Chapter 16

1. Chapter 16The Future of Entrepreneurial Finance: A Global Perspective Material from ENTREPRENEURIAL FINANCE: STRATEGY, VALUATION, AND DEAL STRUCTURE, by Janet Kiholm Smith, Richard L. Smith, and Richard T. Bliss, © by Stanford University, all rights reserved. Instructors may make copies of PowerPoint Presentation contained herein for classroom distribution only. Any further reproduction, distribution, or use of this material, in any way or by any means, is strictly prohibited without the prior written permission of the publisher.

2. Learning Objectives • Review conceptual differences between entrepreneurial and corporate finance • Describe methods for addressing the challenges of entrepreneurial finance • Recognize the potential for new research to address the unresolved issues related to entrepreneurial finance • Understand how international differences contribute to variations in entrepreneurial activity • Understand that change in the market for new venture creation and financing is inevitable • Recognize the implications of change for new venture investors and entrepreneurs

3. Completing the Circle • Then entrepreneur’s investment and financing decisions are interdependent • Investment value depends on the entrepreneur’s ability to diversify • Evaluating the role of active investors • Dealing with information problems • Contracts that align incentives • Evaluating real options and strategic choices • Harvesting the investment • Evaluating opportunities from the entrepreneur’s perspective

4. Completing the Circle • The entrepreneur’s investment and financing decisions are interdependent • underdiversification exposes the entrepreneur to venture-specific risk • entrepreneur’s required rate of return will be higher a diversified investor will place a greater value on the venture • financial contracts that allocate more venture risk to the diversified investor can enhance project value and make all claims worth more

5. Completing the Circle • Investment value depends on the entrepreneur’s ability to diversify • the entrepreneur’s required return depends on the fraction of total wealth committed to the venture • total wealth includes financial and human capital • greater wealth  more ability to diversify • reducing entrepreneur’s investment can enhance value • pursue the venture on a smaller scale • bring in an outside investor • reduce the duration of the commitment

6. Completing the Circle • Evaluating the role of active investors • angel investors and VC firms are often involved in managerial aspects of a venture • active investors expect a return on both financial and human capital investments • the involvement of investors can add value by changing both expected return and risk

7. Completing the Circle • Dealing with information problems • information asymmetry creates a significant barrier to attracting outside investment • entrepreneurs are often overly optimistic about the ventures prospects • ways to overcome information problems • business plan • milestones/staging • reputation • certification • perfomance-based ownership/compensation • signaling

8. Completing the Circle • Contracts that align incentives • entrepreneur must have incentive to exert maximum effort • incentive conflicts among investors • creditor may prefer security over venture value • Evaluating real options and strategic choices • new ventures often represent a portfolio of real options, which may be interdependent • analyze using decision trees, game trees, and simulation

9. Completing the Circle • Harvesting the investment • harvesting alternatives can have a significant impact on venture value • the investment decision is often based on certain assumptions about harvesting • parties to the venture may have different incentives when it comes to harvesting • market conditions may impact harvesting options

10. Breaking New Ground • Extending portfolio theory to consider high-risk investments • Valuing high-risk, long-term investments • Valuing portfolios of complex real options • Assessing the risk characteristics of new venture cash flows • Valuing multiple-period cash flows from an underdiversified entrepreneur’s perspective • Choosing between corporate and private entrepreneurship

11. Breaking New Ground (cont’d.) • Is persistent venture capital firm success due to skill or good luck? • How do financial wealth and the opportunity cost of human capital affect an individual’s decision to undertake a high-risk entrepreneurial venture? • How does the rate of innovation affect the allocation of resources devoted to entrepreneurial activity? • How can entrepreneurial activity be promoted in organizations? • What social and economic institutions foster entrepreneurial activity and can communities develop such institutions?

