Chapter 1 Chapter 1 Introduction to Entrepreneurial Finance Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of

Chapter 1 Chapter 1 Introduction to Entrepreneurial Finance Copyright 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Learning Objectives Understand how new venture finance is different from corporate finance. Understand the centrality to new venture finance of the objective of maximizing value for the entrepreneur. Briefly describe the evolution of thinking about the nature of entrepreneurship and how entrepreneurship relates to new venture finance. Describe the process of new venture formation from inception of the idea to harvesting of the investment. Recognize that studying new venture finance can contribute to better decision-making and increased potential for success. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

Diversification of risk affects investment value. Investment and financing decisions are interdependent. Outside investors may be actively involved in a venture. The parties have different information (and beliefs). The parties have different incentives from each other. New ventures are portfolios of real options. Value to the entrepreneur is different from value to shareholders. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Intellectual Challenge Chapter 1

Construct new venture financial models Assess the timing and amounts of financial needs Estimate risks and expected returns of financial claims Value financial claims in light of diversification Evaluate alternative new venture strategies Estimate the effects of complex options on value Design and negotiate deals Address information and incentive problems Understand the institutions of new venture finance Develop a business plan to attract outside funding After This Course, You Should Be Able To: 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

The Finance Paradigm More of a good is preferred to less. Present wealth is preferred to future wealth. Safe assets are preferred to risky assets. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

Investment Decisions Financing Decisions Mixed Decisions Types of Financial Decisions 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

Terminations as a percent of start-ups Terminations with loss to creditors as a percent of start-ups Source: Case, J., "The Dark Side" Inc. Magazine, 1997, http://www.inc.com/incmagazine/archives/27960801.html, based on The State of Small Business: A Report of the President, 1994, U.S. Government Printing Office, Washington, D.C., 1995. New Business Formations & Terminations

The Objective 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1 Maximum Value for the Entrepreneur

Caveats Investment value is not the only factor an entrepreneur or investor can consider. The CAPM-based valuation models used in the book do not fully describe how investors view risk. Risk and expected return can be estimated, but not measured with precision. Not every new venture investment or financing decision should be carefully modeled and evaluated. Examples in the book are not intended to suggest that any party to a deal should try to capture all of the value for themselves. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

Chapter 2 Overview of New Venture Financing Copyright 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Learning Objectives Learn new venture financing terminology. Understand the value of tying financing to performance milestones. Recognize the distinguishing characteristics of the various stages of new venture development. Identify the financing sources available to a new venture and the factors favoring one financing source over another. Learn the basic structures and availability of various financing sources. Identify the key elements of deal structure and the functions they serve. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Completion of Concept and Product Testing Completion of Prototype First Financing Completion of Initial Plant Tests Market Testing Production Start-up First Competitive Action First Redesign or Redirection First Significant Price Change Some Milestones for New Venture Planning 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2 Block and MacMillan (1992)

Development Stage Start-up Early Growth Rapid Growth Exit Stages of New Venture Development 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Figure 2-1 Stages of New Venture Development 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Bootstrapping Seed Financing R&D Financing Start-up Financing First-stage Financing Second-stage Financing Third-stage Financing Mezzanine Financing Bridge Financing LBO, MBO, IPO Sequence of New Venture Financing 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Self, Friends, and Family Business Angels Venture Capital Investors Small Business Investment Companies (SBICs) Trade Credit and Factoring Asset-based Lending Mezzanine Capital Private Placements of Equity (Relational Investors) IPOs Public Debt Sources of New Venture Financing 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Sources of New Venture Financing 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Figure 2-3 Part I 1978 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2 Venture Capital Commitments by Source

Figure 2-3 Part II 1991 - 1995 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2 Venture Capital Commitments by Source

Figure 2-4 Software/ Information 24.7% Communications 22.8% Healthcare 11.4% Biotechnology 6.7% Consumer 6.6% Medical Instruments 5.0% Business Services 4.7% Industrial 4.5% Electronics 3.6% Computers 3.2% Distribution/ Retailing 3.0% Semiconductors 0.8% Environmental 1.0% Pharmaceuticals 1.8% Investment by Industry - 1997 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Percent Change from Prior Year How Changes in the Stock Market Affect New Equity Capital Raising 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2 Figure 2-6

Figure 2-7 Number of Issues Gross Issue Proceeds in Millions Number of Debt Issues by Proceeds of Issues: 1990-94 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

The Deal Term Sheet Pre-money Valuation Post-money Valuation Investment Agreement Representations and Warranties Covenants and Undertakings Affirmative Covenants Negative Covenants Registration Rights Preemptive Rights Ratchets or Anti-dilution Provisions Deal Structure 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Chapter 3 The Business Plan Copyright 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3 Learning Objectives Learn how and why business plans of new ventures are different. Know what to include and what to leave out. Understand the relationship to strategic planning. Use milestones and financial projections in the plan. Use the plan to signaling the entrepreneurs beliefs, commitment, and capabilities. Understand how the plan can facilitate negotiation with outside investors.

