Entrepreneurial Law and Finance Rafael P. Ribas

Lecture 1- Introduction and overview of entrepreneurial finance

Cases - Which options do they face in starting up their company, who invest their company in each stage. - How to measure the value of your project? The value of your start-up? - Now you know the value, how to structure ow? How to get an investor? They have different views and

goals about your venture. - Crowdfunding. Not much literature about this yet, but we will look why it is so important and what are the challenges investing in firms based on crowdfunding - Employee compensation in the early stages and how do you split equity, the ownership of the firm. How do you pay employees if you dont have cash yet - Exit strategy (IPO), research and finance sees this as most important. If you start a new venture, you need to raise capital, you need exit strategy; at some point you have to make the decision: sell your company, open the capital/ownership of the company or you make the shares tradable. Why exit strategy so important? Answer (class) investors want to know what they get back from the company if they invest in it. Answer (teacher): some point every company have to make a big step. Besides, the investor want something back (liquidity) in the end of the process to make the investment profitable.

Entrepreneurial Finance (study of new ventures) vs corporate finance (large companies) - Entrepreneurial organizations are not large organizations (corporate firms) because of the issues of

below (larger uncertainties, larger financing needs, etc.) - Corporate Finance (CF) concerns investment and financing decisions of large public corporations. o It is assumed that these decisions are independent, thats vey important! o It ignores issues that are secondary in large corporations. - New ventures face: everything is connected, every single step that is made you have other results for

other parts of the organization - Differences between entrepreneurial finance and corporate finance: o Larger uncertainties

Apple comes to you or your neighbour, so you choose Apple. A lot can go wrong in your new company

o Larger financing needs What do big companies need that new venture dont have: large companies have a lot

of cash. A new venture is always going for a new financial source in order to keep your business going, because you dont have enough profit yet to have cash

o Less (or no) collateral (assets) New venture have no assets yet (only chair and table for example) to pay the loans of

the debt to the debters, where big companies sell some asset (buildings for example) to pay the loans if they do not have enough profit

o More severe information problems Difference between the information that the entrepreneur has about the project and the

investor. This gap makes a huge difference in the case of new ventures, because one depends on the other (one party wants to raise capital and the other want to get a return)

In large companies, this information gap is not a big deal as in new ventures, because you have more trust in what the insiders do than what entrepreneurs do in new ventures.

o More severe agency problems (=related to information problem) Conflict between investors and entrepreneurs (investors want to go in way A, but the

entrepreneur wants to go in way B)

Notes: new ventures are not like large corporations, see 5 points above) 8 Important differences

1. Interdependence between investment and financing decisions o In CF, they are treated as independent. o In the case of large companies, there are three types of dependence and different managers,

everyone has their own rule. In the case of entrepreneurial finance, in each step, in each stage of the process of creating the firm, you face new challenges and new financial sources and based on every decision you make in each stage, you go after source A or source B to raise capital and you talk about those sources later.

2. Limited role of diversification

o Entrepreneurs and Investors face different discount factors and view risk differently. o As new venture, you put all your time and resource in one idea, you dont start 3 ventures at the

same time. o Entrepreneurs see time differently about time as well; day-by-day. Difference in horizon, so also

different discount rates because they value time (= ) different. Discount rate = I prefer to receive a return today in stead of tomorrow; suppose I give you 10 euros, what do you prefer: 10 euros now or 12 euros in 2 days? Answer: then 12 euro. BUT: 10 euros now or 10 euros in 2 days, then today ofcourse!

o Entrepreneurs have most often low discount rates, because they are looking for the returns in the long-run, where the investors (banks for example) want the returns within 6 months! So difference in how they both value time and investment

3. Managerial involvement of investors

o In public corp., investors are often passive. o Some startup investors provide managerial services. o In large companies, you have often a CEO, CFO and managerial systems and rules etc. o In new ventures/start-ups, investors dont have the same difference as entrepreneurs, so for this

reason, most of the time there are a lot of requirements in order to receive that cash flow. This requirements comes in the form of managerial issues, in other words: the investors try to control everything and say how to manage things!

4. Information problems (information gap)

o Why do investors do this interfering in the management of a new venture? Answer: Insiders have total different information than outsiders. Not only information, but also you see how the business is managed; is the entrepreneur really working in the business for example?

o In CF, investment decisions are less affected by the information gap between insiders and outsiders.

o In startups, entrepreneurs should find ways to signal their confidence.

5. Incentive problems and contract design o In large corporations you have a CEO and CFO and if hes not working well, you fire him/her. o Unlike managers of large corp., investors usually keep entrepreneurs on a short leash (which

means: see below) o They try to control everything of the entrepreneurs, what they are doing, etc. This is a

contradiction; because entrepreneurs need to have some freedom and decision space o The problem of identify and motivate high-quality entrepreneurs.

6. Real options as determinants of project value o Real options: in each stage of a venture, you face new and other decisions. Each decision increases

or decreases your value! In each stage of the process you have options and decisions that you have to make and every options/decision has a value which can increase or decrease (option A, option B and then a kind of tree -> each decision increases or decreases the value of your project). This is the real-option approach.

o The cash-flow approach only assumes one path in the probability of taking this path; everything that you do is successful and you reach this stage with some probability. You dont consider that you change your decisions or goals in every single stage, you just keep one path!

o Valuing projects based on future cash flows is too simplistic. o In practice, investing involves acquiring, retaining, expanding, staging, and abandoning options

7. Harvesting the investment (the exit strategy)

o Large corporations dont have an exit strategy, because they invest in projects only to increase their cash flow, to increase their profit. So there is a difference between large corporations and new venture; the new venture should not look only at the profit or the cash flow, because you need a kind of strategy that the investors get all the invested money back!

o In CF, investments are evaluated based on how much cash flow is generated. o In EF, a liquidity event must occur (IPO, private acquisition, or share trading) for investors to

realize their returns.

8. Value that Entrepreneur puts in a project and value that shareholders add o The value that entrepreneurs put in a project and the value of shareholders

o They have different views of the world, the product. But also different discount factors, see time in a different way, different value of time and different expectations how profitable the project is.

o In public corp., the focus is on returns to shareholders. o Entrepreneurs are not always interested in maximizing share value or the value of the company

itself, but they are interested in something else (he doesnt say what) Stages of a new venture (this is just an example!) Not all ventures face the same stage. Core of the picture: in each stage you have different options and you can keep going in the same path and moving to the next stage, you can modify your idea on that point or modify some strategies so you can keep moving but in a different path or you can just abandon the project and say; it didnt work and start a new one. So for each stage you face different investors and those investors basically look at those options and see if its worth to give you money/capital or not

Financial sources of venture financing - Bootstrap financing (self, friends, and family)

o Using your own financial resources, credits, friends resources to raise capital to develop your idea or buy a machinery or something

o This is in the seed venture time of a company (so early stage) o Research shows that bootstrapping is most important financial source when valuing your idea

or starting your company o There are no investors yet in your company, so nobody is monitoring what your doing, youre

using your own resources o Not depending on investor assessment. o Problem of this way of financing (using own resources): you cant generate enough cash flow

to keep paying the loans etc, you need to have some investors in mind already to not go broke - Angel Investors o Individuals that use their own resources to invest in the new venture/the product of the venture o Wealthy individuals who provide capital in exchange for bonds or (more often) equity.

Sometimes they dont get their money back, but they invest in so many project that they know this could happen.

o Long-run view; they help entrepreneurs to get new products, innovations and services to the market, they are not only interested in the value of the firm itself

o They mostly have an one-on-one relationship with the entrepreneur - Venture Capitalists (VC) o A group of individuals, put their resources together, hire someone who manages their resources

and take the decisions in which firm they invest. Its more like a fund o Whats difference of investing in a stock or in a fund? Answer: fund you can spread

your risk, so its a little safer than investing in a stock (classmate answer, but Ribas says exactly)

o This is the same as the difference between angel investors and venture capitalists: VCs use their resource, create a fund and then diversify the investments in several different companies (mostly within different industries as well), where the angel investors have a one-on-one relationship with the entrepreneur and they hope the projects work out

o Limited partnerships with a general partner responsible for selecting investments, working with entrepreneurs, and harvesting the investments.

o Buy and sell strategy (= looking for returns on the short-medium term). When you make a agreement with the VC, they usually require you an exit strategy right away. They say: we invest in your project, however, in the end of 5 years for example, if everything goes right, you must sell the company. So even though your company is really doing well, you have this requirement in your deal. In other words: VCs agreements usually gives them the right to force a liquidity event, where angel investors dont have this requirements like an exit-strategy in the contract

o Venture capitalists intervene a lot more than angel investors in the management of the ventures because they want to make sure that they have the returns within the time of the agreement.

