New Venture Financing

Dr. Richard Michelfelder, Ph.D.

Spring 2013

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 NVF Course Outline
1. Introduction
2. The Business Plan
3. Business Legal Structure
4. Developing Pro Forma Financial Statements and
Projecting Cash Flows and Profits, Assessing Financial
Needs
5. Business Valuation, Risk Analysis, the Due Diligence
Process for the New Venture
6. Risk Analysis for the New Venture Using Monte Carlo
Simulation
7. Strategies for Harvesting Value: Initial Public Offering
and Other Methods to Extract Value
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 1. Introduction
1.1 Myths About Venture Capital
1.2 Entrepreneurship
1.3 Economic value growth: Consumer and producer surplus
1.4 Survival of NV’s
1.5 The Entrepreneur and Management
1.6 Entrepreneurial v. Corporate Finance
1.7 Objective: Maximize Value for Entrepreneur
1.8 NV Financing Trends
1.9 Why Investors Seek to Finance NV’s
1.9.1 Concept of Efficient Markets and Portfolio Returns
1.9.2 Returns to NV Investments
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 1.1 Myths about Venture Capital
1. VC firms want to run and have control of your business.
2. You must have an introduction to a venture capitalist to
obtain financing.
3. VC’s are only interested in new technological discoveries.
4. VC’s are satisfied with a reasonable return on investment
5. VC’s are quick to invest.
6. VC’s think management is a secondary consideration.
7. VC’s need only summary information before they invest.
8. VC’s expect little negative cash flow and quick positive
cash flow.
9. VC’s like to invest small amounts of capital.

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 1.2 Entrepreneurship
• False Statement: “Entrepreneurs are born, not made.”
– Personal experience
– Ex-corporate executives and government employees
becoming successful entrepreneurs is almost a cliche’.
– People do not know how nor that they can be
entrepreneurs. Entrepreneurship can be taught.

• PriceWaterhouseCoopers(2005): 2004 Global private

equity and venture investment was $110 billion.

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 1.2 Entrepreneurship
Entrepreneur: acquires and applies resources to exploit uncertain
opportunities to innovate that create value and harvest a portion of that
value.

Studied by economists such as Jean Baptiste Say (move resources to

better use), Frank Knight (risk-taker) and Joseph Schumpeter (creative
destruction and economic growth), and contemporary management
expert, Peter Drucker (create value by creating something new).

Entrepreneurship is generally viewed by policymakers and economic

theorists as a key to economic growth and job creation by continually
moving resources to higher value, higher productivity uses.

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 1.3 Economic Value Growth:
Consumer and Producer Surplus
Demand & Supply for New Good
P D S

P0

Q
Q0
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 1.3 Economic Value Growth:
Consumer and Producer Surplus
Demand & Supply for Old Good
P S

P0

Q
Q0
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 1.3 Economic Value Growth:
Consumer and Producer Surplus
• Sum of consumer and producer surplus is the
definition of societal economic value from
microeconomic theory.
• Note that the area of the two triangles for the new
good were greater than that for the old good. The
increase in the sum of these triangles is economic
value creation.
• Entrepreneurs have always been recognized and
played a key role in economic growth theory due to
the productivity that they create.

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 1.4 Survival of New Ventures

• Legendary NASA flight director Gene Kranz during

the Apollo 13 crisis: “Failure is not an option”
• This is not true for entrepreneurship. It should be
expected during a career in business start-ups.
• US Dept. of Commerce: Of 210 start-ups in a specific
year, 2 will exist 5 years later
• Timmons (1999): 23.7% fail within 2 years, 51.7%
within 5 years, 62.7% within 6 years , 80% after 10
years
• The bottom line: most businesses fail!

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1.5 The Entrepreneur and Management
• Entrepreneurs are typically start-up value creators and
not long-term operating managers.
• The entrepreneurial start-up CEO is usually not a
good long-term operational manager, typically due to
interest. They like to create something new, harvest
value and move on.
• Some CEO’s have proven otherwise, such as Bill
Gates (MicroSoft), Larry Ellison (Oracle), Michael
Dell (Dell Computer).