What is a Business Plan? A written document Summarizes the purpose and overriding strategy of the venture Provides details on operation, financing, marketing, and management A set of hypotheses about an opportunity 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

What Makes the Business Plans of New Ventures Different? 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3 Forecasts and projections usually are less precise. A greater investment in planning may be warranted. Deviations from plans are likely to be due to wrong assumptions. Not very useful for evaluating manager performance. More likely to be relied on externally. More likely to be used to attract investment capital. Often require greater breadth of coverage. Unconstrained by previous decisions.

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3 Preparing a business plan is not the first step. The plan can commit the entrepreneur to an undesirable strategy. Consider aspects of strategy simultaneously, not sequentially. Do not lose sight of the objective. Analysis of strategic alternatives does not belong in the business plan. Be prepared to respond to alternative proposals. Do the Planning Before the Writing

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3 Alternative Product Market and Financing Choices

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3 Focus on the purpose(s) and uses of the plan. Include whatever information is relevant and material. Make certain the audience is neither overloaded nor left to speculate. Include only what is appropriate and necessary, given the use. Identify the key assumptions as assumptions. Include the support for key assumptions. Highlight the critical elements for success or failure. Delineate milestones. So users can evaluate success, modify assumptions, expectations, or strategy. Include financial projections. To test the plan, commit the entrepreneur, facilitate negotiation Contents of the Business Plan

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3 Demonstrate understanding of the technology, market, risks, needs, and potential rewards. Provide evidence of the quality and capabilities of people involved, and that they can function effectively as a team. Provide evidence that key personnel are committed. Bonding Reputation Certification Making the Business Plan Credible

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3 Protecting intellectual property Preempting rivals and first-mover advantage Using non-disclosure agreements Relying on reputation The Issue of Confidentiality

Financial Aspects of the Business Plan 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3 Differing views on what to include Is the future too uncertain to warrant careful forecasting? Include in the plan, or as an appendix? The importance of supporting assumptions Relationship of projections to contract negotiation The value of quantifying risk Value as a diagnostic tool - to facilitate adaptation Updating the business plan

Copyright 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. Chapter 4 New Venture Strategy

Learning Objectives Understand what makes a decision strategic. Understand the interrelationships between financing decisions and other aspects of new venture strategy. Relate strategic decisions to the entrepreneurs objective of value maximization. Describe strategic alternatives in terms of real options. Use decision trees to identify and evaluate real options. Use game trees when strategic choices depend on rival reactions. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Strategic decisions are consequential. Strategic decisions are both active and reactive. Strategic decisions limit the range of possible future actions. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 What Makes a Plan or Decision Strategic?

Figure 4-1 Rapid growth requires a larger organization. Economies-of-scope imply more product lines. Financial Strategy Product Market Strategy Organizational Strategy The more vertical and horizontal integration, the greater the financial needs. Outside investment is more likely the larger the firm. Rapid growth reduces financial flexibility and requires sacrificing control to attract outside financing. Outside v. entrepreneur Debt v. equity Loan covenants Options Staging Type of financing Financial contracts Price Margin Quality Differentiation Product Targeted sales growth Scale and scope Vertical boundaries Horizontal boundaries 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Interactive Financial Strategy

Figure 4-2 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Financial Implications of Product-Market and Organizational Strategic Choices

An Introduction to Options Option - A right to make a decision in the future Elements of an option An underlying asset Exercise price (strike price) Expiration date European or American form Basic options Call option Put option Financial options Real options Complex options Contingencies - Option created by some earlier action Interdependencies - Options with interdependent values 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Value of Asset Value of Underlying Asset Underlying Asset E Expiration Value Call before Expiration 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 The Structure of a Call Option

Buy a Call Write a Call Loss Gain Loss 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Realized Returns on Options

Put-Call Parity Option Pricing Models based on no-arbitrage Stock + Put = Call + PV(Exercise Price) Role of complete markets Financial Options Complete markets Incomplete markets Real Options Complete markets Incomplete markets Complex Real Options (Rainbow Options) Discrete scenarios Simulation 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Valuing Options

Defer - Investing now eliminates the option to defer (learning). Expand - An option to defer part of the scale of investment. Contract - The flexibility to reduce the rate of output. Abandon - Stop investing, and liquidate existing assets. Staging - Substitute a series of small investments for one large. Switching - Re-deploy resources or change inputs (terminate). Change Scope - Expand or contract scope. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Real Options - Some Examples

