ENTREPRENEURIAL FINANCE

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1 ENTREPRENEURIAL FINANCE Strategy, Valuation, and Deal Structure Janet Kiholm Smith Richard L. Smith Richard T. Bliss Stanford Economics and Finance An Imprint of Stanford University Press Stanford, California

2 CONTENTS List of Illustrations xvii Abbreviations xxiii Preface xxvii Acknowledgments xxxix About the Authors xli PART 1 Getting Started Chapter 1 Introduction Entrepreneurship and the Entrepreneur The Finance Paradigm The Rocket Analogy The Stages of New Venture Development Measuring Progress with Milestones Financial Performance and Stages of New Venture Development The Sequence of New Venture Financing The New Venture Business Plan Organization of the Book Summary 31 vii

3 viii Contents Review Questions 32 Notes 33 References and Additional Reading 34 Chapter 2 New Venture Financing: Considerations and Choices Sources of New Venture Financing What's Different about Financing Social Ventures? Considerations When Choosing Financing: The Organizational Form Regulatory Considerations The Deal International Differences in Financing Options Summary 73 Review Questions 74 Notes 75 Chapter 3 Venture Capital 79 References and Additional Reading Development of the Venture Capital Market The Organization of Venture Capital Firms How Venture Capitalists Add Value Investment Selection and Venture Capitalist Compensation Venture Capital Contracts with Portfolio Companies Venture Capital Contracts with Investors The Role of Reputation in the Venture Capital Market Reputation, Returns, and Market Volatility Summary 115 Review Questions 116 Notes 117 References and Additional Reading 119

4 Contents ix PART 2 Financial Aspects of Strategic Planning Chapter 4 New Venture Strategy and Real Options Product-Market, Financial, and Organizational Strategy 126 "V The Interdependence of Strategic Choices: An Example What Makes a Plan or Decision Strategic? Financial Strategy Deciding on the Objective Strategic Planning for New Ventures Recognizing Real Options Strategic Planning and Decision Trees Rival Reactions and Game Trees Strategic Flexibility versus Strategic Commitment Strategic Planning and the Business Plan Summary 157 Review Questions 157 Notes 158 References and Additional Reading 160 Chapter 5 Developing Business Strategy Using Simulation Use of Simulation in Business Planning: An Example Who Relies on Simulation? Simulation in New Venture Finance Simulation: An Illustration Simulating the Value of an Option Describing Risk Using Simulation to Evaluate a Strategy Comparing Strategic Choices Summary 198 Review Questions 198

5 Contents Notes 199 References and Additional Reading 200 PART 3 Financial Forecasting and Assessing Financial Needs Chapter 6 Methods of Financial Forecasting: Revenue Principles of Financial Forecasting Forecasting Revenue Estimating Uncertainty Building a New Venture Revenue Forecast: An Illustration Introducing Uncertainty to the Forecast: Continuing the Illustration Calibrating the Development Timing Assumption: An Example Summary 239 Review Questions 240 Notes 241 References and Additional Reading 242 Chapter 7 Methods of Financial Forecasting: Integrated Financial Modeling An Overview of Financial Statements The Cash Conversion Cycle Working Capital, Growth, and Financial Needs Developing Assumptions for the Financial Model Building a Financial Model of the Venture Adding Uncertainty to the Model NewCompany: Building an Integrated Financial Model Summary 293 Review Questions 294 Notes 295 s References and Additional Reading 296

6 Contents xi Chapter 8 Assessing Financial Needs Sustainable Growth as a Starting Point Assessing Financial Needs When the Desired Growth Rate Exceeds the Sustainable Growth Rate Planning for Product-Market Uncertainty Cash Flow Breakeven Analysis Assessing Financial Needs with Scenario Analysis Assessing Financial Needs with Simulation How Much Money Does the Venture Need? Assessing Financial Needs with Staged Investment Summary 334 Review Questions 335 Notes 336 References and Additional Reading 336 PART 4 Valuation Chapter 9 Foundations of New Venture Valuation Perspectives on the Valuation of New Ventures Myths about New Venture Valuation An Overview of Valuation Methods Discounted Cash Flow Valuation The Relative Value Method Valuation by the Venture Capital Method Valuation by the First Chicago Method Reconciliation with the Pricing of Options Required Rates of Return for Investing in New Ventures Matching Cash Flows and Discount Rates Summary 378 Review Questions 379

7 xii Contents Notes 380 Chapter 10 Valuation in Practice 386 References and Additional Reading Criteria for Selecting a New Venture Valuation Model Implementing the Continuing Value Concept Implementing DCF Valuation Methods New Venture Valuation: An Illustration The Cost of Capital for Non-US Investors Summary 428 Review Questions 429 Notes 429 References and Additional Reading 430 Chapter 11 The Entrepreneur's Perspective on Value Opportunity Cost and Choosing Entrepreneurship The Entrepreneur as an Underdiversified Investor Valuing Partial-Commitment Investments Implementation: Partial Commitment Shortcuts and Extensions Benefits of Diversification A Sanity Check: The Art and Science of Investment Decisions Summary 469 Review Questions 470 Notes 471 References and Additional Reading 472

8 Contents xiii PART 5 Information, Incentives, and Financial Contracting Chapter 12 Deal Structure: Addressing Information and Incentive Problems Some Preliminaries 478 > ' 12.2 Proportional Sharing of Risk and Return Asymmetric Sharing of Risk and Return Contract Choices That Allocate Expected Returns Contract Choices That Alter Venture Returns Implementation and Negotiation A Recap of Contracting with Asymmetric Attitudes toward Risk Information Problems, Incentive Problems, and Financial Contracting A Taxonomy of Information and Incentive Problems Essentials of Contract Design Organizational Choice Summary 520 Review Questions 522 Notes 522 References and Additional Reading 525 Chapter 13 Value Creation and Contract Design Staged Investment: The Venture Capital Method Staged Investment: CAPM Valuation with Discrete Scenarios Valuation-Based Contracting Model Negotiating to Increase Value, Signal Beliefs, and Align Interests Using Simulation to Design Financial Contracts Information, Incentives, and Contract Choice Summary 567

9 xiv Contents Review Questions 568 Notes 568 Chapter 14 Choice of Financing 571 References and Additional Reading Financing Alternatives The Objective and Basic Principles of the Financing Decision An Overview of the Financing Decision Process First Step: Assess the Current Stage and Condition of the Venture Second Step: Assess the Nature of the Venture's Financial Needs Financing Choices and Organizational Structure How Financial Distress Affects Financing Choices How Reputations and Relationships Affect Financing Choices Avoiding Missteps and Dealing with Market Downturns Summary 599 Review Questions 600 Notes 601 References and Additional Reading 605 PART 6 Harvesting and Beyond Chapter 15 Harvesting Going Public Acquisition Management Buyout Employee Stock Ownership Plans Roll-Up IPO 638

10 Contents xv 15.6 The Harvesting Decision 640, 15.7 Venture Capital Harvesting and the "Internet Bubble" Summary 648 Review Questions Notes 650 References and Additional Reading 654 Chapter 16 The Future of Entrepreneurial Finance: A Global Perspective Completing the Circle Breaking New Ground Public Policy and Entrepreneurial Activity: An International Comparison The Future of Entrepreneurial Finance 683 Notes 689 References and Additional Reading 691 Index 695

Contemporary Financial Intermediation

Contemporary Financial Intermediation Extended Contents Preface Acknowledgments About the Authors xv xix xxi PARTI THE BACKGROUND 1 A Friendly Conversation 3 Introduction 3 The Conversation: 1991 3 Follow-Up