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

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CHAPTER ONE

INTRODUCTION

THOUSANDS OF BUSINESS ventures are started every year. Many fail within a short period. Of those that survive, most achieve only meager success, some achieve rates of return high enough to justify the initial investment, and a few achieve phenomenal success. What distinguishes the successes from the failures? There is no single answer. A new venture based on a good idea can fail because of poor implementation or bad luck. One that is based on a bad idea can fail despite excellent implementation. Many that survive but do not thrive should never have been undertaken. Sometimes, even when a venture is hugely successful, early financing mistakes limit the entrepreneur’s ability to share in the rewards.

This is a book on financial decision making for new ventures. It provides the fundamentals for thinking analytically about whether a new venture opportunity is worth pursuing and about how to apply the tools of financial economic theory to enhance the expected value of the undertaking. Although our focus is on for-profit ventures, not-for-profit entrepreneurial ventures face similar challenges. Where there are important differences, we discuss the application of these tools to not-for-profit venturing.

1.1   WHAT MAKES ENTREPRENEURIAL FINANCE DIFFERENT FROM CORPORATE FINANCE?

The guiding principles of financial decision making—in both large, established companies and start-ups—can be stated succinctly:

• More of a good is preferred to less.
• Present wealth is preferred to future wealth.
• Safe assets are preferred to risky assets.

These principles drive choices of resource allocation, including investment decisions and financing decisions. Investment decisions concern the acquisition of assets, which can be tangible, like a machine; intangible, like a patent; or simply an option to take some action in the future. The worth, or value, of an investment depends on its ability to generate cash flows for investors in the future and on the riskiness of those cash flows. Financing decisions concern the choice of financing (debt, equity, or some hybrid such as preferred stock), how much financing should come from investors, and how financial contracts should be structured.

The range of decisions that can be approached using the finance paradigm is much broader than may be apparent at first glance. Financial considerations are applicable, for example, to the choice of organizational form (e.g., sole proprietorship, partnership, or corporation) and to the design of financial contracts to align the incentives of investors and entrepreneurs. Similarly, issues such as the choices of scale and scope of a venture can be analyzed as financial investment decisions (i.e., larger scale requires more outside financing).

If the financial theories and decisions facing all ventures are similar, it is natural to wonder why entrepreneurial finance is worthy of special study—why aren’t the principles of corporate finance directly applicable in an entrepreneurial setting? After all, a basic course in corporate finance concerns investment and financing decisions of large public corporations and generally introduces valuation techniques such as discounted cash flow and cost of capital analysis. The limitation, however, is that corporate finance theory assumes away a number of issues that are of secondary importance in a large corporate setting but are critical to decision making for new ventures. These distinctions make entrepreneurial finance an intellectually challenging area worthy of special study. The focus on entrepreneurship and early-stage ventures dramatically changes the way the finance paradigm is applied.

Moreover, certain techniques of entrepreneurial finance (such as thinking about investment opportunities as portfolios of real options), while they are particularly useful in a new venture setting, are also useful in the context of a large public corporation. They normally, however, do not receive much attention in corporate finance courses.

We highlight 8 important differences:

1. The inseparability of new venture investment decisions from financing decisions
2. The role of necessary underdiversification as a determinant of investment value
3. The extent of managerial involvement by investors in new ventures
4. The effects of substantial information problems on the firm’s ability to undertake a project
5. The role of contracting to resolve incentive and information problems in entrepreneurial ventures
6. The critical importance of real options in determining project value
7. The importance of harvesting (exit) as an aspect of new venture valuation and the investment decision
8. The distinction between maximizing value for the entrepreneur and maximizing shareholder value

Interdependence Between Investment and Financing Decisions

In corporate finance, investment decisions and financing decisions are treated as independent of each other. The manager selects investments by comparing return on investment to the market interest rate for projects of equivalent risk. The manager typically does not need to convince investors of the merits of the investment and does not need to consider simultaneously how ownership of the assets will be financed or whether the firm’s shareholders prefer high-dividend payouts or capital gains.

For start-up businesses, however, the interdependencies between investment and financing decisions are much more complex and important. Among other things, the entrepreneur will not be able to pursue the venture without convincing an investor of the merits and will probably place a very different value on the new venture than will well-diversified investors. These differences are important because the entrepreneur cannot normally sell shares of a private venture to generate funds for current consumption (analogous to receiving a dividend). Therefore, simple adjustments to net present value (NPV) cannot be used to address the divergence of valuations between the entrepreneur and the investor.