Techniques for Reasoning Through Decision Trees Focus on the most important decisions. Reason forward to construct the tree. Track certainties and uncertainties at each decision point. Calculate backwards to evaluate choices. Select the tree branch with the highest expected value. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Demand may be high (30%), medium (50%), or low (20%). Cost of large restaurant is $750,000. Cost of small restaurant is $600,000. Entrepreneur will invest $400,000, outside investor provides the rest. Investor requires 1% of equity for each $10,000 invested. If demand is high - PV large is $1,500,000, PV small is $800,000. If demand is medium - PV large is $800,000, PV small is $800,000. If demand is low - PV large is $300,000, PV small is $400,000. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Decision Tree - Restaurant Example

Figure 4-3 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 High Demand (.3) Large restaurant Do not enter Small restaurant Intermediate Demand (.5) Low Demand (.2) High Demand (.3) Intermediate Demand (.5) Low Demand (.2) High Demand (.3) Intermediate Demand (.5) Low Demand (.2) -$400,000 +.65 x $1,500,000 = $575,000 -$400,000 +.65 x $800,000 = $120,000 -$400,000 +.65 x $300,000 = $-205,000 -$400,000 +.8 x $800,000 = $240,000 -$400,000 +.8 x $400,000 = -$80,000 $0 Accept/Reject Decision to Invest in Restaurant Business

Evaluation of Accept/Reject Alternatives Large-scale entry: NPV conditional on high demand = $575,000 NPV conditional on intermediate demand = $120,000 NPV conditional on low demand = ($205,000) NPV =.3 x $575,000 +.5 x $120,000 -.2 x $205,000 = $191,500 Small-scale entry: NPV conditional on high demand = $240,000 NPV conditional on intermediate demand = $240,000 NPV conditional on low demand = ($ 80,000) NPV =.3 x $240,000 +.5 x $240,000 -.2 x $80,000 = $176,000 Do not enter: NPV = $0 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Figure 4-4 Large restaurant Wait Small restaurant High Demand (.3) Intermediate Demand (.5) Low Demand (.2) High Demand (.3) Intermediate Demand (.5) Low Demand (.2) High Demand (.3) Intermediate Demand (.5) Low Demand (.2) -$400,000 +.65 x $1,500,000 = $575,000 -$400,000 +.65 x $800,000 = $120,000 -$400,000 +.65 x $300,000 = $-205,000 -$400,000 +.80 x $800,000 = $240,000 -$400,000 +.80 x $400,000 = -$80,000 Determine market demand -$400,000 +.65 x $1,300,000 = $445,000 -$400,000 +.80 x $700,000 = $160,000 $0 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Restaurant Business Investment with an Option to Delay Investing

Large-scale entry strategy: NPV = $191,500 Delay until uncertainty is resolved: High demand Build large restaurant NPV conditional on high demand = $445,000 Intermediate demand Build small restaurant NPV conditional on intermediate demand = $160,000 Low demand Do not enter NPV conditional on low demand = $0 NPV of delay strategy: =.3 x $445,000 +.5 x $160,000 +.2 x $0 = $213,500 Value of Option to Delay = $213,500 - 191,500 = $22,000 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Evaluation of Option to Delay

Figure 4-5 Large restaurant Do not enter Small restaurant High Demand (.3) Intermediate Demand (.5) Low Demand (.2) High Demand (.3) Intermediate Demand (.5) Low Demand (.2) High Demand (.3) Intermediate Demand (.5) Low Demand (.2) -$400,000 +.65 x $1,500,000 = $575,000 -$400,000 +.65 x $800,000 = $120,000 -$400,000 +.65 x $300,000 = $-205,000 -$400,000 +.80 x $800,000 = $240,000 -$400,000 +.80 x $400,000 = -$80,000 $0 Expand Do not expand -$400,000 +.70 x $1,400,000 = $580,000 -$400,000 +.80 x $800,000 = $240,000 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Restaurant Business Investment with an Option to Expand Initial Investment

Large-scale entry strategy: NPV = $191,500 Delay until uncertainty is resolved: NPV = $213,500 Build small, with Option to Expand: Conditional on High demand: NPV if Expand = $580,000 NPV if Remain Small = $240,000 Conclusion: Expand if demand is high Conditional on Intermediate demand: NPV of Remaining Small = $240,000 Conditional on Low demand: NPV of Remaining Small = ($80,000) NPV of Small-scale entry with Option to Expand =.3 x $580,000 +.5 x $240,000 -.2 x $80,000 = $278,000 Value of Expansion Option = $86,500 Incremental value over Delay Option = $64,500 The Options are Mutually Exclusive 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Evaluation of Option to Expand

Evaluation of Option to Abandon Large-scale entry strategy: NPV = $191,500 Large-scale entry with Abandonment option: Convert to office with $600,000 value NPV of converting for entrepreneur = ($10,000) NPV with Abandonment Option: =.3 x $575,000 +.5 x $120,000 -.2 x $10,000 = $230,500 Would pay up to $39,000 extra for location that is convertible Small-scale entry with Expansion and Abandonment Options: Convert to office with $300,000 value NPV of converting for entrepreneur = ($160,000) NPV with Abandonment Option: =.3 x $580,000 +.5 x $240,000 -.2 x $160,000 = $262,000 Abandonment has negative value for the small restaurant A result of discreteness of the analysis Conclusion: Build small with Expansion Option NPV = $278,000 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