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 1.6 Entrepreneurial v. Corporate
Finance
• NV finance uses the same tools as corporate finance
but are more difficult to apply:
– Valuation of the business highly ambiguous
• Usually multiples of revenues or pre-tax cash flows
• Determined by the agreement between buyer and seller
• Out-year projections almost incredibly high in many cases and
therefore ignored in formal valuation calculations
• “Pre-money” and “post-money” valuations

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 1.6 Entrepreneurial v. Corporate
Finance
• NV finance uses the same tools as corporate
finance but are more difficult to apply:
– Non-separable investment and financing decisions
• Project investment usually involves use of Net Present
Value of before-income-tax cash flows to make the
decision, then how to finance the investment

C1 C2 Ct
NPV  C0   ...
(1  r ) (1  r )
1 2
(1  r ) t

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 1.6 Entrepreneurial v. Corporate
Finance
• NV finance uses the same tools as corporate finance
but are more difficult to apply:
– Risk diversification is similar from the perspective of the
venture capital fund investor but not for non-fund
investors.
– Harvesting value agreement as a component of the
investment decision
– Corporate control: the manager / investor distinction
becomes blurred
– Focus on maximizing value for the entrepreneur and not
other investors.
– Issues of optimal capital structure irrelevant; no debt
– Dividend policy irrelevant; no dividends
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 1.6 Entrepreneurial v. Corporate
Finance
• NV finance uses the same
tools as corporate finance but
C1
are more difficult to apply: NPV  I 
– There is no risk diversification
m
1  k m 
for the entrepreneur as for the
outside investor and therefore
cost of capital is higher: since C1
NPVe  I 
km < ke, NPVm > 0 and NPVe
< 0 so outside investors are 1  k e 
needed who require a lower
rate of return due to the ability
to diversify.

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1.7 Objective: Maximize Value for the
Entrepreneur
• Entrepreneurs overtly have an objective to maximize
their own wealth.
• Corporate finance CEO’s work for the investors’
interests, except for recognition of principal-agent
conflicts.
• Investors want entrepreneurs to maximize their own
value as long as the same incentive achieves value
creation goal of outside investors.
• In NVF, we differentiate the inside and outside
investors’ interests.

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 1.8 NV Financing Trends
Stage of NV Development:
1. Development
2. Start-Up
3. Early Growth
4. Rapid Growth
5. Exit or Buyout

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 1.8 NV Financing Trends
See PriceWaterhouseCoopers / National Venture
Capital Association Investment by Stage of
Development Report 1995 – 2006

See PriceWaterhouseCoopers Global Private

Equity Report 2005

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 1.9 Why Investors Seek to Finance
NV’s
Investors seek to finance NV with tremendous
risk to realize a rate of return on investment
that is more than commensurate to the
investment as compared with alternatives such
as the S&P 500.

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1.9.1 Concept of Efficient Markets and
Portfolio Returns
Efficient Markets Hypothesis: states that stock prices
instantaneously reflect all relevant and available
information, and therefore only new information will affect
stock prices.
Weak Version: you cannot earn excess returns using past
information

Semi-Strong Version: you cannot earn excess returns

using public information

Strong Version: you cannot earn excess returns using any

information, public or inside information

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1.9.1 Concept of Efficient Markets and
Portfolio Returns
Efficient Markets Hypothesis Statistical Test:
St = α0 + α1St-1 + εt
where:
St: stock price at time t
St-1: stock price at time t-1 or previous period
εt: innovation or new information at time t
For efficiency, α0 = 0 and α1 = 1. so that
St - St-1 = εt, or, the difference in stock prices from one day to
the next is due solely to new, unpredictable information.

This is the stock market “random walk” hypothesis.

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1.9.1 Concept of Efficient Markets and
Portfolio Returns
Efficient Markets Hypothesis:
The bottom line is that you cannot consistently earn a rate of
return above the market return for a similar level of risk.
S&P 500 Portfolio Returns and Risk Statistics:
Long-Run Annual Total Return: 12%
Relative Risk (σ/E(kS&P 500): 22%/12% = 1.83
Sharpe Ratio (E(kS&P 500- Rf)/ σrisk prem. : 8.5%/23%=0.36
90-Day Treasury Bill:
Relative Risk (σ/E(kT-Bill): 3.2%/3.8%=0.80
Sharpe Ratio: 0.60

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1.9.1 Concept of Efficient Markets and
Portfolio Returns
Investors in NV’s seek return / reward trade-
off’s that can “beat the market,” that is, earn
returns than are more than proportional to the
risk level.

Sharpe ratios (risk-to-reward ratios) for stocks

are not that exciting as they are more attractive
for US Treasury Bills.
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 1.9.2 Returns to NV Investments
Investors in NV’s seek return / reward trade-
off’s that can “beat the market,” that is, earn
returns than are more than proportional to the
risk level.

Sharpe ratios for stocks are not that exciting as

they are more attractive for US Treasury Bills.

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 1.9.2 Returns to NV Investments
Review Colin M. Mason and Richard T.
Harrison (2002), “ Is It Worth It? The Rates
of Return from Informal Venture Capital
Investments,” Journal of Business Venturing
17, 211-236.

Review John Cochrane (2005), “The Risk and

Return on Venture,” Journal of Financial
Economics, 3-52.
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