So after you built a company, you have assets, then its time to move to other sources that are less related to equity and more related to debt. Whats the relation between debt en equity? Answer: For example, I need 100 euro to finance my project, suppose that in the end of two years I got a revenue of 110. If I raised debit in the past, I dont need to pay a 110 to the creditor, but I only pay him 100, so I keep the profit. In the case of equity, you share the profit, because he owns a % of the profit/dividend. In case you have less revenue than 100, you have to pay the creditor (in the case

of debit) that amount + some assets (so you go broke). In the case of equity, you share the losses; your loss is their loss as well. So in some case, raising debt in the early stage is too risky. Sources of venture financing - Secured Lenders

o They provide debt capital to businesses with collateral. - Venture Leasing and Trade Credit o For ventures that need equipment and supplies. o So you use the machinery or supply and promise the other party that you will pay for it when

you have enough money and till that time you pay an amount per month/year - Government Programs o Subsidize credits to some projects (energy, oil winning, water, etc.) o Not only money, but also equipment, building, assistance, etc. - Banks (Private Debt) - Public Debt (Bonds) o Bonds = its debit but its tradable - Initial Public Offering (IPO) o You make everything tradable. o Firm sells registered equity shares

Sources & Stages And what about crowdfunding? Definition crowdfunding: its a way of inviting investors to give a small amount to your business. Fits best in R&D stage and start-up stage. There are two types of crowdfunding, debt and equity crowdfunding. Most common is equity crowdfunding: they give you a small amount and you give a small share of the company of a small share of the idea to this person. Website to get in contact with Angel investors: www.angellist.com Basic concepts of finance - Cash income is different from accounting income

o When he talks about profit, he doesnt talk about revenues less costs. Hes talking about cashflows. Whats the difference between accounted income (revenues costs) and cashflows? Answer: when you subtract the costs from the revenues, not everything thats in there is profit or adds value, because part of this profit must be re-invested to keep the firm going.

o Cashflow is the net income minuses taxes and minus what you put in your assets minus how much you must invest in each period (see formula below) - Accountants aim to match revenues and expenses. - Managers and investors focus on the difference between cash inflow and cash outflow (cash flow). - Formula:

Net income = revenues costs depreciation 1-Tc = no tax included\ You want to have a discount rate because you want to have the cash as soon as possible Net Present Value (NPV) - Managers measure profitability on the basis of the Net Present Value (NPV): - Market value and NPV reflect risk and time value and what investors are ready to pay - You want to have a discount rate because you want to have the cash as soon as possible - Problem with NPV:

o For large corporates, when you evaluate a project you are assuming that its taking the whole path as mentioned before. However, in a new venture, there are so many deviations from this path, that makes the expectation about the cash flow unrealistic

o The expectation about the cash flow for the entrepreneur could be completely different than the expectations of the investor have on the cashflow. So the interpretation of the NPV for the entrepreneur and the investors is different. Also the discount rate could be different because they see the value of time differently.

Lecture 2 Overview of financial statements Why are financial forecast important? Answer: you need investors and you must show them what the value of your product/project/company is and why the investors needs to invest in you! Financial forecast is the first step to calculate and demonstrate that your project have value for some investors, you need to estimate how the financial variables of your project over time to assess how much cash you need in each stage of your project and this financial need ofcourse depends on the conditional realized growth pattern of your project. Financial forecast (1/5)

Assessing how much cash is needed, conditional on the realized growth. Basis for estimating the value of a new venture (choice between project A or project B for example).

o Use NPV for example: the cashflows over time. The NPV is the cumulating cashflows times the discount rate minus the amount of cash invested in this project -> this will give you the return. The cashflows in the end will be the return for all the invested, so when its positive it means your project is generating value

Helping comparing options/strategies. Assessing strengths and weaknesses

o Google Glass Strengths: its new, new innovation, nobody has it Weakness: there is no demand, nobody wants a Google glass

o Coffee shops Strengths: you know how much coffee people drink (2 glasses per day, 5 days a week

for example) Weakness: a lot of competitors, maybe you cant beat them

Benchmark to compare actual performance. o When you know your profit and growth rate, you can compare your business with other

companies to see how they are doing Financial forecast (2/5) 7 principles

1. Assumptions: market size, market share, prices. Assumptions = how do you define the parameters of the assumptions, you have to take a set of

comparable firms or you can take variables of the overall industry to see if the project has to deal with a industry that is growing over time or not and finally you have to make some judgments yourself (you have to have some knowledge about the market or product)

Based on comparable firms (sell similar products or use same technology), industry characteristics, expert judgment (you need an expert to make this assignments or you have to have a little knowledge yourself)

Assumptions: how to you define those parameters?

2. Revenue Forecast: its the starting point. Why is revenue starting point of forecast of all the other financial forecasts? Or why are the sales

the starting point? Answer: Once you know your sales or how much sales you have next year, you know how to built your assets and from that you know your costs (because when you sell an item, you know the price of goods sold, know how much machinery you need, etc.) and in the end you know your financial needs (how much cash you need)

Investment needs come later.

3. Real or nominal terms? Either track the inflation rate or adjusts for price changes. Nominal or real price? It depends

o Real price = you are not considering the inflation to account, there is zero inflation, so price is constant (= fixed).

o Nominal price = if overall prices changes, you have to adjust the price in order to deal with these inflations

It depends if you need real or nominal terms.

4. Integrate financial statements through spread sheets: Income statement, Balance sheet, cash flow statement (in this way, so from income statements to

balance sheet to cash flow statements) o Why is net income not a good measure of profit? Answer: to keep the firm growing, you

have to invest and the new income doesnt take those investments into account. For the cashflow, the net income minus the amount of cash that I invest to keep the firm operating/growing and after the investment, you have the free cash flow.

o All the parameters in the financial statements are connected; so if you change one parameter in your sales projection or forecast, you change all the other variables/parameters

For testing assumptions, building scenarios, simulating uncertainty. o If you want to make assumptions or forecasts, you slightly change the parameters over and

over again so you can see the different outcomes

5. Time span for the forecast: track record or harvesting? Forecast for 1 year, 5 years or 10 years? It depends on the purpose, why are youre doing a

forecast; financial needs (how much cash do you need over time) or valuation? Why is exit strategy so important?

o Exit strategy = you sell your company or make your assets liquid, so its a way to sell your company or a way to make the shares tradable in such a way that who has those shares and who has the equity can actually use it to create or realize that value)

6. Intervals: days or weeks (you have too less information, you have no average, there is too much

error/noise in your estimates), months (new ventures), quarters (large corporations), years (large corporations)

7. Is it reasonable? What if analysis/stress tests. (=testing your assumptions)

Financial statements (3/5) Income statement describes revenues and expenses of a certain period.

Revenue = price * amount of pieces sold (quantity) Variable costs = costs that increase when selling more items = COGS for example Fixed / operating costs = it doesnt matter how much you sell, you always need to pay the operating expanses (rent, electricity, water, etc) Interest expense = you pay your creditors Financial statements (4/5)

Balance sheet presents a picture of what the firm owns (assets) and owes (liabilities) and what is left (equity) at a point in time. See picture below

Assets are ordered in liquidity: how can you use that asset to buy something else? Why big companies mostly dont pay dividend? Answer: To invest in uncertainties that could

happen Assets (debit) = debt + equity (credit)

Financial statements (5/5)

Cash flow statement determines financing needs (how much cash on hand)

If you pay dividends, you taking cash out of your company (so then decrease of your cash flow) Question 1: what if you have negative free cash flow but you need cash to operate my business? So

are you going to increase or decrease your debt or giving out more shares? Answer: if you increase debt, youre getting more cash in your company. If you pay debt, it means that youre taking out cash of your company to pay that debt. If you pay dividends, you end up with less cash in your company. The whole point of the cash flow statement is to show if you have some cash left in your company. If you dont have cash, it means you are in trouble; you need more debt, but if they see youre running out of cash, no creditor want to invest in your company anymore.