The Basics Players Order of play Information set Available actions Payoff schedules Strategic interaction Cooperative and Non-cooperative games Sequential-move game - Game tree Simultaneous-move game - Payoff matrix Nash equilibrium Sub-game perfection 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Game Trees

Develop the tree Prune branches involving dominated strategies Specify assumptions about rival actions and reactions 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Evaluating Strategic Games

Figure 4-6 $380,000 ($100,000) Kellys Bar Erins Pub Erins Pub Erins Pub Kellys Bar Enter Stay Out Enter Stay Out Large Small Wait Kellys Payoff Erins Payoff Large Small Stay Out Large Small Stay Out $425,000 $0 $250,000 $200,000 $400,000 $0 $300,000 $100,000 $190,000 $210,000 $0 $300,000 $370,000 $0 $350,000 $0 $0 $0 Kellys Bar Enter Stay Out 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Entry Decision Game Tree

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Extending brand names to new products or marketing through existing distribution channels Defer Expand or contract Abandon Switch inputs or outputs Grow To wait before taking an action until more is known or timing is expected to be more favorable To increase or decrease the scale of a operation in response to demand To discontinue an operation and liquidate the assets To commit investment in stages giving rise to a series of valuations and abandonment options To alter the mix of inputs or outputs of a production process in response to market prices Stage investment To expand the scope of activities to capitalize on new perceived opportunities ExamplesDescriptionOption Adding or subtracting to the daily flights on an airline route or adding memory to a computer When to harvest a stand of trees, introduce a new product, or replace an existing piece of equipment Discontinuing a research project, closing a store, or resigning from current employment Staging of research and development projects or financial commitments to a new venture The output mix of refined crude oil products or substituting coal for natural gas to produce electricity Examples of Real Options

Copyright 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. Chapter 5 Financial Forecasting

Learning Objectives Learn the elements of the cash flow cycle. Understand the four critical determinants of a firms financial needs: minimum efficient scale, profitability, cash flow, and sales growth. Learn how to prepare a sales forecast for an established firm. Learn how to prepare a sales forecast for a new venture. Develop a financial model of a venture using pro forma analysis to integrate income statement, balance sheet, and cash flow items. Identify publicly available data sources to provide an objective basis for underlying assumptions of the financial model. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

A disciplined means to evaluate the cash needs of a venture An aid to determine whether a proposed venture deserves the entrepreneurs investment of capital and effort A means to compare the expected values of strategic alternatives A way to demonstrate project merits to investors and to use in negotiating ownership A way to identify appropriate benchmarks for assessing project development Benefits of Financial Forecasting 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Firm Cash Future Cash 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6 The Firm as a Cash Conversion Process

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6 The Cash Flow of a Business Venture Fixed Assets Capital (equity and debt) Infusions Beginning cash Expenditures EmployeesMaterials Production Inventory Ending Cash Equity ReturnsDebt ServiceTaxes Cash sales Accounts Receivable Credit Sales Collections Reinvestment (to retained earnings)

Key Determinants of Financial Needs 1) Minimum efficient scale and capital intensity 2) Profitability 3) Cash flow 4) Sales growth 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Figure 6-2 Quantity Dollars Q Q* Manufacturers Long Run Average Cost (LRAC) 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Competition in markets where the minimum efficient scale (MES) of an enterprise is large Low profit margins High rates of sales growth Increased reliance on depreciation of assets and less on expensing of assets Expectation of low cash flow levels Increased trade credit offered (accounts receivable as a fraction of assets is high) Decreased trade credit used (accounts payable as a fraction of assets is low) Factors that Increase a Firms Cash Needs 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Introduction to Pro Forma Analysis Sales = 2 x Beginning Assets Net Income = Sales x 0.1 Retained Earnings = Beginning Assets x 0.06 Dividends = Net Income - Retained Earnings Ending Assets = Beginning Assets + Retained Earnings Assumptions for a simple asset-driven business model: 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Assets Sales Net Income Retained Earnings Dividends S/A ROS Retention 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6 Asset-driven Pro Forma Model

Figure 6-3 Assumptions: Sales = 2 x Beginning Assets Net Income = Sales x 0.1 Retained Earnings = Beginning Assets x 0.06 Dividends = Net Income - Retained Earnings Ending Assets = Beginning Assets + Retained Earnings Five Year Pro Forma Analysis for a Simple Business Venture 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Basic Pro Forma Financial Statements (and some others) Sales Forecast Income Statement Cash Flow Statement Balance Sheet The statements are interdependent Income Statement changes affect Balance Sheet and Cash Flow (e.g., higher profit may lead to increased cash balances). Balance Sheet changes affect Income Statement and Cash Flow (e.g., borrowing leads to interest expense and reduces taxes). A financial model should integrate the statements 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6 Integrating Pro Forma Financial Statements