More generally, some investment choices are contingent on certain financing choices. For example, rapid growth may be possible only with substantial outside financing, whereas a large corporation may be able to finance the entire project with internally generated funds. The link between investment choices and financing choices creates complexity that does not arise in corporate finance.

Diversifiable Risk and Investment Value

In corporate finance, the NPV of an investment (project) is determined by applying a discount factor to expected future cash flows.1 Corporate finance proposes that the discount factor depends only on nondiversifiable risk. But this proposition relies on the assumption that investors can diversify at low cost. Although the assumption holds for many investors in a new venture (e.g., the investors who participate in venture capital [VC] funds, wealthy angel investors, or shareholders of large lenders), it categorically does not hold for the entrepreneur. In fact, the entrepreneur often must invest a large fraction of his or her financial wealth and human capital in the venture. This difference between entrepreneurs and investors in ability to diversify results in the project value for entrepreneurs being different from the project value for investors.

In corporate finance, because only nondiversifiable risk matters, the values of different financial claims are additive. At the firm level, value additivity implies that allocation of financial claims among different kinds of investors such as owners and managers does not affect the decision to accept a project. New ventures can also be considered “projects.” But for new ventures, because entrepreneurs and investors view risk differently, each ascribes a different value to the same risky asset. As a result, value additivity does not hold and the allocation of financial claims becomes important.

Managerial Involvement of Investors

In public corporations, investors (stockholders and creditors) generally are passive and do not contribute managerial services. Nor do they normally have access to significant inside information. In contrast, some investors in new ventures (e.g., venture capitalists [VCs] and angel investors) frequently provide managerial and other services that can contribute to the venture’s success. Typically, these investors will have access to inside information that they gain as a result of their continuing investment in the venture and will be involved in important decisions about the venture.

Information Problems and Contract Design

Separate from differences in valuation that arise from underdiversification (differences even when the entrepreneur and investors agree about the expected future cash flows and know that they agree), differences in value can arise because of information problems between the parties. Although information gaps also exist between insiders and outsiders of public corporations, the gaps need not materially affect the investment decisions of public corporation managers. Public corporations generally can, and often do, make investment decisions without much immediate regard to the question of how investors perceive the value of the investment.

Generally, corporate managers need not convince investors, lenders, or employees that a project is worth undertaking, at least in the short run. The situation is very different in the case of a start-up business that requires outside financing. In the latter case, investors look specifically to the venture to provide a return on their investments. Moreover, there is often no easy way for the entrepreneur to communicate her true beliefs about the potential for success of a new venture. From a financial perspective, this places considerable emphasis on finding ways to signal the entrepreneur’s confidence in the venture.

Incentive Alignment and Contract Design

Incentive contracting clearly plays a role in the large public corporation. On the positive side, managerial stock options and performance bonuses are intended to align the interests of managers and investors. On the negative side, debt covenants and similar provisions are designed to discourage reliance on risky debt financing that can lead to inefficient investment decisions and other agency costs associated with heavy reliance on debt. The issues are similar for start-up businesses, but reliance on incentive contracts is, in some respects, more compelling. In contrast to the managers of public corporations, investors generally keep the entrepreneur on a short leash.

There are compelling reasons to find ways to invest in the projects of unproven entrepreneurs. An investor who is good at identifying untested entrepreneurs who are likely to succeed can profitably participate in new ventures that would have been rejected by a less astute investor. The result is that investors use a variety of contractual devices to supplement their ability to identify and motivate high-quality entrepreneurs.

The Importance of Real Options

Students and practitioners of corporate finance know to value projects by discounting expected future cash flows back to NPV. Even in the corporate setting, this approach is oversimplified, except with respect to the most basic independent investment projects. The more difficult valuation challenges are those for projects that include important real options. A real option is the right to undertake certain business initiatives, such as deferring, abandoning, or expanding a capital investment project after the initial investment has been made. In contrast to a financial option, such as a call or put on a share of stock, the underlying asset is tangible and the option reflects a change in how the real asset is used. The reality is that most investing involves a process of acquiring, retaining, exercising, and abandoning real options. Nonetheless, the common practice of ignoring real options in corporate investment decisions suggests that they often are of secondary importance to the decision.