So: If he talks about financial needs, he talks about how much cash is missing to close the financial statements/balance

Suppose the business is running out of cash, you have two solutions: increase debt of getting more equity or more shareholders.

o Question 2: What is problem of raising debts too much? Answer: you need to pay interest, so youre hurting your net income.

o Question 3: What is problem of bringing more shareholders to the company? Answer: the value of your own share goes down, so youre reducing the value per shareholder and the value of your own share as well (3 shareholders, you got 25%, but now 4 shareholders, so now you got 20%)

Note: a lot of companys dont issue equity to pay day-to-day business operations, but to buy other companies or for acquisition

Revenue forecast (= first step of all financial forecast)

Primary driver of investments and costs, and so cash flow and financial needs. Established corp. may forecast sales based on historical data (+ fundamentals). New ventures have no track record. Two approaches

o Yardsticks: data on comparable firms that are very similar to yours! Not only products, but also same technology, etc. For example look at how their revenue and sales is over time and look at yours as well

o Fundamental analysis: variables defining the market. Yardstick companies

First you look for other companies that sell the same products of yours It may not sell the same product, but use the same technology or kind of innovation that your future

costumers will use as well. o For example: Apple launches iPad, so how do you know how many you will sell? There are no

other companies selling this. How to fix this? Answer: look at the amount of people that use both laptop and smartphone (iPad combines both )

Comparison may be based on: o Target market o Uniqueness of the product o Type of technology o Adoption rates o Distribution channels

Find the best match(es).

Example 1: GPS Navigation

You see differences in sales, but the % of the latest firm (GPS Industries Inc.) is much higher (85,7%) than the others, so this is also very important: why do they grow so fast? Example 2: Movies

Also here: Netflix uses the sales and revenues of Blockbuster to know whats the market size and then they adjust another sales channel to capture this market Caveats

Another companys sales might show you an optimistic sale cap. Total sales should be (geographically) scaled.

o E.g., sales/province, sales/store, sales/region. o You cant compare your total sales of your own coffee store in Amsterdam with total sales of

Starbucks for example, so you need to scale to the Starbucks stores in Amsterdam only for example

Data come mostly from successful companies. o How many similar companies have failed? o This is also a reason why you are very optimistic in your forecast.

How the product is delivered?

o You may sell the same products, but its delivered in a different way (Netflix example). You can gain market share by changing the delivery

Market share of established brands(market share of Blockbusters doesnt matter because they dont take all the market share (see Netflix))

o Can we beat the competitors? o Competing vs. Complementing vs. Replacing

Competing = start own coffeeshop in Amsterdam vs Starbucks and other coffeeshops in Amsterdam

Complementing = Netflix versus Blockbusters or Albert Heijn introduces online-shopping besides their physical stores and the competitors (Lidl, Dirk van den Broek) who only have physical stores. Also Bijenkorf and V&D: almost same products, but they take completely different part of the market

So only total market size is important to know, not the market share Replacing = Netflix versus Blockbusters, Uber versus normal taxi services

Fundamentals

For yardstick companys, you have information about sales, sales per store, revenues, etc. However, you dont know why the sales of the company are growing or decreasing. In the case of fundamentals is to built a model to understand why the sales of the specific company/product grow over time

Determinants of other companys sales. For example: you look at Coca Cola and see that the population of potential Coca Cola users (for example kids from 12-18 years old) are decreasing and also the youth are not drinking Coca Cola anymore, but when this 15 years old are 30 years old, they start drinking Coca Cola again. So this is a fundamental; you use age as determinant of a companys sale.

o Location o Costumer demographics o Population growth o Market segments o Saturation (durable goods)

Everybody has a car, but because the car company is keeping improving their cars, you still want to buy a new durable good. Slide changes are necessary to keep selling

We need a model:

Demand and supply approaches

Demand for unique products: o Market share (100%), market size (?)

The challenge is to calculate the market size, because you want to know how many want to use your product

Example: Google Glass and Apple Smart Watch Demand for traditional products:

o Market size (estimated), market share (?) On the supply-side, how fast can a firm grow?

o Managerial, financial and resource constraints Expected sales growth is the minimum of two approaches (unique & supply).

o Slow growth scenarios vs. Rapid growth scenarios. o When calculating the expected sales, you have to take in to account that this has to be the

minimum of the constraints in this demand and the constrains on the supply side. So if you have a kind of rapid growth scenario, I have to consider that all the constraints can come from the supply side; I wont have enough cash to keep up with the demand. In a slow growth

scenario its the opposite; I may have enough cash to keep investing in my company, however there wont be enough demand for my product

When Im projecting my revenue, it says that I should either consider supply constrains or demands constrains and take the minimum of both. But should I look to all the supply and demand side or look at both? Answer: in your scenario, you need to take account both the supply and demand side constrains in order to see what to be the minimum price of your product and then you know that your revenue will have a specific quantity times a price of a product (point where supply and demand meet, basics of Economics..) Uncertainty (=last point of forecast)

Every point estimate has a standard error o Means: if I estimate the average sale is 100, however this estimate has a standard

error/standard deviation of 30. When you actually start your company, I have 95% chance that my sales per year will be between 160 and 40. So from my two point estimate, you can use the confidence intervals which give you a good scenario and a bad scenario. In both cases you can calculate the financial needs. The idea is that the distance between the optimistic and the worse case scenario is that the larger the distance, the larger the uncertainty I have in my forecasts.

Every model has weak and strong parameters. o How sensitive the forecast is to each parameter.

Every forecast has lows and highs (scenarios): o How close they are? The closer the better! (see above) o What is the probability of each one happening? o Whats the worse case scenario?

You only invest in a project/firm if the worst case scenario it is still profitable. BUT if the probability that the worst case scenario is going to happen is 1%, then you can take the risk ofcourse (other percentages as well, but just an example). SO the probability of a scenario to happen is also important!

So now you know how to read and do your financial statements, you know broadly how to do your revenue forecast, so you put your revenue forecast in your financial statements and your financial statements pop-up the other variables for your forecast. Now you can asset your financial needs or how much cash you need to get your project go. Financial needs

Important: to keep your firm running; a firm should NEVER run out of cash. If you dont have cash, you need to find a way to raise debt

o But; if you only have cash and you have no debt or dividends to pay or no investments (with investments you gain equity), your money is a waste. Cash has no value then. Why do firms accumulate so much cash if it has no value? Answer: for uncertainty, maybe they need a huge amount of cash for a next investment so you can use this cash without raising more capital. The higher the uncertainty in your forecast and projections, the higher the amount you should save and keep away from investments in order to play safe in the forecast

o Always carry enough to the next milestone. o Running short of cash can suggest the venture isnt on track.

There are 2 approaches to assess financial needs: 1. Sustainable Growth Rate

The rate in which the firm at least needs to grow in order to keep alive 2. Cash Flow Breakeven

What is the cash flow that I need every period also in order to keep operating and move to the next period

Sustainable Growth Rate (SGR) The rate in which the venture can be sustained only using the initial investment.

o So the idea is that you collect all the debt, sold out all the equity, I have my amount of cash in the beginning and after that I dont need to raise debt or initial more equity. The firm can operate until the end of the milestone only based on this growth rate

o However, if the actual growth rate is less than the sustainable growth rate, the firm is in trouble. Simply, because youre not generating enough profit to keep the business going. On the other hand, if the actual growth is higher than the sustainable growth rate, this means you can keep on operating but I still need additional financing for my company in order to keep up with this actual growth, so you need to re-asses your financial source in order to keep up with this growth that is higher than its replacement rate

If actual growth > SGR, then additional financing is required. Assumption for this model is: variables grow in fixed proportions (all the ratios are constant over time)

SGR = g* Notes 1. For each euro of asset you have a fixed amount of sales that you can do from this one year asset. 2. For each euro of equity, you have a fixed amount of assets every period. 3. For each euro of sales, you have ex profit and ex euros that are generate of profit per period (not sure -> look up in theory?) 4. For each euro of net income, you have a rate in which you pay dividend or retain my profits (not sure -> look up in theory?)) SGR - Example