Figure 6-4 Assumptions Ending Balance Sheet Cash Flow Statement Income Statement Beginning Balance Sheet Sales Forecast Integration of Financial Statements: The Circular Flow 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

1) When will the venture begin to generate revenue? 2) How rapidly will revenue grow? 3) Over what span of time (3 years, 5 years, 10 years, etc.) should the forecast be made? 4) What is an appropriate forecasting interval (weekly, monthly, annually, etc.)? Key Questions to be Answered in a Sales Forecast 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Forecasting the Sales of an Existing Business The forecast can be based on the existing track record of the business Some considerations Forecasting in levels or changes Forecasting in real or nominal terms Weighting of historical data Forecasting based on underlying factors for which forecasts exist 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Combining Growth Rates and Current Sales Levels to Forecast the Sales of an Existing Business Average Sales Growth = 8.06% Range = -3.7% to 20% 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Forecasting in Real Terms Average Real Sales Growth = 3.66% Range = -10.7% to 17% 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Using Weighting to Improve a Forecast Weighted Average Real Sales Growth = 1.96% 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Using Regression Analysis to Forecast Regression Model: Expected Real Sales Growth = 3.34% + 5.24 x Change in Real GDP 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Forecasting for a New Venture No track record on which to rely Yardstick approach Comparable firms in relevant dimensions IPO prospectuses Other data sources Fundamental analysis Market and market share Engineering cost estimates Demand-side approach - How much customers would buy Supply-side approach - How fast the venture can grow Credibility and support for assumptions Mixed approach 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

General Rules of Financial Forecasting Build and support a schedule of assumptions. Begin with a forecast of sales. If sales growth is expected to track inflation, consider forecasting sales in real terms. When using historical data to forecast, consider a weighting scheme that focuses on the firms most recent experiences. For new ventures, choose several yardstick firms to use in developing underlying assumptions regarding expected performance. Integrate the pro forma balance sheet and income statement variables through a financial model. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6 Part 1

General Rules of Financial Forecasting Consider time span. To assess financial need, project at least until the firm expects follow-on financing. To determine venture value, extrapolate to the point of harvest. Determine the planning horizon of the venture to establish forecasting intervals. Test the models rationality by tracing line items across financial statements. Apply sample scenarios and compare outcomes to estimates. Try a basic sensitivity analysis to ensure that the model yields reasonable results when magnitudes and growth rates of key variables change. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6 Part 2

Figure 6-5: Part I 1) Development will require 18 months, during which no sales will be made. 2) Initial sales of $10,000 in the 19th month. 3) Sales will grow 8% per month in real terms for three years and at the inflation rate thereafter. 4) Cash operating expenses during the development period of $15,000 per month, plus inflation. 5) Inflation at 9 percent per year. 6) A $200,000 production facility will come on line at the end of month 18. The facility is to be leased by the company for the first 5 years of operation, with monthly payments of $3,000. 7) Gross profit of 60% of sales revenue on materials costs with trade discounts. 8) Selling expenses of 15% of sales. 9) Administrative expenses of $2,000 per month beginning in month 19, growing at the inflation rate, plus 15 percent of sales (Included in development period operating expense total). New Company Assumptions 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Figure 6-5 Part II 10) Entrepreneurs salary of $3,000 per month through the first full year of sales (included in initial operating expenses), increasing thereafter by $500 per month. 11) Corporate tax rate of 45%. No loss carry forward. 12) All sales are for credit. The average collection period is 45 days. No discount for prompt payment. 13) The inventory turnover rate is 5 times per year, measured against ending inventory. 14) The company desires to maintain the greater of 30 days sales in cash or $10,000. 15) All materials are purchased on credit, with terms of 2/10 net 30. The company anticipates paying in time to receive the discount. The payables period is 10 days. 16) The entrepreneur will borrow any funds necessary at a rate of 1% per month. 17) Initial investment by the entrepreneur of $200,000. Additional financing as needed by borrowing on a line of credit. New Company Assumptions 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

(Forecast generated monthly, selected months shown) Figure 6-6 New Company Sales Forecast 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

