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Samenvatting van colleges Entrepreneurial Finance en het boek Venture Capital and the finance of Innovation

Samenvatting van de colleges van het vak 1ZM70 Entrepreneurial Finance gegeven door dr. Dolmans aan de TU/e in 2016-2017.
Uitgebreide samenvatting van het boek Venture Capital and the Finance of Innovation (2e editie).
Lijst met definities
Lijst met formules
Cijfer voor het vak: 9


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Summary Entrepreneurial Finance
Venture Capital & the finance of innovation, 2nd edition
By Andrew Metrick & Ayako Yasuda
Lecture slides 1 6
SB - 2017

Contents
Chapter 1 The VC Industry .................................................................................................................. 2
Chapter 2 VC Players........................................................................................................................... 3
Lecture 1: What is entrepreneurial finance ............................................................................................. 4
Chapter 3 VC returns ........................................................................................................................... 5
Chapter 4 The cost of capital for VC ................................................................................................... 6
Chapter 7 The analysis of VC investments .......................................................................................... 7
Chapter 8 Term sheets (optional) ......................................................................................................... 8
Lecture 2: The VC industry .................................................................................................................... 9
Chapter 10 The VC method ............................................................................................................... 13
Chapter 11 DCF analysis of growth companies................................................................................. 15
Chapter 12 Comparables analysis ...................................................................................................... 16
Lecture 3: Introduction to valuation...................................................................................................... 18
Chapter 19 R&D Finance................................................................................................................... 22
Chapter 20 Monte Carlo simulation ................................................................................................... 23
Lecture 4: R&D Valuation .................................................................................................................... 23
Chapter 13 option pricing .................................................................................................................. 25
Chapter 21 real options ...................................................................................................................... 26
Lecture 5: Valuation real options and strategy .................................................................................. 26
Chapter 22 Binomial trees ................................................................................................................. 28
Chapter 23 Game theory .................................................................................................................... 29
Chapter 24 R&D Valuation ............................................................................................................... 30
Lecture 6: Real and game theory .......................................................................................................... 31
Summary of articles .............................................................................................................................. 33
List of definitions .................................................................................................................................. 40
List of formulas ..................................................................................................................................... 44


Chapter 1 The VC Industry
A VC has five main characteristics:
1. A VC is a financial intermediary, meaning that it takes the investors capital and invests it
directly in portfolio companies.
2. A VC invests only in private companies, so they cannot be immediately traded on a public
exchange.
3. VC takes an active role in monitoring and helping the companies in its portfolio.
4. A VCs primary goal is to maximize its financial return by exiting investments through a sale
or an Initial Public Offering (IPO).
5. A VC invests to fund the internal growth of companies.
A VC fund is organized as a limited partnership, with the venture capitalist acting as the general
partner (GP) of the fund and the investors acting as the limited partners (LP).
Angel investors = Similar to VC but use their own capital and do not function as financial
intermediary.
Corporate Venture Capital = internal venture capital division (CVC), focusses on other strategic
objectives next to financial returns.
There are different types of private equity investing
1. Venture capital
2. Mezzanine = a form of late-stage VC. Form of subordinated debt, additional equity
participation in the form of options.
3. Buyout = take majority of control on their portfolio companies.
a. Leveraged buyout = gaining majority of control by using borrowed money.
4. Distress (special situations) = focus on troubled companies
Basic distinction between Private Equity and Hedge funds is that private equity funds are on longterm investors and hedge funds are on short-term traders.
VC activities
a. Investing = prospecting new opportunities until a contract has been signed
a. Screen hundreds of possibilities
b. Dozen given detailed attention, fewer will merit a preliminary offer
i. Offer given by a term sheet = outlines the proposed valuation, type of
security and proposed control rights for the investors.
c. If accepted, VC performs due diligence = analyzing every aspect of the company
d. If satisfied closing the deal
b. Monitoring = working with the company through board meetings, recruiting and regular
advice.
c. Exiting
Management fees = LPs put up the capital and are given a few percentage points of this capital paid
every year.
The remainder is then invested by the GP in private companies. Most common profit-sharing
arrangement is 80-20 split = after returning the original investment to the LPs, the GP keeps 20% of
everything else = carried interest.
Stages of growth
1. Seed/startup stage prove of concept
2. Early stage completing development where products are mostly in testing or pilot
production, just made commercially available
3. Expansion (mid) stage initial expansion of company, may or may not be showing profit
4. Later stage reached fairly stable growth rate, may or may not be profitable, positive cash
flow