For example: you start with 100 dollars from your investors and you assume that for each dollar of equity, I have 1.5 in assets (my leverage is constant). This asset is equal to debt + equity, so the amount of debt that youre presuming is 0.5, so in the end for each dollar of equity, 50 comes from debt and 50 from assets. For each dollar of asset you generate 3 dollars in sales (so this is another fixed rate that you presume), so from 1.5 in assets you can generate 450 in sale and you know that for each item that you sell you have a unit profit, namely 10% so you spent 90% of your asset paying the cost of that good. So net income is 45 dollars. For this 45 dollars you decide to retain 66.7% (2/3) and you paying 33.3 (1/3) on dividends. Question: is this a smart decision in an early stage of your venture? Answer: Unless the investors say you have to, dont do! Keep your cash in the company and keep growing, unless you have a kind of agreement. So finally, if you retain 30

dollars from the net income, you increase your initial equity with 30 dollars which means the value of your company or the value of the equity increase 30%. So thats the sustainable growth rate, so if you go on with this process, I never need extra cash to keep your business operating. You can keep your business operating only by the initial investment of 100 dollars. Why is this so important? Answer: this is so important because if you break down the format that the growths come from the value of the equity, which depends on the return on equity, which is basically the new income over the initial equity, you realise that the return on equity is the return on sales (NI (Profit)/Sales) times the turnover (Sales/Asset) times Assets/Equity. In the end the sustainable growth rate will depend on the leverage or how much debt you raise per period. So, if this sustainable growth rate depends on the leverage, than if you increase the leverage you increase the growth of your firm. In other words: to increase the growth of the firm, you need to increase the leverage or the growth rate. SGR Formulas

BUT what is the problem of increasing the leverage too much? Answer: if you increase the leverage, you not necessarily increase the growth rate because it will reduce the return on sales or reduce your net income. So you hurt your net income by raising debit but on the other hand increasing leverage may increase your growth ways. So it goes both ways, you need to find some sort of equilibrium in this formula in which given the growth rate how much leverage you need to keep it go. Another question: should you aim for a very fast growth rate or for a very small growth rate? Answer: it depends (like always). If youre not sure about the market size, if you have a lot of uncertainty, you may adopt a small slow growth, because you want to see little by little how you can catch the market. However, think about the iPad of Apple; when they launched the iPad they knew new tables will come on the market within a few months, so the strategy could not be like: release the iPad in only one country, see what happens and then release the others. So they must have a fast growth strategy in order to kill the competitors and have a unique profit for a very short period of time.

Cash flow breakeven Not related to investments, but just related to how much revenues you need to keep the firm operating

given its size. In other words: what is the cash inflows that I need to sustain all the cash outflows? The level of sales (BEP) at which a venture is able to maintain operations without additional funding.

o Cash inflows to sustain cash outflows Cash flow BEP does NOT fund growth (only depreciation). Principle:

o What is the cost of selling an additional unit? A few units wont cover fixed costs

Cash flow BEP Example

So you keep growing to the point in which the cash outflows break evens with the revenue. From this point, you know that youre firm is not shutting/breaking down anymore. However, if you take the revenue minus expense approach, you may find that this break even point (BEP) is much larger and this could be a mistake, because it could be too conservative if your decisions are based on notion of profit rather than this notion of cash flow. But now the question is: what happens in the beginning of a new venture in terms of cash flows? Answer: you never start with positive cash flows, you usually have a lot of negative cashflows to you reach the point of positive profits. So what happens is that it doesnt matter if in year or two you have negative cashflows if you know that based on your revenue forecasts, you will reach the break even point. So if your forecast show that you have negative cashflows in the first and second year, BUT in in the third, fourth or fifth year you reach the breaking point, you can keep operating, so you dont need financial needs. Financial needs

The venture might not reach the BEP in the first years, so additional cash is needed. Breakeven analysis can be combined with revenue forecast, telling when the BEP will be reached. Both SGR and BEP can be applied to a range of realistic scenarios.

Lecture 3 Valuation methods for new ventures Valuation of New Ventures

The ability to generate future cash flows (FCF) What is different about valuing new ventures?

o Higher risks and higher uncertainty o Higher potential rewards? o Exit and liquidity more important (you need this to pay back your investments) o Not just a go/no-go decision (in large corporations projects can be dropped very easily)

When do you need to invest in a company? When it first starts or after the IPO -> at the beginning The average return of the stock market isnt so different from investment market. Because the returns are more dynamic with start-ups but the average is somewhat the same.

Valuing is critical because o It determines the fraction of FCF going to investors (what do you offer the investors?) o Are the terms asked by investors acceptable? (fair or not?) o It anticipates future problems, financing needs and risks. (once you have calculated the value

of the company and all the processes taken to calculate it, you know all the scenarios! ) Whatever path the company may take)

Challenging but important

Example 1: o An entrepreneur opens a restaurant in Amsterdam and plan to open 10 others in different

European cities. How to account for the growth opportunity that is conditional on early success? You

can use the track record of the first restaurant. Example 2

o A university technology transfer office is consider licensing a new tech to 2 firms: 1. A large corp. offering $100,000 up-front and 1% of the sales. 2. A start-up offering $50,000, payable in 5 years, and 10% of its equity. Which one is

better? Depends on the value of the different companies. You need valuations! Example 3:

o A high-growth company persuading a university researcher. Her salary is $120,000.

o They offer $40,000 in salary and the option to buy 3% of the company. Should she take the job? Again it depends on the value! Has also to do with risk

aversion! One of the founders of Google left the company before it went so well. How do you put value and risk into an answer and how do you make this decision? Valuation approaches

1. Discounted Cash Flow (DCF) (lot of theoretical foundation coming from this approach) o Risk-adjusted discount rate (RADR) o Certainty equivalent (CEQ) approach

2. Relative Value (RV) or Multiples (Very simple) 3. Venture Capital (VC) method 4. Real Options One of the most powerful tools to value new ventures!

Discounted cash flow (DCF) Determining FCF from operations:

You start with revenues and then you direct to costs. The idea is that your estimated cash flows are discounted that bring the value of those future cash flows to the present. What are the factors that influence the discount rate? Rate of risk free investments (government bonds) Uncertainty

2 approaches for estimating Present Value (PV) of FCF.

o RADR is the more used approach -> includes the discount rate o But CEQ is easier to estimate for new ventures. Then you estimate the discount rate within

your future cash flows. o Difference is in how they adjust expected FCF for risk. o With full information, they yield identical estimates.

But the information needed differs. Risk-Adjusted Discount Rate (RADR)

e.g. you have negative cash flows first and you see that your cash flows are growing, then you can estimate a growth rate. And then you can formulate an exit strategy. TV = terminal value If PV I > 0 then you have a positive NPV -> people will want to invest. If NPV = 0 or negative no one will invest. Terminal/Continuation Value

Point when expected CF starting growing at a constant rate (g). o E.g., long-term industry growth rate

Typically at investors exit time ( at the time you want to sell your company or do an IPO) The shorter the period of CF estimates, the higher the effect of TV on NPV (e.g. a period of three years

will have more weight per year when defining NPV)

Discount rate

So certainty and uncertainty! Risk can be measured by standard deviations. Or standard errors or variance.

o Deviations from the estimated value. How to price a measured risk?

o Entrepreneurs and investors have distinct risk- premiums. Why? Diversification -> entrepreneurs put all they have in one project, and investors spread

their money on different projects. Risk premium (from investors point of view the risk premium can be easily calculated)

Distinction between systematic (market) risk and idiosyncratic (nonmarket, firm-specific) risk. o Diversification reduces idiosyncratic component. -> By increasing the amount of projects in

their portfolio they are reducing the idiosyncratic component. But there is also a part that investors cant hedge.

Market/Systematic Risk If something happens in the market then all projects in this market will go down or up. That is something that you face no matter what. E.g. earthquake or financial crisis.

Each asset will act in a different way. The higher the beta, the higher the systematic risk.