The Framework of New Venture Valuation Copyright 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Learning Objectives Know the difference between a hurdle rate and a realized rate of return. Know why hurdle rates for new ventures usually are higher than realized rates of return. Know the difference between a hurdle rate and the opportunity cost of capital. Know how to use the Capital Asset Pricing Model to estimate cost of capital. Know how to use the risk-adjusted discount rate and certainty equivalent forms of the CAPM. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Learning Objectives (continued) Know the limitations of the CAPM for new venture valuation Know the differences between the CAPM and the Option Pricing Model and be able to reconcile their use. Know how diversifiable risk affects expected returns. Know why the valuation of the entrepreneur is likely to be different from that of the investor, and how to use the information in deal negotiation. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Strategic Planning Estate Planning Partnership formation and dissolution Initial public offering (IPO) Stock options and Employee stock ownership plans (ESOPs) Mezzanine financing Negotiating a merger or sale of a venture The Many Uses of Valuation 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Beauty is in the eye of the beholder. The future is anybodys guess. Investors in new ventures demand very high expected rates of return to compensate for the risks. The outside investor determines what the venture is worth. Valuation Myths 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Hurdle Rates For Venture Capital 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

14% - 92 firms in 60s and 70s. 23% - before fees, 100 firms in the 60s 16% - public fund stock returns from 1959 to 1985. 27% - 11 firms from 1974 to 1979. 13.5% - from 1974 to 1989. 20.7% - from 1987 to 1996. How are the hurdle rates reconciled with realized rates? Venture Capital Realized Rates of Return (based on various studies) 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Valuation Methods Value = Present value of future cash flows Two conceptually equivalent approaches The choice of method depends on information availability. RADR - Risk-Adjusted Discount Rate CEQ - Certainty Equivalent Cash Flow 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

What cash flows should be valued? What discount rate should be used? Issues for RADR Valuation 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Factors Affecting the Discount Rate for RADR Valuation Compensation for deferring consumption (time value) Compensation for bearing risk (risk premium) A measure of risk - the standard deviation of holding period returns. The discount rate is not a matter of personal risk tolerance. It is market determined It is based on opportunity cost The discount rate depends on the ability of an investor to diversify. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Opportunity cost of capital Estimating the Discount Rate CAPM All measures are based on holding period returns. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8 What discount rate should be used?

The Feasible Set and the Efficient Set of Risky Portfolios Figure 8-2 Return Risk (Standard Deviation) Preferred portfolio of highly risk-averse investor Preferred portfolio of risk-tolerant investor Efficient Set Feasible Set 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

The Efficient Set, the Market Portfolio, and the Capital Market Line Figure 8-3 Return Risk New preferred portfolio of highly risk-averse investor New preferred portfolio of risk-tolerant investor Capital Market Line Market Portfolio Efficient Set r r F M MM 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

How Portfolio Risk Depends on the Number of Assets in the Portfolio Figure 8-4 Risk Number of Assets in Portfolio Portfolio Diversifiable Risk Non-diversifiable Risk M 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

The Capital Asset Pricing Model Figure 8-5 Beta 1.0 Return Security Market Line Market Portfolio r r F M 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Measures of Cash Flow Expected Actual Cash Flow Operating Cash Flow Operating Cash Flow = EBIT + Depreciation Expense - Capital Expenditures - Increase in NWC Cash Flow to All Investors (both stockholders and creditors) Total Capital Cash Flow + EBIAT = Operating Cash Flow - Actual Taxes Cash Flow to Creditors (expected in light of default risk, potential prepayment, potential additional borrowing) Debt Cash Flow = Expected Interest Payments + Expected Net Debt Service Cash Flow to Stockholders (expected in light of expected cash flows to creditors) Equity Cash Flow = Operating Cash Flow - Expected Interest Payments - Expected Net Debt Service - Expected Actual Taxes Other Measures of Cash Flow Contractual Cash Flow to Creditors (assuming no default or prepayment) Contractual Cash Flows to Creditors = Contractual Interest Payments + Contractual Net Debt Service Unlevered Free Cash Flow (expected if no debt financing) Unlevered Free Cash Flow - Operating Cash Flow - Theoretical Taxes as Unlevered

Matching Cash Flows to Discount Rates for Various Financial Claims Figure 8-6 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Issues for CEQ Valuation What cash flows should be valued? How are risky cash flows adjusted to their certainty equivalents? What is the discount rate for valuing certain future cash flows? 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

CAPM The CEQ Form of the CAPM 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 8

Chapter 7 Financial Contracting Copyright 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Understand how and why staging and other real options affect the values of new venture financial claims. Value the financial claims of a new venture using either discrete scenario analysis or simulation. Use financing modeling and valuation techniques to study game theoretic issues that arise for the parties to a new venture. Construct financial contracts to signal information and align incentives. Evaluate the effects of alternate financial contracts on the values of the financial interests of the entrepreneur and outside investor. Learning Objectives

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Determining the Required Shares of Staged Investment 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Equation (1) shows how the required fraction of equity can be determined when future rounds of financing are anticipated. Fraction of Equity Required = Ending Fraction of Equity Required x (1 - Sum of Fractions Required by Investors in Future Rounds) (1) Using this equation, the required share of the investor in the second round is 10.30 percent. 10.30 % = 10.05 % / (100 % - 2.43 %) Similarly, the the required share for the investor in the first round is 31.77 percent. 31.77 % = 27.80 % / (100 % - 2.43 % - 10.05 %)

