Entrepreneurial Finance And Venture Capital

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Entrepreneurial FinanceAnd Venture Capital

• Professor XXXXX
• Course Name / Number

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Entrepreneurial Finance

• Need to fund rapid growth externally
• Mostly intangible assets Little ability to
  borrow
• Extremely high risk, potentially high return
  companies
• Must attract top people with minimum cash outlay

Challenges
Entrepreneurial growth companies very reliant on
equity finance
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Sources Of Start-Up Capital For A Sample Of 132
Small Companies
Source Richard B. Carter and Howard E. Van
Auken, Personal Equity Investment and Small
Business Financial Difficulties,
Entrepreneurship Theory and Practice 15 (Winter
1990), pp. 51-60.
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Global Venture Capital Investment and Fund
Raising, 1995-2001
Bn
Source 3i/PriceWaterhouseCoopers in Global
Private Equity 2002 A Review of the Global
Private Equity and Venture Capital Markets
www.pwcmoneytree.com
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Impact of Three Decades of U.S. Venture Capital
Funding
Represents 13.1 (sales) and 5.9 (employment)
of 2000 U.S. national totals Source Jeanne
Metzger and Channa Brooks, Three Decades of
Venture Capital Investment Yields 7.6 Million
Jobs and 1.3 Trillion in Revenue, National
Venture Capital Association (October 22, 2002).
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U.S. Venture Capital Techniques and Practices
Institutional venture capitalists vs. angel
capitalists SBICs, financial and corporate
venture capital, venture capital limited
partnerships
Total venture capital funding and investment has
surged since 1993

• Annual fund-raising 2-4 billion, 1980-1993
• Raised 59.2 billion in 1999, 104.6 billion in
  2000, 40.6 billion in 2001
• Fund-raising and investment highly correlated

Sources Data for 1980-1999, Venture Capital
Journal, various issues Data for
2000-2001, PriceWaterhouseCoopers and National
Venture Capital Association (www.nvca.com).
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U.S. Venture Capital Sources Of Capital
Originally, most funding from wealthy
individuals During 1960s 70s, financial
institutions very important
Since 1978, pension funds have become predominant.
University and other foundations/endowments also
important
U.S. and foreign corporate participation highly
variable
Federal and state governments play small role in
venture capital industry.
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How Investments Are Structured
Venture capitalists typically make early and
expansion stage investments.

• The earlier the stage of investment, the more
  onerous the venture capitalists terms will be
  (price, control surrendered)

Venture capitalists almost always invest using
convertible preferred stock.
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Typical VC Investment Contract Covenants
Ownership right agreements set voting rights,
board seats
Ratchet provisions protect the venture
capitalist in the event of new equity sales
Demand registration rights, participation rights,
repurchase rights exit strategies for venture
capitalist
Stock option plans designed to attract and
motivate key managers
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Geographic and Industrial Investment Patterns
Venture capital investments are highly
concentrated geographically.

• California usually receives over half US total VC
  investment. Silicon Valley attracts 25-50 of
  total.
• New England, NYC, Washington DC also major
  recipients

Investments predominant in high-technology
industries Specific target industries change
over time.
Are venture capital investments profitable though?
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Average Annual Rate of Return to Investors in U.S
VC Funds

Source Data from Venture Economics as reported
in Paul Gompers and Josh Lerner, The Venture
Capital Revolution, Journal of Economic
Perspectives 15 (Spring 2001), pp. 145-168, fig.2

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The Pricing Of Venture Capital Investments

• Based on companys development stage, expected
  future firm value and entrepreneur prestige
• Earlier the development stage, higher the return
  demanded
• Expected future market value based on firms
  expected earnings (NI) and likely P/E ratio at
  exit date (IPO or merger).
• Algebraically Exp MV Exp(NI) x P/E
• Venture capital pricing inputs Required return
  (r), years to exit via merger or IPO (n), and
  initial investment amount (A)
• Looking for expected firm value in n years (FV)
• From this determine fraction of equity (Equity)
  VC receives

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The Pricing Of VC Investments

• Step 1 compute value of VC stake at exit date

FV A (1r)n 5,000,000 x (1.50) 5
38,000,000

• Step 2 compute expected firm market value at
  exit date
• Based on Exp(NI) and expected P/E ratio

Expected MV Exp(NI) x P/E 4,000,000 x 20
80,000,000

• Step 3compute fraction of firms equity VC will
  take today

Equity FV Exp MV 38,000,000 80,000,000
0.475
So venture capitalist invests 5 million,
receives 47.5 of firm. Very expensive financing!!
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Venture Capital Exit Strategies
Preferred exit vehicles IPO, followed by mergers

• On average, IPOs return about 4 times initial VC
  investment
• Mergers less than half as profitable

Third exit forced sale (redemption) to
entrepreneur
Venture capitalists do not sell many shares at
IPO Hold for 1-2 years after IPO, then distribute
shares to limited partners
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Nations Legal Systems the Size of its Venture
Capital Industry?
Sources Venture capital investment,
PriceWaterhouseCoopers GDP data, World Bank
Group Family of legal origin data, Rafael
LaPorta, Florencio López-de-Silanes, Andrei
Shleifer and Robert Vishny, Law and Finance,
Journal of Political Economy 106 (1998), pp.
1113-1150.
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European Venture Capital