Investors are only interested in systematic risk. There is one critical assumption for this model: that public tradable assets have an NPV of zero. What happens if a NPV asset or project out there is positive, everybody wants to invest. Then the price will go up. The cost of investment goes up, so the NPV goes down into zero. Why zero? Because if the NPV is negative nobody will go after this project. Then you reduce the price so the investment cost will go down. So the NPV will be zero as well. ITS ALL ABOUT THE LAW OF SUPPLY AND DEMAND! Think of an asset that is similar to my asset and has a similar risk as my project that is public tradable. If you have this information, then you can run a regression between the similar asset and the market (e.g. S&P 500). CAPM, Example

Monthly Returns of Cisco Stock and S&P 500 Ciscos return tend to move in the same direction, but with greater amplitude If I include an asset with a Beta greater than one, I increase the risk of my portfolio. I compensate by adding assets that have a Beta smaller than one. If I only have Betas in my portfolio that equal one, there is no effect of risk or adding that asset. How about if the Beta is less than zero? That means that the market goes one way, the asset will go the opposite way. This is to hedge risks against the market.

CAPM, Example

is the slope of the best-fitting line and measures the expected change in Ciscos return per 1pp change in the market return.

Deviations from the best-fitting line correspond to diversifiable, non-market risk. The problem of the RADR approach. It is hard to define an asset that has a similar risk as the asset of

interest. It is hard to define this beta. You can use other companies data.

Open circles? You try to calculate the NPV of a project to convey investors. But you need the beta to calculate the NPV. The net present value and beta are both defined at the same time. You may have many solutions for two variables using one equation. You have to have some kind of strong assumptions when calculating NPV. Try to argument the best scenario. Certainty Equivalent Approach (CEQ) (more simple approach)

Problem of RADR is to find zero-NPV market assets to use as a basis for the discount rate (CAPM). Basically Im trading risk. The idea is the following. When flipping coin. 1000 euro or zero. Or 400 euro straight away or the previous game. This is the point of risk aversion. Some investors are risk averse whilst others not.

CEQ of a risky CF is the certain (risk-free) CF that is equally valuable to the investor. o For risk-averse investors, CEQ < E[CF]. What is the amount of cash flow that avoids you of

flipping the coin? The risk adjustment is made to the CFs:

o Dont have to calculate risk-premium, its only about risk free rate. CEQ, example

Deal or No Deal, the game show. Same as choice between given amount or flip the coin o 26 briefcases each of which contains an amount from $0.01 to $1 million. o Contestant chooses 1 of the 26, which remains close until the end.

Its expected value is $131,478.54 o Over a series of 9 rounds, briefcases are opened and the expected value of the first changes. o At a certain point, the banker offers a certain payment that is less than the expected value in the

first briefcase. If contestants CEQ is less than bankers offer, game is over.

How to estimate the discount (RD)?

Youre interested in the cash flows of your project and the average market return. So the whole industry. Its not that simple. When you build your scenarios (economy goes well, stays the same or goes bad. 3 scenarios). Then you know what your sales will be in the three scenarios. The relation between market outcomes are based on assumptions and how you tackle the market. The way you compete against other brands. So more theoretical assumptions than regression.

What is difficult in this approach is that it is hard to calculate the correlation between the market return. Cash flows can be negative. There is no bound. But the correlation coefficients minimum and maximum is -1 and +1. So suppose your model says 0.7, it can also be that rho can be 0.5 or 0.9, because rho is bounded. Up until now you have forecasted cashflows and discounted them. In the following method you ignore those cashflows and then you estimate this present value. Using multiples or explanatory variables. Remember from multiple regression model the dependent and independent variables. There are two ways of estimating present value. You use this method to estimate the last part that is related to the terminal value. In which you expect that the firm grows at a constant rate. So you can compare your firm to another firm in the market. Most of those multiples are based on revenues or earnings from income instatement. You can estimate from a similar public company comparable to yours what your earnings or revenues will be. Relative Value (RV) Method

It uses data from public companies and public and private market transactions to estimate value. Main idea: gathering information on value drivers of comparable firms (multiples).

o E.g., profitability, expected growth, and risk. Useful for estimating terminal value (TV). Most multiples are based on revenue or earnings from Income Statement.

o But there are also multiples based on assets on the balance sheet. Accounting-based Multiples

They relate the value of venture equity or total capital to reported accounting information. Most common is the Price-Earnings (P/E) ratio:

o Gives the (market) value of equity on the basis of reported NI (less dividends). This is based on financial statements of another company. So you can recognize the stage and based on this you make an estimate. In this method youre not interested in alternative scenarios. You only want to see the value in one point of time. So its an estimate that is not really waterproof. It is a very simple method. You dont talk about risk but expected income.

Others (based on capitalization): o Price to cash income, price to levered cash flow, price to revenue, etc.

Based on enterprise value: EV = E + D cash: if your company has not the similar proportion of equity and debt as the company that is compared it is better to use this approach.

o EV to EBITDA (Earnings before interest, taxes, and depreciation and amortization), EV to sales, EV to book value of debt and equity. It is important to realize that if you choose a ratio, other ratios should give you somewhat similar results. If this is not the case then you are not dealing with a similar company.

Non-accounting-based multiples Here you can use the multiple regression approach. Very straightforward approach. No balance sheet or financial statements.

Industry-specific nonfinancial metrics. Examples of proxies for ventures value:

o Magazine: projected number of subscribers, pages of advertising. o Biotech co: number of patents. o Internet co: number of website visits, average time spent on the site.

They can be used to estimate (regression) either equity or EV. o Depends how comparable and new venture are financed in the same way.

Pros and Cons of multiples Pros

Easy to implement (using ratios or regression) there is no need to complex financial forecast. A lot of people use this approach.

Frequently used by practitioners and generally accepted by finance community Market-based (it uses market values). This for an investor much more important than the bookvalue.

This because the investor wants to sell his equity to marketvalue and not the bookvalue. Cons:

Public firms may not be too similar you dont know this exactly We cant observe prices of similar private deals between different companies. Current financial measures are linked to assets in place, with little relationship to future performance.

You dont know it all. In other words, it is too simple. Multiples in practice

Constitute a group of comparable companies o Similar products, geographical spread, similar markets, financial structure (leverage) o Exclude clear outliers in order to keep your average more robust.

Use recent average (a few years) of value Use more than one multiple Calculate mean and medians for each multiple because the medians dont have problems with outliers. For large variations in the sample, understand these differences. For multiples of equity, use data from:

o Listed companies o Recent acquisitions

Multiples are used to check consistency Multiples are used as an intermediate step to conduct the method hereunder: Venture Capital (VC) Method

Often used by venture capitalists there is no theory or statistic behind this method. It is more about feeling. It is how the investors feel about that project. They are interested in one thing: the terminal value. Why? Because this is what they will get when they make their investment liquid. There is only one scenario, and that is the successful one.

o But not as transparent and consistent as other methods Value is estimated on the basis of projected harvest-date cash flows

o Under the assumption that the venture meets its objectives (success scenario) It generates less valuable information:

o It doesnt provide milestones to track performance. Because we only look at terminal value. o It doesnt allow investors and entrepreneurs to identify key drivers of value.

VC Steps

1. Forecast sales or earnings/cash flow for a period of years. When they start getting positive. 2. Estimate the time at which the VC will exit the investment, harvesting by acquisition or IPO. 3. Value the exit price (TV) based on an assumed multiple (P/E, sales, etc.)

a. Multiple reflects the capitalization of earnings for a company as successful as in the scenario. 4. Discount interim CF and TV at rates ranging between 25-80% per year. There is no theory on how to

calculate a discount rate. Investors always use a discount rate between 25% and 80%. Very high! All the uncertainty of the project goes to the discount rate. It is important as entrepreneur to calculate your own discount rate. To see if they are fair.

a. This yields the PV.

5. Compute the minimum fraction of ownership an investor would require (VCs stake). VC Method

Its based on optimistic forecast(no alternative scenario), so the hurdle rate is intended to compensate for risks.

o Rates well above cost of capital o VCs dont believe entrepreneurs projections anyway.

Rates are higher also because: o Shares purchased are illiquid. o VCs provide services that need to be compensated for (adding value).

Reputation capital, access to skilled managers, industry contacts, network, etc. they sell you network and put this cost on the discount rate.

VC method is based on intuition and experience o No real guidance for young entrepreneurs and first-time investors. By trying different discount

rates with different entrepreneurs they estimate discount rates. So based on the history of the VC.