12. Public Policy and Entrepreneurial Activity • Can innovation and entrepreneurial activity be fostered by public policy? • U.S. and other countries’ success with high-tech, high-growth ventures • Distinction between opportunity-based and necessity-based entrepreneurship • Early-stage entrepreneurial activity by country (Figure 16.1) • agrarian economies have high levels of entrepreneurial activity • industrialize countries with large, established companies have lower entrepreneurial activity

13. Figure 16.1

14. Public Policy and Entrepreneurial Activity • Amount and source of R&D funding (Figure 16.2) • wealthier countries have high levels of R&D, primarily from business expenditures • in countries with relatively low R&D spending, most of the funding is from non-business sources

15. Figure 16.2

16. Public Policy and Entrepreneurial Activity • Categorizing countries by their comparative advantage (Porter 1990) • factor-driven • rely heavily on natural resources • efficiency-driven • small and medium-size manufacturing; productivity focused • innovation-driven • mature economies; shift to service sector • Prevalence of high-growth entrepreneurship (Figure 16.4)

17. Figure 16.4

18. Public Policy and Entrepreneurial Activity: Some Caveats • Fostering entrepreneurial activity means tradeoffs • may conflict with existing social mores • can interfere with labor market dynamics • may divert resources from established businesses • Policymakers must have clear objectives in mind • institutional entrepreneurship or individual initiative • necessity vs. opportunity-driven • innovative vs. replicative entrepreneurship

19. The Role of Institutional Structure in Stimulating Entrepreneurial Activity • An institutional structure likely to stimulate new venture activity does the following: • facilitates assessment of risks and rewards • limits exposure to risk and increases expected rewards • both facilitates and limits risk-taking by the entrepreneur • includes patient investors with minimal need for liquidity • has a tax system which favors capital investment • facilitates diversification and pooling of risk • provides easy access to public capital markets • makes investment decisions that are predominantly market-driven

20. The Role of Institutional Structure in Stimulating Entrepreneurial Activity • Facilitates assessment of risks and rewards • accessible, reliable and low-cost information on market size, characteristics, production and distribution costs, etc. • clustering of new ventures can facilitate information flow • rise of the Internet and other technological advances • Limits exposure to risk and increases expected rewards • establishment and enforcement of property rights (both formally and informally) • protection of intellectual property

21. The Role of Institutional Structure in Stimulating Entrepreneurial Activity • Both facilitates and limits risk-taking by the entrepreneur • bankruptcy laws limit downside risk to the entrepreneur • institutional and societal acceptance of failure • labor force mobility • Includes patient investors with minimal need for liquidity • pension funds, endowments, and other institutions that can invest significant sums in new ventures • preference for equity, precludes most banks • Investors bring technical and managerial expertise • has a tax system which favors capital investment • facilitates diversification and pooling of risk • provides easy access to public capital markets • makes investment decisions that are predominantly market-driven

22. The Role of Institutional Structure in Stimulating Entrepreneurial Activity • Has a tax system which favors capital investment • tax systems based on income (vs. value added) encourage entrepreneurial activity • low capital gains tax rates and the ability to defer/time gains encourages investment in new venture equity • Facilitates diversification and pooling of risk • VC funds and angel groups • syndication of investments

23. The Role of Institutional Structure in Stimulating Entrepreneurial Activity • Provides easy access to well-functioning, public capital markets • allow investors and entrepreneurs to diversify more easily • provide monitoring and a way to incentivize and discipline managers • facilitates exit strategies with lower transaction costs • disclosure requirements and efficient information transmission allow companies to go public sooner

24. The Role of Institutional Structure in Stimulating Entrepreneurial Activity • Makes investment decisions that are predominantly market-driven • subsidized programs can lower the cost of funds and foster entrepreneurial activity • capital allocation decisions should still be driven by a profit motive and competition for funds

25. The Future of Entrepreneurial Finance • Methods of selecting new venture investment opportunities will improve • investors and entrepreneurs will develop better methods for deciding whether to pursue opportunities • data available for assessing potential rewards and risks can be expected to get better and more accessible • better ways to structure deals will be developed

26. The Future of Entrepreneurial Finance (cont’d.) • Changes in the set of investment opportunities will threaten existing institutions • the rate of technological progress will change • the direction of technological progress will change • promising new opportunities can arise anywhere • clustering of entrepreneurial activity will persist

27. The Future of Entrepreneurial Finance (cont’d.) • Changes in the competitive climate threaten existing institutions • competition among investors will intensify • competition among investors will be increasingly global • the rate at which capital flows to new opportunities can be expected to increase • new competitive structures will emerge