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

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PREFACE

HISTORY ABOUNDS WITH examples of extraordinary entrepreneurs whose new ideas and products have changed the world. Many people are enamored with the idea of creating new products and starting businesses. Accompanying the interest in venture creation, there is broad interest in venture capital, investment banking, and careers related to new venture financing, deal structuring, and harvesting.

Our primary motivation for writing this book is to empower students and practitioners to be more successful in developing and financing their ideas. Our overriding orientation is to apply the theory and methods of finance and economics to the rapidly evolving field of entrepreneurial finance.

This book is unique in several ways. First, it builds on and significantly extends the tools and methods of corporate finance and financial economics to approach the difficult and important financial problems associated with starting and growing new ventures. Building on the foundations of financial economics makes the lessons more general and memorable and the applications easier to implement in varied settings. Mastery of the framework facilitates clearer and more defensible evaluation of opportunities and choices than is possible based on heuristics and intuition. With reliable and rigorous tools, you can be more confident that the decisions you make will be the right ones.

Second, while many books address aspects of entrepreneurship (writing business plans, leading and managing new ventures, etc.), this book has a unique and direct focus on the question of how new venture financing choices can add value and turn marginal opportunities into valuable ones. We emphasize value creation as the objective of each financial choice that an entrepreneur or investor makes—including recent developments in new venture contracting, staging, deal structuring, real options, risk, diversification, and exit. Understanding the effects of each choice has the potential to add tremendous value to ideas and innovations.

Third, in contrast to other books on entrepreneurial finance, we specifically address the influences of risk and uncertainty on new venture success, with particular attention to risky ventures with significant upside potential. We use discrete scenario and simulation analysis throughout the book to evaluate alternative strategies, assess financial needs, assess risk and expected cash flows as elements of valuation, and compare different deal structures and contract terms.

Fourth, because both valuation and assessment of cash needs depend on projections of cash flow, we devote significant attention to methods of forecasting the pro forma financial statements of new ventures in an integrated fashion. Integrated financial modeling enables the entrepreneur or investor to use financial forecasting to conduct scenario analysis and to simulate such things as how growth rates that are faster or slower than expected affect cash needs.

Fifth, we provide a comprehensive survey of approaches to new venture valuation with an emphasis on applications. Our approach to valuation is more comprehensive than most because we approach valuation from a contracting perspective that is affected by the different assessments of the entrepreneur and the investor. We recognize that the entrepreneur’s unique circumstances can lead to value conclusions that are different from those of a well-diversified investor.

WHY STUDY ENTREPRENEURIAL FINANCE?

Whether you see yourself as an entrepreneur, a corporate financial manager dealing with new projects, an asset manager, an investor, or a social entrepreneur, a solid understanding of entrepreneurial finance can help you make better decisions. Couple this with the estimate that over 50% of new businesses fail within a few years, and the value of understanding new venture finance becomes clear. Perhaps more telling is that even if a business survives, the entrepreneur may not. In a majority of venture capital-backed start-ups, non-founders are appointed CEO within a few years of the start of operation.

How can the hazards and pitfalls of forming new ventures be avoided or mitigated? The answer is to understand the financial economic foundations and use the best available decision-making tools and methods. A new venture should not be undertaken unless the expected reward is high enough to compensate for the value of forgone opportunities. Investing personal resources and time in a venture that should never have been pursued is just as serious an error as failing to invest in a good venture. Throughout the book, we reiterate and demonstrate through examples that this trade-off of risk and return is not easy to assess intuitively. Rather, this is an area where analytical rigor can add considerable value.

Even the best initial projections, however, can prove to be overly optimistic as the future unfolds. It is important to base the decision to continue or abandon a venture on the same kind of rigorous analysis that was used in making the original decision. It is all too easy to continue investing time and resources in a venture that is destined for mediocre long-run performance or to give up on a venture that has experienced a temporary setback but still offers the potential for substantial gain.

It is a rare individual who is good at both recognizing an opportunity and managing the venture to capitalize on that opportunity. Careful design of the organization at the outset helps ensure that a venture does not fail just because the visionary was not well suited to manage the day-to-day operations. Careful design also can help ensure that the entrepreneur does not lose control of the venture unnecessarily.

WHAT’S NEW ABOUT THIS BOOK?

This book builds on our previous books, Entrepreneurial Finance (2000, 2004) and Entrepreneurial Finance: Strategy, Valuation and Deal Structure (2011). Like the earlier books, it ties the applications to the underlying disciplines of finance and economics and makes clear in what ways the study of entrepreneurial finance is distinct from corporate finance. In contrast to other books, this book focuses less on small business entrepreneurship and focuses more on issues facing high-risk ventures that have significant growth potential and are candidates for external equity capital such as angel and venture capital investing. We emphasize key considerations such as new developments in financial contracting and negotiation, hypothesis-driven entrepreneurship, adding value through deal structuring and staging of investment, the choice and timing of financing, and valuation of risky ventures, including valuation of real options.