All based on VCs bargaining power o More VCs firms in the market, entrepreneurs experience, track record, and capital inflows

increase valuations. Once you increase competition in VC, there will be a decrease in discount rate. Entrepreneurs dont only move like places like Silicon Valley to meet with other entrepreneurs, it is also to be in a more competitive environment when it comes to VCs.

Conclusions he finds this course too intense for 8 weeks. The cases are meant to practice.

DCF methods are the most logical o Based on solid and theoretical approach o But often difficult for new ventures o CEQ is simpler and less biased.

DCF may work as benchmark for other methods. If you accept the deal or not. To have an idea how projects can change in comparison to others.

Valuation by Multiples: you should make strong assumptions. Then you can see that these methods are consistent or not over time. Then you can adjust your assumptions.

o Great variability in the common measures o Myopic measures (based on past book values). o But useful to verify robustness of DCF assumptions.

Appendix RADR

The difficulty of using RADR:

PV is in both sides of the equation

Lecture 4 - Real Option Valuation Definition

In practice, investment projects can o either be done now or later (option of delay) o be abandoned, downsized, or expanded (option to adapt) o create new investment opportunities (option to pursue follow-up projects)e

Any strategic plan accounts for these changes after an initial decision is made. These choices are called Real Options.

o Flexibility and anticipation of changes creates value. o Traditional NPV/DCF analysis often ignores this value.

Example I: New Markets

Consider the strategy of Focal Communications, a Competitive Local Exchange Carrier (CLEC): o They can either enter 10 local markets simultaneously or enter them sequentially.

Uncertainty comes from the markup of price: o 50% chance of HIGH markup (say 25%), with implied valued of $13.9M per city. o 50% chance of LOW markup (say 15%), with implied valued of $5.9M per city.

Sequential entry reveals how valuable the CLEC is before expanding. o Information is obtained by entering the first market (say Chicago)

Staging the Local Markets

If in the first year in Chicago, they learn the markup is 15% (not 25%), then it is NOT optimal to enter the other markets.

The value without the real option is: (5.9*0.5 + 13.7*0.5)*10 = $39M With the real option: (5.9*0.5 + 13.7*0.5) + 0.5*(9*13.7)/1.16 + 0.5*0 = $57M Investors are not passive.

Discount Rate Example II: Shutting Down

Consider the simple option to shut down: o Metals Inc. is bidding to acquire a mine with 75 million kg of copper. o Extraction costs $0.80 per kg. o Extraction can only start in one year (development of the mine). o Projected price of copper (per kg) next year:

Assuming a discount rate of 5%, what is the maximum that Metals Inc. should bid?

Value of the Mine (START OF RECORDING) Ignoring the shutdown option:

- Negative PV, no bid.

But Metals Inc. has the option to not extract the copper if price is low:

They should bid up to $3.57 million. Buying the extraction rights is a real call option, with a strike price of $0.8 per kg. So the idea is that you fix the price so you create one sided risk, like explained further hereunder. Some Basics

An option is the right to make a decision in the future. you dont have to take this decision. In the stock market, a call option is the right to buy a share at a future date for a price established today

(strike price). So if the price goes up you can actually profit from it. o The payout increases with the actual stock price.

A put option is the right to sell an asset in the future at a pre-established price. Buy this option at high market price and sell the asset when the price is low.

o The payout increases if the asset depreciates. One sided exposure to risk

There is one sided exposure to risk because you only sell or buy when it is actually profitable to do so. If the price is too high or low then you just dont use the option. Then the NPV is zero. So if the price is increasing or decreasing in your advantage then your NPV is higher than zero. Financial Option vs. Real Option

Like financial options, the value of real options increases with risk and time to expiration. o The higher the variance, the higher the value of the option. What is related to the variance?

The time to sell or buy the asset. What has more value, 5 or 10 years? From the stock market, we can fairly estimate what happens in 5 years, and the belonging variance. But as time increases the standard error or the variance will increase as well because of uncertainty

But real option markets are not complete. Opposite to financial markets. o The Law of One Price (LOP) doesnt apply.

With financial options -> if NPV Investment > 0, everybody will want that option, and that options will return to NPV Investment = 0. The idea of arbitrage. If two different assets have the same cash flow, then they must have the same price. Example of selling German beer in the Netherlands. You can sell it in NL until supply and demand will establish to the same price in NL as in Germany.

o No necessary relationship between real option premium and real option value. You cannot trade a real option. One exception. The insurance market is one option for

trading real options. Why? Because you can insure yourself against a bad economy. Real options are often interdependent. In the case of financial option portfolios. And the calculate the

value by the weighted average. This is not the case with real options. This is because the decision on the option influences the other one.

o The value of a portfolio cannot be determined by adding up individual values. o The decision to exercise a real option has implications for the values of others.

Decision Tree

Useful way to conceptualize alternatives that involve real options. o It helps to identify relevant options and critical decisions. In your project.

2 Important techniques o Backward induction: start with the last decision points and eliminate alternatives recursively.

You start from the end and then you will go back, eliminating the least profitable alternatives o Prune the tree: By eliminating irrelevant options recursively, we focus on the important

choices. Decision Tree

Invest in large or small, or not go at all. You have three choices, after that the nature takes over. If you know the demand, you will go high. If its low, you go small. But you dont know. So you calculate the probabilities. Calculate for each possibility the expected value. This is a very simple example. In this example its only about the variable cost.

More complex tree

This example is about whether to expand or not. The decision of expanding comes usually after the state of nature. When Im comparing expected values and select something, what does that tell about my risk aversion? Nothing, Im risk neutral. When risk aversion starts to play a role, then you put heavier weight on the bad outcomes. Valuing Real Options What discount rate should we use? The point is that real option doesnt use this type of discount rate. The only discount rate we use is the risk free rate. You dont have the same expected cashflow with real options. What is the systematic risk (Beta) of the option- embedded project?

Difficult to determine because of non-linearities in the expected cash flow. We can follow the risk-neutral valuation approach. You recalculate the probability of a cash flow accounting for a risk adjustment. Tracking Portfolios: Replicate cash flows of call option with common stock and debt

Tracking Portfolio If I want to calculate the market value of a real option, I replicate the cash flows of this real option with common stock plus debt. E.g. in the good state and bad state cash flow. In the good state I have the same return as with bonds, same debt. But the returns will change.

Amounts:

Current value of the option is:

Remember law of one price. Worst explanation ever given in academic history. G= good state B = bad state Risk-Neutral Valuation Assume that investors are risk neutral and earn the risk free rate of return on all investments. Under this assumption:

This is not the actual probability, but the one that takes into account risk-aversion. Current value of option:

Back to the Example, Metal Inc. Suppose there is a future position on copper, which pays $0.6 per kg a year later. In a risk-neutral world:

Good state = 0.9 Bad state = 0.5

So if you calculate p back from this equation, you now can calculate the risk adjusted probability In this case: p = 0.25 (risk-adjusted probability) Current value of option:

Good situation cash flow: 75 Bad situation cash flow: 0

Therefore, $1.785M is the PV of the project.

Lets use the tracking portfolio to calculate the value of the real option again.

I have the financial option of buying future copper. I buy at 0.6 and sell at 0.9 or 0.5, plus the returns of my bonds. Another bad explanation, unbelievable. He just fills in the formula, so you must know what each letter stands for. The present value of operating in the future market should be equal to the present value of operating in the current market. Why? -> discount rate. Because of arbitrage. They should both be zero. Moral of the story is that both methods yield the same result. Both give the same answer. Sometimes you dont have different scenarios for cash flows (good, bad, moderate), but a continuum of cash flows. So cash flows with variance, meaning that they have a normal distribution. Then you use: Black-Scholes Formula

What if CFs are not binomial (High vs. Low)? There is no probability of success or no success. Its a continuum now.

Suppose assets returns are normally distributed. Then: Strike price: is the cost of producing the product. The pre-established price of cost of that transaction.

Black-Scholes and Real Options How do we translate key variables into real options?

T: Length of time till option has to be realized K: Expenditure required to acquire project assets : Riskiness of project S0: Present value of project

Use DCF analysis to get S0

Use scenario analysis to get volatility of S0

With assumptions about the probability of various outcomes. Assumptions about CFs under different scenarios Volatility of comparable company.