• European venture capital (EVC) comparable to U.S.
  in size
• U.S. outpaced 1995-2000, but again comparable
  amounts
• 25.1 billion invested 1999 34.9 billion in
  10,440 firms in 2000 declined to 14.9 billion
  thru 3Q2002, but less decline than US
• Fund-raising grew from 5 billion in 1995 to 48
  billion in 2000 declined to 11 billion thru 3Q
  2002.
• Investment concentrated geographically and
  industrially
• Over half of European total invested in UK many
  years.
• France second, Germany third, Italy fourth
• Small nations do better as of GDP.
• EVC still series of national markets, separate
  legal systems
• Technology accounts for increasing fraction of
  EVC
• 28 of 1998s total investment now over half
• New investments targeted at internet shifting to
  start-up

Sources PriceWaterhouseCoopers and European
Private Equity and Venture Capital Association
(www.evca.com).
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European Private Equity Investment 1989-2002
Bn
Source Data from PricewaterhouseCoopers and
European Private Equity and Venture Capital
Association, 2nd Highest Year for the European
Private Equity Industry, European Private Equity
Venture Capital Association website
(www.evca.com).
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European High-Tech PE Investment by Industry
Source PriceWaterhouseCoopers, Money for Growth
The European Technology Investment Report 2001
(www.pwcmoneytree.com).
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European Venture Capital Differences With U.S.
Until recently, little of EVC was true venture
capital

• 45 of private equity still in buyout funds
• True European venture capital at most 1/3 U.S.
  industry size

European difficulties in promoting high-tech
sector

• Lack of European Silicon Valley a severe
  handicap
• Little tradition of technology transfer from
  universities

Much different sources of capital for EVC
EVC funds set up as investment companies, not
limited partnerships
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European Private Equity Raised by Type of
Investor, Year 2000
5.6
7.4
24.2
10.9
4.2
21.7
11.4
Source PricewaterhouseCoopers and European
Private Equity and Venture Capital Association as
reported in Simon Targett, Institutional
Investment Should Do More, Financial Times
(June 14, 2001), European Private Equity Survey,
p. 5
12.9
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Returns to Categories of European Private Equity
Investment
Source Pricewaterhouse-Coopers and European
Private Equity and Venture Capital Association,
Pan-European Survey of Performance From
Inception to 31 December 2000 (http//www.evca.co
m)
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Key Difficulties Facing EVC
Core problem Inability to develop viable IPO
market

• Several entrepreneurial growth company markets
  developed by European exchanges in late 1990s
• Germanys Neuer Markt developed rapidly 1997-Mar
  2000
• Has fallen by 95 from peak many scandals
• Announced plans to close Neuer Markt, September
  2002
• Some European EGCs can go public via NASDAQ
• Must solve this for VC industry to thrive!

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Asian Venture Capital Practices and Overview

• Classic VC had little role in Asia until
  recently
• Rapid growth fueled by other sources (families,
  groups).
• Total VC pool about 110bn in 2001 vs 16bn in
  1990
• Technology accounts for 5.2bn, or 44 of 2001
  total.
• Largest VC pool in Japan very conservatively
  managed
• Controlled by banks, brokerages as source of loan
  business
• China accounts for two-thirds of developing Asia
  VC.
• Attractive growth market, but risky, key sectors
  regulated
• Hong Kong, Singapore play key coordinating roles
  in VC.
• Two-thirds of VC raised locally, most of the rest
  comes from or through Singapore, Hong Kong.
• All governments trying to Develop VC varying
  success.
• Corporations govt, not VC partnerships, are
  key VC actors
• India has had some success 700mn in 1999,
  mostly tech.

Source World Bank Group (www.worldbank.org)
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VC Investments in Developing Countries

• VC investment in developing nations has been
  small.
• Much of what is called venture capital is really
  subordinated debt financing.
• Lack of financial and legal infrastructure makes
  VC investing in developing very risky.

Chart 1. Venture Capital Stock
mm
8,000
Central E.Europe Developing Asia
7,000
6,000
5,000
4,000
3,000
2,000
1,000
Source Anthony Aylward, Trends in Venture
Capital Finance in Developing Countries, IFC
Discussion Paper no. 36, World Bank (Washington
D.C., July 1998)
0
1992
1993
1995
1990
1991
1994
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VC Investments in Developing Countries
Source Anthony Aylward, Trends in Venture
Capital Finance in Developing Countries, IFC
Discussion Paper no. 36, World Bank (Washington
D.C., July 1998)
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Key Requirements For A Strong Venture Capital
Industry
What economic, cultural and legal features will
promote a strong venture capital industry?

• A tradition of entrepreneurship and risk-taking
• A well-established legal system, with good
  investor protection
• A supportive, but non-interventionist, government
• A stable regulatory system that doesnt penalize
  start-ups
• A free (and mobile) labor market, rich in
  engineering talent
• A non-punitive taxation regime that allows use of
  stock options
• A strong RD culture, especially in universities
  or national labs
• A vibrant IPO market, but could be a result, not
  a prerequisite
• Funded pension system (independent funds) very
  helpful

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Entrepreneurial FinanceAnd Venture Capital
EGCs have large external funding needs. Venture
capitalists provide risk capital as well as
managerial oversight. U.S. venture capital
highly concentrated geographically and
industrially. U.S. and European venture capital
increased dramatically last decade.