The values of real options associated with an investment depend on the degree of uncertainty surrounding the investment. For projects such as an investment in research and development or an investment in a new industry, uncertainty levels are likely very high. This uncertainty adds to the importance of considering embedded option values. Nowhere is the importance of option values more central to investment decision making than for a start-up business. Staging of capital infusions, abandonment of the project, growth rate acceleration, and a variety of other choices all involve real options and contribute to the need for a process of investment decision making that focuses on recognizing and valuing the real options that are associated with the project.

Harvesting the Investment

In corporate finance, investment opportunities are evaluated based on their capacity to generate free cash flow for the corporation. The investment decision does not depend on when the cash flows are distributed to investors, except that corporations generally will not retain cash that they cannot invest profitably.

In their decisions to invest in the shares of a public corporation with liquid shares, investors normally are not focused on when they will sell or on the anticipated valuation at the time of sale or on the costs associated with selling. Investing in new ventures is different. New venture investments normally are not liquid and often do not generate any significant free cash flow for several years. Most investors in new ventures, and many entrepreneurs, have finite investment horizons. To realize returns on their investments, a public offering of equity or another kind of liquidity event must occur (e.g., an acquisition of the venture for cash or freely tradable shares of the acquirer). Such harvesting opportunities are among the main ways investors in new ventures realize returns on their investments. Because of the importance of liquidity events, they generally are forecasted explicitly. The forecasts are formally factored into valuation of the investment.

Value to the Entrepreneur

The final difference between start-ups and public corporations is the focus on the entrepreneur. In the public corporation, the focus of decision making is on investment returns to shareholders. In a start-up, the true residual claimant is the entrepreneur. In the corporate setting, maximum shareholder value is the most frequently espoused financial objective. In contrast, the objective of the entrepreneur in deciding whether to pursue the venture and how to structure the financing is to maximize the value of the financial claims and other benefits that the entrepreneur is able to retain as the business grows.

It is easy to envision cases in which an objective of maximizing share value would not be in the entrepreneur’s best interest. This is particularly true if the entrepreneur is unable to convince investors of the true value of the project and would therefore have to give up too large a fraction of ownership, or if the entrepreneur values other considerations besides share value.

While the principles in this book are often developed and presented from the perspective of the entrepreneur (by structuring the investor’s claim to have an NPV of zero), they are no less valuable for investors. The analysis can easily be reformulated around the objective of maximizing NPV for an investor, such as a VC or angel investor. With regard to valuation and contracting, because both parties can benefit from knowing how the other views the venture, we study these topics from both perspectives.

1.2   ENTREPRENEURSHIP AND THE ENTREPRENEUR

The term “entrepreneur” is of French origin. Its literal translation is simply “undertaker,” in the sense of one who undertakes to do something. In the early 1700s, the English banker Richard Cantillon coined the use of the word in a managerial context. He emphasized the notion of the entrepreneur as a bearer of risk, particularly with respect to provision of capital. This early usage, however, does not adequately characterize our current understanding of what it means to be an entrepreneur.

In the early 1800s, the French economist J. B. Say described the entrepreneur as a person who seeks to shift economic resources from areas of low productivity to areas of high productivity. Although Say’s notion points us in a useful direction, it is too general. Most purposeful human activity can be described as shifting economic resources to higher-valued uses (or at least attempting to do so).2

The contributions of Cantillon and Say gained renewed attention in the early 1900s through the writings of two other economists. Joseph Schumpeter (1912) viewed the entrepreneur as actively seeking opportunities to innovate. In his view, the entrepreneur is the driver of economic progress, continually seeking to disturb the status quo in a quest for profits from deliberate and risky efforts to combine society’s resources in new and valuable ways. Current use of the term “entrepreneurship” derives from these views and from more recent thinking by management scholars such as Peter Drucker. Drucker, who was a personal friend of Schumpeter, describes entrepreneurs as individuals who “create something new, something different; they change or transmute values.”3

Today, entrepreneurship is most often described as the pursuit of opportunities to combine and redeploy resources, without regard to current ownership or control of the resources. This notion clearly draws on the definition offered by Schumpeter but adds structure by recognizing that the entrepreneur is not constrained by current control of resources.

Thinking of entrepreneurship in this way suggests a multidimensional process. The entrepreneur must:

• Perceive an opportunity to create value by redeploying society’s resources
• Devise a strategy for marshaling control of the necessary resources
• Implement a plan of action to bring about the change
• Harvest the rewards that accrue from the innovation

This definition is broad enough to encompass entrepreneurship that arises in the for-profit sector, including extant corporations, as well as in the not-for-profit sector, including in universities and charitable foundations.

