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Transcript of © 2007 Thomson South-Western Chapter 26 Entrepreneurial Finance And Venture Capital Professor XXXXX...
© 2007 Thomson South-Western
Chapter 26Entrepreneurial Finance
And Venture Capital
Professor XXXXXCourse Name / Number
22
Entrepreneurial Finance
Entrepreneurial growth companies
Rapidly growing public or private firms
Large external funding needs and imperfect access to public financial markets
Often based on proprietary technology or unique service
Challenges:
Need to fund rapid growth externally Mostly intangible assets; Little ability to borrow Extremely high risk, potentially high return
companies Must attract top people with minimum cash
outlay
Entrepreneurial growth companies very reliant on equity finance
33
Types of Venture Capital Funds
Institutional venture capitalists SBICs Financial and corporate venture capital Corporate venture capital Capital limited partnerships
“Angel” capitalists
44
Annual Venture Capital Investments in the United States, 1990 –2005 (in $ billion current dollars)
55
Geographic and Industrial Investment Patterns
Venture capital investments are highly concentrated geographically.
California usually receives over half US total VC investment. Silicon Valley attracts 25-50% of total.
New England, NYC, Washington DC also major recipients
Investments predominant in high-technology industries;
Specific target industries change over time.
Are venture capital investments profitable though?
66
U.S. Venture Capital Investment by Industry: 2004 and 2000
77
U.S. Venture Capital Investments by Stage of Company Development, Percent of Total Investment, 1997–2004
%
88
Economic Impact of 35 Years of U.S. Venture Capital Funding, 1970 –2004
99
How Investments Are Structured
Venture capitalists almost always invest using convertible preferred stock.
Venture capitalists typically make early and expansion stage investments.
The earlier the stage of investment, the more onerous the venture capitalists’ terms will be (price, control surrendered)
Staged financing
Preserves cancellation option for venture capitalist at each stage
Same venture capitalists tend to remain throughout a firm’s development.
1010
Distribution of Rights and Responsibilities
Venture capital contracts allocate risk, return, and ownership rights between the entrepreneur (and other existing owners of a portfolio company) and the fund, depending on (1) the experience and reputation of the
entrepreneur (2) the attractiveness of the portfolio
company as an investment opportunity (3) the stage of the company’s development (4) the negotiating skills of the contracting
parties (5) the overall state of the market
1111
Typical VC Investment Contract Covenants
Ownership right agreements: set voting rights, board seats
Ratchet provisions: protect the venture capitalist in the event of new equity sales
Demand registration rights, participation rights, repurchase rights: exit strategies for
venture capitalist
Stock option plans: designed to attract and motivate key managers
1212
Convertible Securities
1. Because convertible debt or preferred stock is a distinct security class, contract terms and covenants specific to that issue are negotiable. F
2. Firms can create multiple classes of convertible debt or preferred stock, and use these securities to construct complex contracting arrangements with different investor groups.
2. Seniority places the VC ahead of the entrepreneur in the line of claimants on the firm’s assets should the firm not succeed.
3. Give VCs the right to participate in the upside when portfolio companies thrive.
1313
The Pricing Of Venture Capital Investments Based on company’s development stage, expected future
firm value and entrepreneur prestige Earlier the development stage, higher the return
demanded Expected future market value based on firm’s expected
earnings (NI) and likely P/E ratio at exit date (IPO or merger). Algebraically: Exp MV = Exp(NI) x P/E
Venture capital pricing inputs: Required return (r), years to exit via merger or IPO (n), and initial investment amount (A) Looking for expected firm value in n years (FV) From this determine fraction of equity (%Equity) VC
receives
An example....
Venture capitalist to provide $5 million
IPO expected: n = 5 yrs; Exp(NI)= $4,000,000; P/E = 20
A = $5,000,000; r = 50%.
1414
The Pricing Of VC Investments
Step 1: compute value of VC stake at exit date:
FV = A (1+r)n = $5,000,000 x (1.50) 5 = $38,000,000
Step 2: compute expected firm market value at exit date: Based on Exp(NI) and expected P/E ratio:
Expected MV = Exp(NI) x P/E = $4,000,000 x 20 = $80,000,000
Step 3:compute fraction of firm’s equity VC will take today:
%Equity = FV ÷ Exp MV = $38,000,000 ÷ $80,000,000 = 0.475
So venture capitalist invests $5 million, receives 47.5% of firm.
Very expensive financing!!
1515
Venture Capital Exit Strategies
(1) IPO of shares to outside investors
(2) Sale of the portfolio company directly to another company
(3) Selling the company back to the entrepreneur/founders (the redemption option)
1616
Venture Capital Exit Strategies
Preferred exit vehicles: IPO, followed by mergers
On average, IPOs return about 4 times initial VC investment Mergers less than half as profitable
Third exit: forced sale (redemption) to entrepreneur
Venture capitalists do not sell many shares at IPOHold for 1-2 years after IPO, then distribute shares to limited
partners
1717
European Private Equity Investment, 1989–2004 (in € billions)
1818
European Private Equity Investment, by Industry (2003 and 2000)
1919
European Private Equity Raised by Type ofInvestor, Year 2003 (€ 29.096 billion total investment)
2020
Distribution of European Private Equity Investment by Stage of Company Development, 1997–2004
2121
Investment Returns to Categories of EuropeanPrivate Equity Investment, 1984–2003
2222
European Venture Capital
European venture capital (EVC) comparable to U.S. in size
Investment concentrated geographically and industrially
Technology accounts for increasing fraction of EVC
2323
Key Requirements For A Strong Venture Capital Industry
A tradition of entrepreneurship and risk-taking A well-established legal system, with good investor protection A supportive, but non-interventionist, government A stable regulatory system that doesn’t penalize start-ups A free (and mobile) labor market, rich in engineering talent A non-punitive taxation regime that allows use of stock options A strong R&D culture, especially in universities or national labs A vibrant IPO market, but could be a result, not a prerequisite Funded pension system (independent funds) very helpful
What economic, cultural and legal features will promote a strong venture capital industry?
2424
Does a Nation’s Legal System Influence the Size of Its Venture Capital Industry?