This formula is used to asset pricing. How can we use this to new ventures? How to calculate the present value of the whole project? How do I calculate S0. I use the discounted cash flow approach So there is a relationship between discounted cash flow and the value of a real option put together in formula. For exercising that real option. How to calculate sigma of cash flows? -> error term on cash flows, than you know the probability of your cash flows (scenarios). Another bad bad explanation.

But in a continuous case there are no scenarios. You have a continuum of scenarios. From this continuum of cash flows you have a standard deviation. Another way of calculating the sigma is by calculating the volatiltity of a similar company in the market. You know the volatility of those cash flows by analyzing them over time and then you can calculate the sigma using data from others. From Decision Trees to Game Trees

Decision trees do not incorporate other agents reaction (competitors, investors, etc.). o its like a decision tree, but its not nature that does something but other agents (competitors)

act to my decisions. You dont play random. Your strategy changes as the strategy of your competitors or investors change their strategy.

o Playing strategic game Strategic games commonly played:

o Business plan: An entrepreneur must decide how much optimism to put into the projections.

Overoptimistic projections might imply deals of investors with tighter returns. o Strategic partnering: A potential partner might become a competitor. E.g. vertical integration

with a partner, now the partner knows a part of the company and can become a competitor o Control: How much control to forsake in exchange for funding. Discussed last week with

venture capitalists and business angels. Your losing control but youre getting more funding. o Information disclosure: Deciding whether to patent an idea now (and risk copycat entry of

rivals) or maintain it as a secret.

Example game tree:

Three options: large bar, small bar, and waiting to what the competitor does. If i go for a large bar. My competitor stays out. When I do small bar, competitor will go in. Now if I wait, my competitor can choose to enter or wait. They will enter the market even though they know I go large. from this tree you will see that Kellys bar will go large right away. Sometimes its difficult because sometimes the same cash flow are generated with options. Then you will put probabilities on what the decisions of the competitor. The idea of trees is to make the most simple model but include all the options.

Lecture 5 - Deal Structure Introduction

The importance of outside investment, even for wealthy entrepreneurs: (example: suppose that my financial need for a venture is 2 million dollars. I have 6 million in the bank. Why would you invite other investor to put capital in my venture? To decrease and diversify the risk.)

o Entrepreneurs can invest less and increase diversification o Outside investments can increase the PV of the venture o Investors may provide advice and information that enhance value (that increases the expected

cashflow) How contracts can benefit both entrepreneurs and investors. (both want at least zero or positive NPVs) Deal terms:

o Diversification differences o Information asymmetry (parties dont know always all the information from each other) o Expectations (what are the projections of the entrepreneurs, but also what are the projections

of the investors? Are they alike? Or not?) o Incentives (investors want that if they have given the money, that the entrepreneur does his

very best, and that he doesnt just cash out the investment) What Do Entrepreneurs Care About?

Building a successful business Raising enough cash to sustain the venture Maintaining as much value and control of the company as possible (bargaining game with investor.

Both invest in the company, how much goes to the entrepreneur and how much to the investor?) Getting expertise and contracts to grow the company Sharing some of the risks with investors Financial returns from the venture (even though the entrepreneur loves his product, he does want the

financial return for his effort) What Do Investors Care About?

Maximizing financial returns (they only care about financial return) Ensuring that firms make sound investment and management decisions (they want to know that if they

invest money that the company makes the right decisions) Participation in later financing rounds if the venture is successful (when it is already known that the

venture is successful) Achieving liquidity: sell the firm in IPO or merger (they want an exit strategy! this is in order to

liquidate their equity) Building own reputation (Why? Because if they are successful, they will get better projects and they get

higher hurdle rates, and can charge higher demands in contracts) What Do Both Care About?

The success of the new venture The split of financial returns ( they both want to extract the best deal out of the contract) The allocation of control rights Eventually liquidating some or all of their stake in the company Potential problems Disagreement of direction Conflict of interests (in the beginning you have to be sure that both have aligned interests. That

investors dont misuse the venture, and that the entrepreneur doesnt misuse the money of investors) Logic Behind the Contracts 1. Financial returns are divided to

Reward investors for their investment in the firm Provide incentives to entrepreneurs to maximize value and to stay with the firm Provide investors with incentives to add value

2. Dynamic allocation of control: More control to entrepreneur if things turn out well More control to investors/VC if things dont turn out well in the AVID Case! In IP rights

3. It provides incentives to achieve a liquidity event Proportional Sharing of Risk

Consider a entrepreneur who has $6 million in cash. Suppose her venture requires an investment of $2 million.

o Should she look for outside investor? While an investor would diversify the investment and require a low discount rate (say 8%), the

entrepreneur would require a much higher rate (say 37.5%). (investors face only market risk, because they diversify! But entrepreneurs also have their idiosyncratic risk because they invest all the money they have in one project)

o If the project is expected to generate $10.75M in CF in 6 years, whats the NPV of a $2M investment from the investor and from the entrepreneur:

For the entrepreneur, the higher her investment, the lower the amount remaining for diversification.

o Therefore, the higher her discount rate. (so reverse: the lower the investment made by the entrepreneur, the higher the amount she could use for diversification)

Example Assume constant return to scale, so that each $ invested generates $5.37 in CF after 6 years.

The entrepreneur has a non-negative NPV up to $1.631 million (NPV is maximized at $636K). If size (investment needed) is given (?), an outside investor must be found. (why does the entrepreneur

needs outside investment? You need to have a certain an amount of cash to keep operating. If you make very low investments, you wont have enough cash to keep the company operating) (sometimes taking high growth strategy in the beginning is really risky. It is better to stage your projects)

Sharing Ownership Proportionally

From previous example, the investor should enter with $1.364 million o To maximize entrepreneurs NPV.

With proportional sharing, the investor, with 68.2% of the total investment, receives 68.2% of equity. Thus the entrepreneur maximizes her NPV by choosing the ownership share. In practice, this is not a likely contract structure. (this because the entrepreneur wants to remain

control. In reality, there is a game in which the investor puts in probably less than 68%. Why is that the case? See next slide)

Allocation of Expected Returns

It may be better having an investor than not having one at all. But itd be much better to get a bigger piece of the pie. If the capital market is competitive, investors go after any project with positive NPV.

o They compete by lowering their equity share Example: a venture need $2M to start and requires $1.5M from outside investment and has a market

value of $6M.

(investors will have a lower but still a positive NPV)

From a zero-NPV investment of $1.5M, $500K (25% of $2M) is the proportional investment of the investor. (that is proportional to the equity they receive from the company. This will cover the cost of capital. This is proportional to equity the investor receives)

o And the remaining $1M is the side payment (=the entrepreneurs free leverage) to the entrepreneur

(In the extreme case that the entrepreneur puts nothing in the company, he does get money and equity. Since entrepreneurs cant mitigate risks, why dont they sell all their equity and work there as employee? Why does this not happen. Even if they know their NPV? There are several reasons. Entrepreneurs are subjective about their venture. They are more optimistic, they believe that their value will be more. Another reason is that market are not so competitive. What the investors offer is often below the market value. From the point of view of investors, they need the entrepreneur to have an incentive to work hard. . Allocation of Expected Returns

The side payment reduces the entrepreneurs capital contribution for the 75% remaining. o From $1.5M to $500K. o It enables the entrepreneur to invest more in the market, increasing her NPV (How?).

The side payment works as a free leverage for the entrepreneur. o Or a payment for human capital.