Chapter 2 VC Players
Capital calls/drawdowns/takedowns = periodic capital provisions raised by GPs from LPs
Committed capital = total amount of capital promised by the LPs over the lifetime of the fund
Investment period/commitment period = span of years in which fund invest in portfolio companies
Follow-on investment = further investments after an investment period
Vintage year = year a fund is raised
Fund-of-funds (FOF) = organized as a LP, with many of the same rules as other private equity funds,
investing in other private-equity funds, not portfolio companies
FOF act both as LP and GP.
Management fee = a set percentage of committed capital every year (2%) for LPs
Lifetime fees = sum of the annual management fees for the life of that fund
Investment capital = the committed capital of the fund minus lifetime fees
Why are VC funds different from other money management industries who have management fees
1. If management fees were based on portfolio values, these fees would be low in the first years.
Not allowing VCs to pay their fixed costs.
2. Management fees based on portfolio value would create an incentive for VCs to invest
quickly, which is a sacrifice in quality.
3. Market values of the portfolio are hard to calculate for nontraded companies.
Realized investments = investments that have been exited or those in companies that have been shut
down
Unrealized investments = investments that not yet exited in companies that still exist
Cost basis (of an investment) = the dollar amount of the original investment
Invested capital = the cost basis for the investment capital of the fund that has already been deployed
Net invested capital = invested capital minus the costs basis of realized and written-off investments
To minimize the incentive to overinvest in early years the management fee base (often) changes from
committed to net invested capital after the five-year investment period is over.
Carried interest basis (carry basis) = threshold that must be exceeded before the GPs can claim a
profit
Profit = exit proceeds committed capital
Contributed capital = the portion of committed capital that has already been transferred from the
LPs to the GPs invested capital plus any management fees paid to date
Net contributed capital = contributed capital minus the cost basis of any realized and written-off
investments
Priority returns (preferred returns/hurdle returns) = GP promise some preset rate of return to the
LPs before the GPs can collect any carry factor affecting the timing of carried interests rare in
early stage, common in late stage only affects the timing, not the total amount of carry.
Catch-up provision = provide the GPs with a greater share of the profits once the priority
return has been paid the GP receives a greater share until the preset carry percentage has
been reached.
If there is no catch-up then the GP earns carry on the portion of profits above the priority
return.
Clawback = the LPs right to take back from the GPs carry when excess losses have been made
Clawback become more of an issue when there is a priority return.
Variations in carry occur in:
the percentage level of the carried interest
the carried interest basis
the timing of the carried interest





priority returns
clawbacks

Restrictive covenants = limitations set by LPs for GPs. They come in three categories
1. Restrictions on management of the fund
a. Main incentive problem for carry provides an upside to the GP without the
corresponding downside
2. Restrictions on the activities of the GP
3. Restrictions on the types of investment

Lecture 1: What is entrepreneurial finance
Financial planning and forecasting
- An aid to determine whether venture deserves the entrepreneurs investment of capital, time
and effort.
- A disciplined means of evaluating the cash need of a venture stimulates financial awareness.
- Provides an internal and external benchmark for development.
- Demonstrates economic potential to potential investors.
- Provides the basis for evaluating the financial terms and ownership terms of a deal with
prospective investors.
- A means of comparing the expected values of strategic alternatives
A financial plan is based on assumptions about:
- Sales forecasts - Who your customers are, sales per customer, number of customers and
growth rate of sales
o Time frame of two or three years
o Develop a unit sales projection easier than breaking it up into components
o Use factors for a new product
o Break the purchase down into factors e.g. restaurant, occupied tables per hour
o Project price for the estimated units of different sales items
- Costs forecasts - The costs of doing business
o Associated with the sales forecast
o Set the average costs per unit
- Income statement & cash flow statement - The timing of cash receivables and payables
o Depreciation refers to two aspects
The allocation of the cost of assets to periods in which the assets are used
The decrease in value of assets
o Assumptions about the timing of cash receivables and payables are specified in a time
frame (Net Working Capital)
o Cash flow Cash received from sales cash paid to suppliers, salaries, labor, taxes
and interest = net cash from operations + sales of assets + new debt + new equity
investment = net cash prior to disbursements new assets purchased stock
redemptions dividends paid debt retired = net cash
- Balance sheet - The starting value of cash and assets
Always make three scenarios best case, worst case and realistic case.
Sources of finance
- Founders
- Family and friends
- Business angels
- Seed capital
- Venture capital