The first step is to “perceive an opportunity to create value.” What are the characteristics of a good entrepreneurial opportunity? In general, the opportunity should:

• Address a need or solve a problem for the customer
• Identify a new product, service, process, or market
• Demonstrate a sustainable competitive advantage
• Offer the potential to be profitable and create value for the parties involved

Our focus in this book is on assessing the last point, but the other factors are integral to the venture’s likelihood of success and to value creation for the entrepreneur.

Survival and Failure Rates of New Businesses

To be successful, an entrepreneur needs to maintain a clear focus on how strategic choices and implementation decisions are likely to affect rewards. While this may increase the likelihood of success, many new ventures do not succeed and all entrepreneurial activity takes place in a dynamic economic environment.

FIGURE 1.1
Survival rates of new ventures
SOURCE: https://www.bls.gov/bdm/entrepreneurship/bdm_chart3.htm.
The figure shows survival rates of new business establishments that were initiated in 1995, 2000, 2005, and 2010.

Figure 1.1 shows the survival rates of new ventures from a U.S. Department of Labor longitudinal study of business ventures that were launched from 1994 through 2016. The figure provides data for ventures started in 1995, 2000, 2005, and 2010. Based on the data, 50% of ventures survive for at least 5 years and about 35% survive for at least 10 years. There is almost no difference in survival rates across the four starting years in spite of the fact that they encompass varied periods of economic growth.

Survival cannot be equated to success, nor does nonsurvival mean failure. In fact, in a Small Business Administration (SBA) study based on data compiled by the Census Bureau, one third of the entrepreneurs of businesses that did not survive reported that they considered the venture a success.4 Among other possibilities of successful closure, nonsurviving businesses may have been established to take advantage of transitory opportunities, may have been closed in one location and reopened in another, or may have been acquired. This would imply a “failure” rate significantly lower than suggested by the nonsurvival data in Figure 1.1.

Although survival rates are consistent over time, the pace of business creation and termination can vary significantly with economic conditions. Figure 1.2 shows data on private sector establishment births and deaths between 2006 and 2017. Over the entire period, there were approximately 9.0 million firm births and 8.5 million deaths, for a net creation of about 500,000 additional establishments. Looking at subperiods reveals a different story. In the two years leading up to the recession of 2008, there was a net increase of approximately 175,000 new businesses. For the following two years, 2008 and 2009, deaths exceeded births by 212,000. As the economy began to pick up steam, births again surpassed deaths. For the last eight quarters of available data, there was a net creation of over 200,000 new establishments.

FIGURE 1.2
Private sector establishment births and deaths
SOURCE: https://www.bls.gov/news.release/cewbd.t08.htm.
The figure shows the number in thousands of births and deaths of establishments between 2006 and 2017.

The dynamism of the new venture landscape is expected. Entrepreneurs constantly come up with new and innovative ideas, but the pursuit and successful execution of the ideas is fraught with uncertainty. In addition, as firms evolve, decisions to merge, sell, or abandon the venture are a normal part of any evolving economy and, in fact, are necessary if assets are going to be consistently put to highest and best use.5

NOTES

1. A “project” is the fundamental building block of corporate finance. In basic courses it is treated a black box where cash flow forecasts are unbiased and the task for the manager is to assess risk and choose the right discount rate when determining net present value. In more advanced courses, projects are analyzed with techniques such as sensitivity analysis, simulation, and other computer-assisted techniques that look more objectively at the uncertainty associated with cash flows. See, for example, Brealey, Myers, and Allen (2017).

2. Kirzner (1979) discusses early views of entrepreneurship.

3. Drucker (1985), p. 20. Bull and Willard (1994) survey definitions of entrepreneurship and conclude that most are permutations of, or derivative of, Schumpeter’s view.

4. See Headd (2003).

5. For insights on returns to entrepreneurship, see Hall and Woodward (2010), who study returns to an important class of entrepreneurs. They find that the typical venture-capital-backed entrepreneur received an average of $5.8 million in exit cash. Almost three quarters of entrepreneurs receive nothing at exit and a few receive over a billion dollars. See also Moskowitz and Vissing-Jorgenson (2002), who find evidence of a “private equity premium puzzle” in that returns to entrepreneurs who invest in their own ventures would have done just as well if they had invested in public equity instead. However, Kartashova (2014) examines a longer time span and finds that the private equity puzzle occurs in only some time periods. All of the authors point out the riskiness of entrepreneurship and the nondiversified position that entrepreneurs face.