other people s Wholesale: Institutions (pensions, insurance) Retail: Dedicated funds (Investment trusts, limited partnerships, VCTs, EIS) VC Investment Stage Size Context cont d Various: Seed, startup, expansion, MBO/MBI Smaller than those of captive funds Horizon Longer: 5-7 years Management Hands-on Exit route Private: Trade sale (% ) Public: flotation on 2 nd ary market (% ): AIM, TechMark Numbers Chart 4: Numbers of investments by stage Source: BVCA, 1999, Table 4 Refinancing bank debt Secondary purchase MBI Startup Other early stage MBO Expansion Chart 5: UK investment value by stage Source: BVCA, 1999, Table 4 Value of investments by stage Context cont d Charts 4 and 5 show that in term of numbers Business expansion accounts for almost half of venture capital investments Management Buyouts & Early stage Each accounts for about a quarter of investments However, in terms of total share of funds Management buyouts take the lion s share (75%) Early stage take a very small proportion (5%) Startup Other early stage Expansion Secondary Refinancing bank MBI MBO purchase debt 1

11 Context cont d Chart 6 shows that this is accounted for by size of investment the average size of VC investment is largest in MBOs at around 16m smallest in Startup and Expansion at around 1m and 2m respectively Average amount invested ( ) Chart 6: Average size of investment by stage Source: BVCA, 1999, Table 6 Average formal VC investment size by stage, UK 1999 Startup Other early stage Expansion Secondary purchase Refinancing bank debt MBO MBI Stage of investment Exercise 3: Job matching in venture capital Which of the above two fund types (if any) would you most likely fit into, jobwise? Why? VC Industry structure Market segments Seed, Startup Expansion Secondary purchase MBO/MBI Rescue/turnaround Technology VC firms Focus Generalist Context cont d Range of market segments e.g. 3i, Apax, HSBC Specialist Specific market segments e.g. Early Stage or Biotechnology Number of funds Chart 7: VC fund distribution by Stage Source: Denny(2) Chart: Number of VC funds by Stage of investment, 1998 The chart shows that Fund focus Numbers of funds are evenly distributed by Stage, but Early Stage has lower representation than the rest Generalist are about as common as specialist funds 4 2 Early stage Development Mid size MBOs Large MBOs Generalist All funds Stage 11

12 Exercise 4: DIY industry analysis Go to the BVCA website and check out How many VC firms there are in the membership How many are in the following sectors High tech Biotechnology Telecommunications Computers Electronics Conventional E.g. consumer goods Calculate the average size of company (assets under control) in each broad sector Compare the two sectors and explain Fund performance VC industry performance (see Chart 8) Stage returns in the UK Rate of return rises steadily with scale from Early Stage to MBO It is highest in the early years of the investment, or in shorter-lived investments (Data doesn t tell us which) Generalist funds come out about average over all stages Chart 8: Returns by Stage and Duration Source: Denny, 2 Exercise 5: High tech returns Percentage IRR per annum Returns to VC investment by Stage, years 5 years 1 years What is commonly meant by a high tech firm? Would you say that high tech returns are likely to be higher/lower/the same as conventional investments? List your reasons 5 Early stage Development Mid size MBOs Large MBOs Generalist All funds Stage of investment Returns to specific sectors:high-tech (Answer to Exercise 5) UK high tech investments at early stage Differ from the typical early stage investment They provide higher returns than other stages in that sector 28% versus 23% Higher returns than Expansion (15%) and MBO/I (2%) See Chart 9 These returns were measured from inception to 1998 Thus they avoid the distortion of the technology stocks bubble of the year 2 High-tech cont d Highest returns were in fact in Communications (38%) IT (23%) Biotech and Healthcare (21%) 12

13 Chart 9: High tech sector returns VC benchmark comparisons IRR (% p.a.) High tech Venture Capital investment returns, from inception to 1998 ( Source: Bank of England, The financing of technology-based small firms, 21) Total high tech Early stage high tech Expansion MBO/I Comparison with alternative investments (benchmarks) See Chart 1 The return to VC investment is higher over a shorter period: VC delivered a 3% p.a. IRR to investors over 3-5 years After that (1 years) returns halve to 15% pa. The FTSE1 is the best alternative use of funds over the period at 23% IRR pa. The FTSE Small Cap. showed the lowest return of the alternatives considered. At an IRR of 15% it returned about half that from VC investment Chart 1: VC and benchmark comparisons VC cross-country comparisons IRR (% p.a.) Comparison returns to Venture Capital, 1997 (Source: Denny, 2) 3 years 5 years 1 years How do returns in different countries compare? See chart 11 The relative returns to Stages across countries differ significantly: 3-year returns to VC investment were Higher for MBOs in the UK than in the EU and USA Higher for Early stage in the USA and EU than in the UK UK pension funds FTSE All share FTSE1 FTSE Small Cap. Average venture capital return Comparison investment Chart 11: Cross-country VC returns VC returns by stage and duration IRR (% p.a.) year returns to VC investment by stage in the UK, EU and USA, from inception to 1998 (Source: Bank of Engand, 21) Early stage/seed MBO Total UK USA Europe How do venture capital returns vary with stage and duration of investment? See chart 12 Survey covers 134 Venture Capital funds But no standard errors are reported by duration of investment Therefore numbers in individual cells may be small and unreliable However, they suggest (subject to the above) that In the short run (the first year particularly), returns on larger investments are greater than small This holds for investments of longer duration e.g. 1 years 13

14 Chart 12. VC returns by stage & duration Summary and conclusions VC returns by stage and duration of investment (Source: Bank of England, 21) 1 years 9 years 8 years Entrepreneurial enterprises are risky, opaque activities The traditional financial markets therefore seem to supply inadequate funding to them IRR (%, p.a.) Early stage Development Mid MBO Large MBO Generalist 7 years 6 years 5 years 4 years 3 years 2 years 1 year Outside equity is more appropriate than debt for these enterprises Venture capital supplies outside equity to unquoted potentially fast growth companies This is most commonly supplied by cumulative convertible preference shares The UK venture capital industry is the biggest in Europe and second in the world (first being the US) The most common VC investment is for expansion of established firms However, more money overall goes into Management Buyouts/Buy-ins Returns to UK venture capital in the last 3-5 years have outperformed the relevant benchmarks Returns to high tech investments have exceeded the rest However, these returns partly reflect the recent bubble in the tech sector See Notes below Further reading 14