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Staging and Market Capitalization Investors are disappointed if capitalization does not increase from one round of financing to the next. Figure 13-2 shows why. Investment Round First Stage Second State Third Stage Investment Share of Equity Received Capitalization $1,373,077 $700,000 31.77% 10.30% 2.43% $4,321,992 $13,330,844 $28,806,584

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Step 1: Estimate the expected cash return and total risk (standard deviation of cash flows) of the entrepreneurs financial interest in the venture. Step 2: Estimate the expect cash return and risk of the entrepreneurs investment in the market portfolio. Step 3: Use the above results and the correlation between the venture and the market to estimate the expected cash return and total risk of the entrepreneurs total portfolio. Step 4: Value the portfolio by the CEQ method (based on its total risk). Step 5: Infer the value of the entrepreneurs investment in the venture by subtracting the market value of the entrepreneurs investment in the market index portfolio. Evaluating the Entrepreneurs Investment Based on Expected Returns

Single-Stage Investment with Discrete Scenarios

Valuing Financial Claims with Proportional Allocation (continued) 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

Valuing Financial Claims with Equity Shifted to the Entrepreneur (continued) 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Valuing Financial Claims with the Entrepreneurs Investment Reduced (continued)

How Changing the Contract Affects Value 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Valuing Financial Claims with Equity Shifted to the Entrepreneur (continued)

How Staging with Mandatory Investment Affects Value 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Game Tree for Staged Investment Nature chooses Entrepreneur offers multi-stage investment Entrepreneur offers single-stage investment Investor accepts offer Investor rejects offer Investor accepts offer Good state: Success is likely Bad state: Success is unlikely Invest in second stage Do not invest NPV (1000,100) NPV (0,0) NPV (90,10) NPV (0,0) NPV (1800,500) NPV (400,-200) NPV (-200,-1800) Do not invest NPV (200,-300) Terminal nodes show NPV (entrepreneur, investor)

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Investor Valuation of Two-Stage Investment with Discrete Scenarios (continued)

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Investor Second-Stage Investment Decisions

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Entrepreneur Valuation of Discrete Scenarios with Second-Stage Investment Optional (continued)

Staged Investment with Abandonment Option Figures 13-11, 13-12 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Simulation: Conditional Stage-2 Investment (cont.) (Note: figures do not relate to prior slide

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Abbreviated Example (continued) (note: figures do not relate to prior slide)

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Valuing the Second-Stage Option Claims by Discounting the Conditional Cash Flows (continued)

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Valuing Financial Claims by Discounting All Expected Cash Flow (continued)

Results of Simulating the Decision Tree 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 13 Simulation Tree Results Under Alternative Market Potential Assumptions

Chapter 8 Venture Capital Copyright 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Historical Development of Venture Capital as an Institution 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14 Venture Capital New Commitments

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14 Sources of Venture Capital Funds

The Organizational Structure of a Venture Capital Fund 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14 Organizational Structure of Venture Capital Investment Portfolio Companies Value creation Generate deal flow Screen opportunities Harvest investments Negotiate deals Monitor and advise General Partners Venture Capital Fund Pension plan Endowments Life insurance companies Corporations Individuals Limited Partners Effort and 1% of capital Annual Management Fee 2-3% Carried Interest 20- 30% of Gain 99% of Investment Capital Capital Appreciation 70-80% of Gain Investment Capital and Effort Financial Claims

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14 Summary of Terms: Venture Capital Limited Partnership Agreement

Managing the Investment Portfolio 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14 Allocation of Venture Capitalist Time

The Venture Capital Investment Process Development of Fund Concept Secure Commitments from Investors Generate Deal Flow Closing of Fund First Capital Call Screen Business Plans Evaluate and Conduct Due Diligence Negotiate Deals and Staging Additional Capital Calls Invest Funds Distributing Proceeds Cash Public Shares Other Harvesting Investment IPO Acquisition LBO Liquidation Value Creation and Monitoring Board service Performance evaluation and review Recruitment management Assist with external relationships Help arrange additional financing Year 0 2-3 years 4-5 years 2-3 years or more 7-10 years plus extensions

Incentive Conflicts and Structures 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14 Key Covenant Classes of Venture Capital Limited Partnerships

Chapter 9 Choice of Financing Copyright 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15 A Partial List of Financing Sources for New Ventures and Private Business Asset-based Lending Business Angels Capital Leasing Commercial Bank Lending (various forms) Corporate Entrepreneurship Customer Financing Direct Public Offering Economic Development Program Financing Employee-provided Financing Equity Private Placement Export/Import Bank Financing Factoring Franchising Friends and Family Public Debt Issue Registered Initial Public Offering Research and Development Limited Partnerships Relational Investing or Strategic Partnering Royalty Financing Self (bootstrapping) Small Business Administration Financing Small Business Investment Company Financing Term Loan Vendor Financing Venture Capital