In Practice

If venture CFs are more valuable to investors than to entrepreneurs, why entrepreneurs dont sell all their equity?

o Trading all risky claims for cash. Because:

o Entrepreneurs place subjective value on the venture o Entrepreneurs are often more optimistic, so investors may not offer enough. o Capital market is not so competitive, so offers will be often below market value. o Entrepreneurs effort is important to success, so entrepreneurial ownership is a way of aligning

incentives and interests. Passive Investors vs. Active Investors

Weve just talked about passive, well-diversified investors so far. Other two cases:

o Subsidized, passive investors:

Who receive subsidies intended to promote the creation of new business Often seek lower-risk claims and prefer debt over equity Better suited to invest in small business with positive cash flow Tend to shift total risk towards the entrepreneur (reducing NPV) Do not necessarily pass the subsidy to the entrepreneur

o Active investors: Also contribute with expertise to increase returns and reduce risks. Demand larger ownership interests

The decision between active, passive, and subsidized depends on entrepreneurs NPV. Up until now we talked about passive investors. They dont necessarily offer any other extra service. They dont change the cash flow of this company. Lets consider one passive investor that receives a subsidized loan in order to transfer the cashflow to the venture. What is a passive investor? They can offer the same loan as opposed to a bank with much smaller interest. Bank borrows from the market, and lend to the venture. Subsidized investor takes the same loan, minus the subsidized part, goes and lend to the venture. So they are much alike banks but because of the subsidizes the loans of subsidized investors are lower. Subsidized investors want to invest in low investments with low risks. A second problem is sometimes related to competition. Subsidized investors have almost no competition. The spread of one institution is much higher. The rate of subsidized institutions is even though they are less competitive lower than loans of banks. And now consider active VCs. They are taking the risk, just like the others, but in addition they provide a positive change in cash flows. They provide a positive npv and demand more equity because they provide those services Example Consider the following alternatives:

1. Proportional sharing: a passive investor offering $1.5M in exchange for 75% of common stocks 2. Ownership shifted: A well-diversified passive investor offering $1.5M in exchange for 40% of common

stocks 3. Subsidized investor: provide $1.5M in exchange for 30% of common stocks. Annual cost of funds is

2% below the CAPM- based discount rate. 4. Active investor: provide $1.5M in exchange for 45% of common stocks. CF is expected to increase by

10% and std. deviation decreases by 10%. It all depends on the NPV!

EXAMPLE

Discount rate is different because of the subsidizes. The passive guys provide the same cash flow, but with an active investor the cash flow increases and change the distribution They require a different % of equity. They have different NPVs. EXAMPLE

In which one of the cases there is more room for negotiating? The first one. From the bottom we can see that the NPV with the active investor is the highest. The problem of the active investor here is that they have room for negotiating, but they are adding services so they want compensation for that. They will say that they pay that 2 million to human resources (for the services) and state that there NPV is very low because of this.

Information Asymmetry Before the agreement: each party is unsure about what the other knows

o Is the venture a cherry or a lemon? (entrepreneurs and investors take advantage of their own information to catch as much value of the agreement. And what if the company isnt doing so good? Can you blame the entrepreneur? And what if the investors dont provide the services they have promised?

After the agreement: how much effort is applied to the project? How to evaluate performance? Incomplete information vs. Asymmetric information: (the difference is that if they have asymmetric

beliefs, they want to profit from that information) o If both parts are ignorant regarding an outcome but share the same beliefs, the contract can be

simple. o The problem is when they have asymmetric belief and private information.

They have the incentive to distort their true information and beliefs to extract more from the other.

Adverse Selection (is before the agreement) & moral hazard (is after the agreement)

Entrepreneurs compete for funds by presenting optimistic projections and omitting negative information. ( suppose two projects, one is good and one is bad)

o Investors react by offering high hurdle rates. (for both the projects) o Problem: Good ventures tend to be undervalued and not pursued.

The existence of lemons drive cherries out of the market. (this is because the good projects think the hurdle rate is too high and wont continue with investor. And lemon will take the rate. And because of this, investor has a lemon and rates go up even more.) ( he provides example of used cars. Can you ever believe the seller? He will always say that the car is really good even though its shit)

Why an investor is interested in the venture? o Investors may only seek for competitive threats. o Well-intentioned investors are beaten by too good to be true offers. (even though there is

well intentioned investor that has low rates you also think this is too good to be true) Example

An investment opportunity of $600K that can be funded by a VC. Assumptions:

o There are 2 equally likely states of returns: State1 and State2. One is good and 2 is oke. o Entrepreneur learns the true state at time 0. (he already knows the state and the return of this

investment) o VC investor learns the true state at time1. (so after the investments made) o VC market is competitive (VC pays for shares that are worth $600K).

Asset Values:

Entrepreneur states at time zero that he will undertake the expansion no matter which state occurs. (so he will do the investment no matter what)

Value of the venture at time 0 for entrepreneur (he takes average): V = ($300 + $100)/2 + ($80 + $20)/2 = $250

Total value, V = V+E =250+600 = $850

EXAMPLE

In State 1:

300 + 80 + 600 = 980

In State 2:

100 + 20 + 600 = 720

Note that shares are correctly priced:

TYPO in slides, 280 -> = 288 Example 1. Entrepreneur is better off not raising capital (E = 0) in the good state (1):

Ve(1) = a(1) = $300

2. But VC recognizes that: If they are looking for investors at time 0, then they know State 2 will occur.

3. VC will not invest $600 to get only $508 VC will demand a bigger share in exchange for $600, at least 83.33%.

4. There will be only $720*(0.167) = $120 remaining to entrepreneur. Entrepreneur is worse off than if committed to raise equity no matter what.

Since his assets in state 1 is 300, he will never invest in state 1 Now he will only invest in state 2. So if the investor knows this, he assumes the venture is in state 2. So VC will give less money In the end, the entrepreneur will lose. Next lecture 6 this will be explained further, and possibilities on how to overcome this problem are presented.

Lecture 6 Deal structure II and Exit Strategy

Review Information asymmetry - Before the agreement: each party is unsure about what the other knows

o Is the venture a cherry or a lemon? - After the agreement: each party is unsure about what the other is actually doing. o How much effort is applied to the project? o How to evaluate performance? o How can every party still do their best after the agreement?

Review Adverse selection - Entrepreneurs compete for funds by the same investor and they are both presenting optimistic

projections about their own project and omitting negative information. o Investors react by offering high hurdle rates (entrepreneurs project such a good projections,

investors think and know they are hiding something -> react with high hurdle rate) High hurdle rates are for example high proportion of the shares, very low price for

shares, etc. o Problem of high hurdle rates: Good ventures tend to be undervalued and not pursued.

The existence of lemons drive cherries out of the market. - Why an investor is interested in the venture? o Investors may only seek for competitive threats. o Well-intentioned investors are beaten by too good to be true offers.

Adverse Selection; so what happens? - Investors are concerned entrepreneurs will mislead them into overvaluation

o They compensate that behavior by discounting the estimated value. Consequence is that good projects are undervalued and bad projects on average will be overvalued. How to avoid this? See below - We need to find ways of overcoming this concern:

1. Option for investor: do stage investment. Staging investments with abandonment option. Idea is: you define some goals/targets over time or some milestone for the

projects and you just give the project of the entrepreneur a part of the investment and when they reach the target, you give the second or third part

2. Entrepreneurs return is high only if venture is successful To avoid negative NPV offers. Example: if the venture is successful and suppose the entrepreneur as X% of the

shares, the entrepreneur can keep that percentage of the shares. If the venture is not successful, the investor receives a percentage of the X% of the entrepreneurs share, so the investors get a higher control of the venture

3. Contracts that work as a revelation mechanism Revelation mechanism; the idea that as investor you know that there are two types

of projects, so what you can do is provide two different deals and contracts in such a way that bad projects will choice one type of project and good projects will choice another type of contract. They dont choice the same project.

For example: you offer contract in which entrepreneur lose part of the shares if hes not successful and a contract in which regardless the state, you always get X% of the equity. So what happens in the end if the project fails, the entrepreneur has to quit the project and you as investor receives alpha times the assets (minus liabilities!) of the company. So alpha is what is going to the investor. So in the second contract, if it fails, all the assets will go to the investor. In summary, if the entrepreneur is sure about the project to be successful, he will choice the second

contract and if the entrepreneur is not sure about the contract, he will choice contract 1 (NOT SURE, A LITTLE VAGUE)

Example Adverse selection

What was the example of lecture 5?

As entrepreneur you need 600.000 dollar to make investment If the entrepreneur makes the investment, he can grow either 80 or 20 million. If he doesnt do the

investment, the assets wil keep the way there are (300 or 100). The point is: the investor doesnt know in which state (1 or 2) we are, so the investor doesnt know if the firm will grow with 80 or 20 million, but the entrepreneur knows (for example the entrepreneur knows the real value of the assets, the investor not)

So what happens? If the entrepreneur is real in state 1, they dont need the investment. In the entrepreneur is real in state 2, they need the investment. So the investor knows that when the entrepreneur needs investment, the entrepreneur is in state 2 So everybody loses in this case. So instead that the entreprene