Entrepreneurial Finance
Venture Capital, Deal Structure & Valuation, Second Edition
Janet Kiholm Smith and Richard L. Smith

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Contents and Abstracts
1 Introduction
chapter abstract

The chapter provides an introduction to the book, addressing key questions such as how entrepreneurial finance is different from entrepreneurship and how it is different from corporate finance. The chapter makes the point that since new venture failure rates are high, good decision making is key, that motivations for engaging in entrepreneurship are highly varied and that there are important global differences in motivation. The chapter introduces the important role of staging as the way to manage the entrepreneurial process in a way that creates value-enhancing real options and defines the key stages of new venture development.

2 New Venture Financing: Considerations and Choices
chapter abstract

The chapter reviews the main financing sources available to entrepreneurial ventures. The chapter begins with the sequence of new venture development and relates development stages to financing sources that are likely to be available. It also addresses difference in financing choices of profit-oriented versus not-for-profit ventures and how legal organizational form relates to financing choices. The chapter reviews the regulatory structure that is most relevant to entrepreneurial ventures, with an emphasis on U.S. regulations, and reviews international differences in financing options. It concludes with a recap of financing choices and a discussion of how financial distress affects available financing choices.

3 Venture Capital and Angel Investing
chapter abstract

The chapter provides a comprehensive review of the development and organization of venture capital and angel investing, including development of the institutions, the organizational structures of venture capital firms and angel groups, and the investment returns to investing in venture capital. The chapter includes analysis of the structure of venture capital funds and examines how the structure affects investment selection and the sharing of returns between the general and limited partners of the fund. It also examines how the responsibilities of the general partner evolve over the life of the fund. The chapter explores how venture capital investors can add value to entrepreneurial firms, questions the relative importance of luck and skill in development of the industry, and examines how reputational capital enables venture capital firms to invest without specific commitments to continue funding. The chapter includes an exploration of recent developments in angel financing.

4 Venture Deals
chapter abstract

This chapter examines the contractual relationship between the entrepreneur and the investor and explores how financial contracting can be designed to benefit both parties. Emphasis is on the considerations that bear on the choice of contract terms, namely differences between the entrepreneur and investor in diversification, the information they possess, their expectations, and their incentives. Involving an outside investor can enable the entrepreneur to invest less and increase diversification, lower the required rate of return, increase the present value of the venture, and provide expertise, advice, and information that enhance value. There are also potential problems arising from disagreements over direction, time devoted to maintenance of the relationship, and conflicts of interest, among others. Contracts can be designed to address these concerns. In financial terms, contracts with investors allocate risk, allocate expected returns, and change risk and expected returns.

5 New Venture Strategy and Real Options
chapter abstract

In business settings, the overarching objective is financial return. This chapter establishes the basics of strategic planning in an entrepreneurial setting and develops a framework for evaluating alternative strategies. Almost any strategic plan affords opportunities to change course after the initial direction has been selected. In financial terms, these choices are described as real options. Finance provides a means of valuing real options and taking account of those values in the initial strategic choice. The chapter framework describes real options as decision trees and uses investment valuation to evaluate alternative strategies. The framework begins with identifying the objective and the strategic alternatives for achieving it. The alternatives are structures of real options that can be described and evaluated as the branches of a decision tree.

6 Developing Venture Strategy Using Simulation
chapter abstract

Decision trees are used to identify strategic alternatives and to examine the sensitivity of expected value to discrete changes. To deal with the limitations of decision trees, this chapter introduces simulation and demonstrates its use to evaluate strategic choices that include real options. Simulation can take into consideration uncertainty about the environment, the venture itself, and possibly the reactions of rivals. The normal way to represent uncertainty in a simulation model is to describe each element of uncertainty as a statistical distribution. Simulating the future of a venture begins with building a spreadsheet model, identifying the key decision variables, and introducing mathematical expressions that describe important uncertainties that bear on value, cash needs, or other important factors. The trial data can be analyzed for the purpose of refining key decisions such as how much cash to invest at the outset or to estimate the value of a particular real option.

7 Revenue Forecasting
chapter abstract

Financial forecasting is a critical element of new venture planning. The chapter begins with a discussion of the uses of financial forecasting and introduces the basics of financial forecasting, beginning with forecasting revenue. Revenue forecasting is important because revenue is a key driver of value and for determining how much to invest in the inputs that are essential for responding to demand. The revenue forecast is developed by specifying the assumptions that drive revenue and revenue growth. The chapter presents a variety of forecasting techniques and reviews information sources that can serve as a foundation for key assumptions. The forecasting methods are used to design and construct forward-looking pro forma financial statements that enable forecasting of venture performance in an integrated way.