Crowd funding
Bank loans
Debt to suppliers
Customer prepayments
leasing companies


Established companies
Government grants and
credits
Public stock offering

Sources and stages of funding
Personal resources and self-funding
1. Moonlighting founder is still working a regular job
a. Advantages: Income from job helps to support the entrepreneur during low cash and
provides working capital. Provides a source of survival income
b. Disadvantages: two jobs is difficult to manage. Problems arise when employee is
working on his own venture during office hours
2. Bootstrapping to start a firm by ones own efforts and to rely solely on the resources
available from oneself, family and friends. Entrepreneurs become more efficient and cost
conscious.

Chapter 3 VC returns
= =

+
1
1

Rt = return for period
Pt = the value (price) of the portfolio at the end of period t
Dt = the dividends (distributions) earned by the portfolio during period t
Pt-1 = the value (price) of the portfolio at the end of period t-1
Compound return = multi-period returns = (1 + ) 1
Annual returns are used more frequent


= (1 + ) 1
Realized returns/Historical returns = returns that have been earned in the past
Expected returns = returns that are forecast for the future
Gross-return index Sand Hill index = lower bound on the gross returns to VC
Net-return index Cambridge Associates (CA) index = upper bound on the net returns to VC
The problem with annualized returns is that each year weighs equally, providing counter-intuitive
numbers. Therefore an IRR can be computed
Internal Rate of Return (IRR) = weighs effectively each dollar equally (cash flows)
Weaknesses of IRR
1. IRR cannot be directly compared to periodic returns
2. Standard practices of IRR calculation can lead to confusion


3. Does not usually make a distinction between realized and unrealized investments
4. Misleading in the first few years of a fund
a. J-curve/hockey stick = the form of the IRR curve of successful VCs.
5. Not showing how much money is made
Well how to answer how much money did you make me
Value multiple/investment multiple/realization ratio/absolute return/multiple of money/times
money = measurement to show how much money is multiplied for every dollar invested
Can be divided into realized and unrealized investments
Gross value multiple = value multiples on a gross basis for e.g. showing performance where no
fees were charged.
Used to quickly communicate the raw investment performance of a GP, calculating shortcut estimates
for carried investments

=

= % ( )
( )
=


% =

Carry% = the percentage level of carried interest
GP% = the fraction of the investment that is expected to be paid to the GP as carried interest
Can never be higher than carry%

Chapter 4 The cost of capital for VC
Idiosyncratic risk = diversifiable risk = unsystematic risk that is endemic to a particular asset and
not a whole investment portfolio
Can be mitigated through diversification
Capital Asset Pricing model = describes the relationship between systematic risk and expected
return for assets
= = + ( )
ri = cost of capital for asset i
Ri = expected return for asset i
Rf = the risk-free rate for borrowing and lending
Rm = return on the whole market portfolio
= level of risk for asset i
Market premium = (Rm Rf)
Beta reflects the covariance of an assets return with the returns on the overall market. The higher the
Beta, the higher the return
Market risk/non-diversifiable risk/systematic risk =
In order to operationalize the CAPM model a regression analysis can be computed to produce the
Beta desired. This gives an Alpha an abnormal return also known as performance evaluation
regression.
The main driver of financial risk is covariance