Factors That Affect the Choice of Financing Financial needs of the venture Stage of Development Financial Condition Product-market Considerations Organizational Considerations Track Record/Reputation/Relationships 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

Immediacy of the need Size of the immediate need Duration of the immediate need Cumulative need 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15 Financial Needs of the Venture

Completeness of the management team Ease of communicating the ventures merit Value of managerial/consulting services Importance of flexibility/adaptability 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15 Stage of Development

Risk/Return characteristics of the venture Taxable income status Operating cash flow status Time to a liquidity event Transferability of tax benefits to investors Available collateral Cash flow cycle 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15 Financial Condition

Importance of rapid growth Importance of relationship with a supplier or distributor Dedication of distributors to the product Value of centralization of control 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15 Product-market and Organizational Considerations

Track record of the venture Importance of future financing needs Past failure or financial distress Likely failure in the near future Reputation of the entrepreneur Relationships with financing sources 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15 Track Record/ Reputation/Relationships

Some Financing Choices Securitization Strategic investing Franchising Venture capital Angel investing Corporate venture investing SBA programs Direct public offering Factoring R&D Limited Partnerships Vendor financing Public offering 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15 SourceAmountPercent Principal owner524.331.33% Angel finance603.59% Venture capital311.85% Other equity215.212.86% Total equity 830.649.64% Commercial banks313.818.75% Finance companies82.14.91% Other institutions50.12.99% Trade credit264.115.78% Other business financing82.14.91% Government8.10.48% From principal owner68.54.09% Credit cards2.40.14% Other individuals24.51.46% Total debt 842.950.37% Total 1673.4100.00% Note: Includes all non-farm, non-financial, non-real estate small businesses Source: Berger and Udell (1998). Estimates of Financing to Small Businesses and New Ventures as of 1992.

Chapter 10 Harvesting Copyright 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Harvesting Alternatives Initial public offering Private placement / private sale Roll-up IPO Management buy-out Employee stock ownership plan 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

The Underwritten IPO Process The role of the underwriter Issue pricing Due diligence Certification Distribution Market making Harvesting by going public In the IPO After the IPO Cost of public offering Cost of harvesting by going public 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

The IPO Issue Pricing Process for a Firm Commitment Underwriting Figure 16-1 Comparable Firm Values Comparable Transactions and IPOs Discounted Cash Flow Valuation Information from Issuer Preliminary Estimate of Value New Information from Market New Information from Due Diligence Filing Range reported in Preliminary Prospectus New Information from Market Indications of Interest from Roadshow Take down Due Diligence Issue Price reported in Final Prospectus

Underwriter fee: 5-7 percent of proceeds Direct issuing cost: 1-5 percent of proceeds Underpricing: 10-15 percent of proceeds Total : 16-27 percent of gross proceeds 17-31 percent of net proceeds 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16 IPO Cost

IPO usually is a small fraction of total value. Selling shareholders normally harvest in the aftermarket. Selling shareholders bear their share of the dollar-valued cost of the IPO. Percentage cost of IPO is less important than percentage cost of harvesting. 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16 Cost of Harvesting by Going Public

Private Placement / Private Sale Exchange modes Equity for cash Assets for cash Equity or assets for equity Valuation Discounts compared to public market value Cost of private sale Choice of public or private sale 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

Roll-up IPO The underlying theory of value creation The off-setting costs Structural solutions Net benefit (cost v. share value) Examples 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

Roll-up IPO 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16 Figure 16-3 Owner of Private Company A Owner of Private Company B Owner of Private Company C Exchange of shares for new shares, cash, and employment contracts New Company IPO Public Market Investors

Family-owned Businesses and ESOPs Leveraged v. unleveraged ESOPs Advantages and disadvantages of ESOPs Valuation of ESOP shares to owners to employees 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16

Structure of a Private Leveraged ESOP Panel (a) ESOP Initiation Company Establish ESOP Plan ESOP Trust Sell shares to ESOP trust for cash Owner/ Entrepreneur Evaluation of equity for fee Cash loan secured by Company shares Valuation Service Bank Figure 16-2

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16 Structure of a Private Leveraged ESOP Panel (b) Annual Retirement Contribution Funding Company Annual retirement contribution ESOP Trust Funding of employee retirement Employees Evaluation of equity for fee Loan repayment/ Release of shares Valuation Service Bank

2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 16 Structure of a Private Leveraged ESOP Panel (c) Share Redemption at Employee Retirement Company Annual Retirement contribution ESOP Trust Share redemption by Trust Employees Evaluation of equity for fee Valuation Service

Documents

Chapter 1 Chapter 1 Introduction to Entrepreneurial Finance Copyright¸ 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of