8 Financial Modeling
chapter abstract

The chapter illustrates how to build and integrate financial statements into a model for cash needs assessment and valuation. Income statement and balance sheet are integrated to develop the pro forma statement of cash flows. For estimating income statement and balance sheet relationships of a company with no operating history, it is useful to rely on data from comparable companies. There are two elements of forecasting: the first is developing the assumptions that drive the model; the second is building and integrating the financial statements. If the statements are properly integrated, the full impact of changing any assumption will be reflected consistently in all statements and all forecast periods. The chapter begins with a review of the three main financial statements and how they are linked. With this background, the chapter develops statement integration. The chapter describes standard sources of information and demonstrates their use for developing assumptions.

9 Assessing Cash Needs
chapter abstract

An entrepreneur must have a sense of the cash required to carry the venture to the point where it becomes self-sustaining or capable of attracting additional funding. The chapter focuses on methods of assessing financial needs. As a general principle, an entrepreneur can benefit by raising only enough cash to carry the venture to the next milestone. At that point, the lower risk of failure should enable the entrepreneur to raise capital on more favorable terms. Combining cash flow breakeven analysis with projections of sales growth can help the entrepreneur assess the investment that would enable a venture to achieve revenue sufficient to maintain operations. The sustainable growth model seeks to identify the conditions under which growth can be sustained solely by the initial investment. The model is helpful for estimating the financing needs of early-stage ventures. Scenario analysis and simulation focus on how uncertainty affects financing need.

10 Foundations of New Venture Valuation
chapter abstract

How do VCs and other investors select the projects in which they invest? And how do they settle on the ownership stakes, terms, and conditions they require in exchange for investing? This chapter introduces the foundations of valuation and presents the most widely used valuation methodologies, identifying the pros and cons of each. An important lesson is that if the assumptions are all consistent, then, in a perfect world, every valuation method will produce the same estimate of value. Of course, in reality they do not. The data and assumptions in each valuation effort are estimates of the "true" underlying values. Differences in estimated value across methods therefore reflect the effects of estimation errors. The art of valuation is in deciding how to weight the information from each approach and use it to reach a conclusion about value.

11 New Venture Valuation in Practice
chapter abstract

This chapter, after presenting a framework for selecting a valuation method, addresses use of the continuing value approach for making the valuing of going concerns tractable. The chapter then addresses the challenges of making the assumptions needed for applying any CAPM-based approach to DCF valuation. The last part of the chapter uses a single example to illustrate all of the valuation approaches and to highlight the advantages and disadvantages of each. The chapter can serve as a handbook for generating the information that is required to implement each valuation approach and illustrates how the approaches are related. It can aid in selecting the approaches that will be most useful for addressing a particular valuation problem. The appendix illustrates how the value of the entrepreneur's claim depends on how much of the entrepreneur's wealth is committed to the venture and uses simulation to show the impact of underdiversification on value.

12 Designing and Valuing Staged Investment with Real Options
chapter abstract

Staging investment in new ventures can enhance value by enabling the parties to test hypotheses, reduce uncertainty, and generally exploit the structure of the real options that comprise the venture. Because the effects are complex, comparing deal structures can be challenging. This chapter uses the valuation methodology developed in earlier chapters to examine how staged investment can enhance value. The chapter is focused on designing staged investment structures that deal with these complex yet common issues. Among other considerations, staging has great potential to help mitigate the full range of information and incentive concerns. A well-planned staging strategy can create tremendous value, especially for venture opportunities that succeed, and can help the entrepreneur realize a larger share of the value.

13 Harvesting
chapter abstract

Harvesting is a critical component of initial investment decisions. Investors evaluate opportunities based on the expectation of a liquidity event that will enable them to realize a return and shift attention to other projects. To estimate exit value, investors must make assumptions about how and when the investment will be harvested and the return they will realize. This chapter examines important harvesting alternatives. Much of the chapter concerns the factors that bear on the decision of how and when to harvest. Going public and private sale of the venture to another firm (i.e., acquisition) are the harvesting alternatives that normally receive the most attention in business plans. Other important alternatives include a management buyout (MBO), sale of the business to employees or other members of the team, and continuing to operate the venture. Having surveyed the alternatives, the chapter concludes by examining the factors that affect the harvesting choice.

14 The Future of Entrepreneurial Finance
chapter abstract

This final chapter covers several forward-looking topics related to entrepreneurial finance. It begins by highlighting essential concepts and tools that have emerged from the study of entrepreneurial finance. It then reviews public policy in an international context and how policy relates to entrepreneurial activity. The chapter concludes by identifying areas of research that address important unanswered questions in the field and where research has the potential to offer significant insights as to how new venture finance will evolve.