There are three main problems for the interpretation of estimation cost of capital for VC
1. Style adjustments
Fama-French model (FMM) used for estimating the cost of capital
= + ( ) + + +
SIZEt & VALUEt = the returns to portfolios of stocks designed to be highly correlated with their
respective investing styles. The Betas are the regression coefficients on these returns.
SIZE and VALUE are known as factors, hence FFM is a three factor model, with the Betas being the
factor loadings.
2. Liquidity risk
Pastor-Stambaugh model (PSM) allows to estimate the premium using data on VC returns by
adding a liquidity factor to the FMM.
= + ( ) + + + +
LIQ = new liquidity factor.
3. Stale values
As estimates are often based on very old information, leading to the phenomenon of stale values. Stale
values cause problems when we estimate the regression models as before, our beta estimates will be
downward biased, because the stale prices will not reflect the full current impact of the market on the
value of VC companies.

Chapter 7 The analysis of VC investments
A potential VC investment goes through four stages before any money changes hands:
1. Screening
2. Term sheet
3. Due diligence
4. Closing

Term sheets are preliminary contracts designed as a starting point for the more detailed negotiations
required for the contract.
A big component of VC success is the quality of prospects at the screening stage also called the deal
flow. The generation of high-quality deal flow, also called sourcing, is a major challenge and takes a
big chunk of VC time and energy.
Important elements of initial screening
- Market test = does this venture have a large and addressable market
- Management test = does the current management have the capabilities to make this business
work
The evaluation of the management team (the management test) is most qualitative part of screening
and due diligence.
The first part of the due diligence is the meeting of VCs with the company management. This is called
the Pitch Meeting.
In general, the more competitive the dal, the quicker the firm will want to deliver a term sheet, and the
more of the diligence that will be left until afterward. Many term sheets include a period of
exclusivity.
There are twelve main topics for a due diligence investigation
1. Management most important part. Often evaluations lead to VC demands that seasoned
executives be hired to fill new roles such as CFO or VP.
2. Market examine the initial impressions of the overall market and convince that a large
addressable market exists.
3. Customers


4. Product (conduct focus groups and surveys)
5. Technology - consult experts in the field. Research the legal protection provided. The best
time to find out that a companys technology infringes on someone elses patent is before you
make an investment.
6. Competition Underestimating the competition is a red flag about managerial capabilities.
7. Projections business plan projections are always grossly inflated. Although such inflation is
expected, it is still important that management understands how to grow.
8. Channels
9. Partners VCs speak with any partners and confirm that relationships are healthy and stable
10. Money investigate how high the burn rate is = to calculate how long a company can last
between rounds of investments.
11. Transaction terms
12. Terrible things this encompasses legal due diligence and environmental due diligence

Chapter 8 Term sheets (optional)
Fully diluted basis = assumes that all preferred stock is converted and that all options are exercised.
Tranches = the $investment spread across multiple payments
Original purchase price (OPP) = price per share
Aggregate purchase price (APP) = price paid for all shares of a security
Post-money valuation = analogue to market capitalization for public companies.
To compute (equity) market capitalization for a public company, the price per share is multiplied to
the shares outstanding. Post-money valuation is calculated in the same way.
=
Pre-money valuation = market capitalization before investment
= $
Founders and employees hold common stock, whilst investors hold preferred stock.
Dividend
There are three ways for preferred stock to receive dividend.
- As startups are often cash poor they cannot provide dividend, therefore they issue dividend
preference to preferred stock. Dividend preference = one cannot pay any dividends to
common stuck unless you first pay dividends to the preferred.
- Alternatively, preferred stock might receive accrued cash dividends to be paid in cash only
upon a deemed liquidation event.
- Finally the preferred stock might receive stock dividends = adds the total holdings of
preferred.
o Such stock is called payment-in-kind (PIK) preferred.
Dividend rights may be cumulative or noncumulative. Difference being that cumulative dividends
accrue even if not paid, whereas noncumulative dividends only accrue during the final period before
they are paid. Cumulative dividends can accrue by:
- Simple interest (same flat percentage yearly)
- Compound interest (which includes dividends paid on previous dividends)
Liquidation preference
A liquidation preference tells an investor where he stands in the capital structure hierarchy.
2X or 3X liquidation preference requires that the investor be paid back double or triple their original
investment before any of the (junior) equity claims are paid off.


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