Coming on the heels of the JOBS Act of 2012, there have been a number of innovations in the ways new ventures are financed and the contract terms that are used. Worldwide, there has been considerable growth in both angel and venture capital investing. There is more variety in the sources of financing available to entrepreneurs, ranging, as examples, from crowdfunding, to initial coin offerings (ICOs), to mini-IPOs. Technological changes have resulted in reduced costs of experimenting with new venture ideas, leading to an explosion of start-ups seeking early-stage funding. The result has been an increase in the prevalence of early-stage “nonpriced” financing in the form of sophisticated convertible notes and an increase in the number of funding rounds.

We emphasize the usefulness of hypothesis-driven entrepreneurship by tying it to an intuitive discussion, using decision trees, of how real options can be created and exploited. The chapter on venture deals (Chapter 4) reflects the centrality of understanding how financial contacts can mitigate information costs and align incentives of the entrepreneur and investor. We examine venture contracting terms in detail (such as liquidation preferences, conversion rights, and antidilution terms) and analyze the terms of new-style convertible notes that now are commonly used by angels and some VCs in early stages. We reflect uncertainty of the real option values by combining decision trees and simulation (Chapter 5). The analysis is step-by-step in the context of specific examples. We devote significant attention to financial forecasting and the construction of integrated pro forma financial statements, as both are key to valuation, contracting, and assessment of cash needs.

We break new ground in several areas by presenting material and analytical approaches that extend the frontier of academic research related to entrepreneurial finance. The book focuses on U.S. institutions but also provides international perspective by illustrating, throughout, the many similarities and the differences in analysis for U.S. ventures versus international ventures.

The book concludes with a summary of major themes and a discussion of international differences in institutions and public policies aimed at encouraging innovation and entrepreneurship. We also identify open questions regarding the future of entrepreneurial finance. A number of technological changes have the potential to dramatically change the landscape for finance, including, as examples, blockchain and cryptocurrency, crowdfunding, artificial intelligence and machine learning, and internet connectivity (IoT).

INTENDED AUDIENCE

This book can be used as a text in an advanced finance or entrepreneurship course and by scholars who are interested in research related to entrepreneurial finance. However, its intended audience is broader. The book is appropriate for students, entrepreneurs, practitioners involved with new ventures, and corporate financial managers looking for ways to encourage corporate venturing. We have designed the book for readers who are familiar with the basic concepts and tools of corporate finance, accounting, economics, and statistics, and who seek a rigorous and systematic approach to adding value to new ventures through financing and deal structuring. On the companion website, we provide brief reviews for those who feel the need for a refresher on some key background concepts.

The book is appropriate for graduate students, advanced undergraduates in business and economics, and executive MBA students. In our own teaching, we use the book and related materials with students at all levels. Because entrepreneurial finance builds on and integrates all areas of management, a course developed around the book can serve as a capstone integrative experience to the MBA or an undergraduate business degree.

The book can be used effectively in an entrepreneurial finance course or in a course on venture capital and private equity. It is designed to be used either as a stand-alone resource or in conjunction with cases or a business planning exercise. Each chapter includes end-of-chapter review questions. The book’s website has end-of-chapter problems that are designed to give hands-on opportunities to apply the lessons of each chapter.

The book can be used in a variety of different course formats:

Some users like our use of simulation throughout the book. For those, we rely on readily available software (@RISK) and also provide files on the website that contain examples and problem solutions that are prepared using @RISK and also Oracle Crystal Ball, another popular software package.

For those who are oriented to case method teaching, we have provided a series of our own interactive cases that correspond to the book chapters and have developed a list of commercially available cases that work well with the book.

For those who see value in linking the coverage of entrepreneurial finance to a business planning exercise, the organization of the book follows the normal organization of the thought processes and financial contents of a business plan.

A NOTE ABOUT THE WEBSITE AND INTERNET RESOURCES

The book is designed to be used most effectively in conjunction with resources we provide on the book’s website, https://www.sup.org/entrepreneurialfinance. Much of the book relates to software, spreadsheets, templates, simulation applications, and interactive cases and tutorials that are available for download. For those teaching from the book, we also provide PowerPoint presentations by chapter. Instructor-specific resources are password protected. Instructors can gain access to teaching materials that accompany the book by contacting Stanford University Press at info@www.sup.org.

The website contains problems and interactive cases, along with solutions, that complement the book material. All Excel figures in the book, including charts, are available as downloadable files so that the user can review the spreadsheet structure and cell formulas. When we use quantitative examples in discussion, the website normally includes a file that contains the backup spreadsheet analysis.

SIMULATION

Because of the usefulness of simulation to evaluate risk and uncertainty, both prominent features of new venture development, we incorporate it into the book. Many readers will be familiar with commercial simulation packages such as @RISK and Oracle Crystal Ball. We primarily rely on @RISK in the book examples but provide both @RISK and Oracle Crystal Ball versions of the simulation analysis on the book’s website. When an Excel syntax is used in a simulated cell in a spreadsheet, we use the @RISK syntax. If you are a user of another commercial package you can study the parallel syntax by opening and modifying our example files.

SPREADSHEETS AND TEMPLATES

The website contains soft copies of the figures and tables in the book, including several templates that you can use to study your own new venture valuation questions (i.e., you can easily edit the template to study and value your own cash flow projections). We have provided copies of spreadsheets that are imbedded with simulation formulae as well as versions that do not require simulation.