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New Venture Financing

New Venture Financing. Dr. Richard Michelfelder, Ph.D. Spring 2013. NVF Course Outline. Introduction 2. The Business Plan 3. Business Legal Structure 4. Developing Pro Forma Financial Statements and Projecting Cash Flows and Profits, Assessing Financial Needs

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New Venture Financing

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  1. New Venture Financing Dr. Richard Michelfelder, Ph.D. Spring 2013

  2. NVF Course Outline • Introduction 2. The Business Plan 3. Business Legal Structure 4. Developing Pro Forma Financial Statements and Projecting Cash Flows and Profits, Assessing Financial Needs 5. Business Valuation, Risk Analysis, the Due Diligence Process for the New Venture 6. Risk Analysis for the New Venture Using Monte Carlo Simulation 7. Strategies for Harvesting Value: Initial Public Offering and Other Methods to Extract Value

  3. 1. Introduction 1.1 Myths About Venture Capital 1.2 Entrepreneurship 1.3 Economic value growth: Consumer and producer surplus 1.4 Survival of NV’s 1.5 The Entrepreneur and Management 1.6 Entrepreneurial v. Corporate Finance 1.7 Objective: Maximize Value for Entrepreneur 1.8 NV Financing Trends 1.9 Why Investors Seek to Finance NV’s 1.9.1 Concept of Efficient Markets and Portfolio Returns 1.9.2 Returns to NV Investments

  4. 1.1 Myths about Venture Capital • VC firms want to run and have control of your business. • You must have an introduction to a venture capitalist to obtain financing. • VC’s are only interested in new technological discoveries. • VC’s are satisfied with a reasonable return on investment • VC’s are quick to invest. • VC’s think management is a secondary consideration. • VC’s need only summary information before they invest. • VC’s expect little negative cash flow and quick positive cash flow. • VC’s like to invest small amounts of capital.

  5. 1.2 Entrepreneurship • False Statement: “Entrepreneurs are born, not made.” • Personal experience • Ex-corporate executives and government employees becoming successful entrepreneurs is almost a cliche’. • People do not know how nor that they can be entrepreneurs. Entrepreneurship can be taught. • PriceWaterhouseCoopers(2005): 2004 Global private equity and venture investment was $110 billion.

  6. 1.2 Entrepreneurship Entrepreneur: acquires and applies resources to exploit uncertain opportunities to innovate that create value and harvest a portion of that value. Studied by economists such as Jean Baptiste Say (move resources to better use), Frank Knight (risk-taker) and Joseph Schumpeter (creative destruction and economic growth), and contemporary management expert, Peter Drucker (create value by creating something new). Entrepreneurship is generally viewed by policymakers and economic theorists as a key to economic growth and job creation by continually moving resources to higher value, higher productivity uses.

  7. 1.3 Economic Value Growth: Consumer and Producer Surplus Demand & Supply for New Good D P S P0 Q Q0

  8. 1.3 Economic Value Growth: Consumer and Producer Surplus Demand & Supply for Old Good P S D P0 Q Q0

  9. 1.3 Economic Value Growth: Consumer and Producer Surplus • Sum of consumer and producer surplus is the definition of societal economic value from microeconomic theory. • Note that the area of the two triangles for the new good were greater than that for the old good. The increase in the sum of these triangles is economic value creation. • Entrepreneurs have always been recognized and played a key role in economic growth theory due to the productivity that they create.

  10. 1.4 Survival of New Ventures • Legendary NASA flight director Gene Kranz during the Apollo 13 crisis: “Failure is not an option” • This is not true for entrepreneurship. It should be expected during a career in business start-ups. • US Dept. of Commerce: Of 210 start-ups in a specific year, 2 will exist 5 years later • Timmons (1999): 23.7% fail within 2 years, 51.7% within 5 years, 62.7% within 6 years , 80% after 10 years • The bottom line: most businesses fail!

  11. 1.5 The Entrepreneur and Management • Entrepreneurs are typically start-up value creators and not long-term operating managers. • The entrepreneurial start-up CEO is usually not a good long-term operational manager, typically due to interest. They like to create something new, harvest value and move on. • Some CEO’s have proven otherwise, such as Bill Gates (MicroSoft), Larry Ellison (Oracle), Michael Dell (Dell Computer).

  12. 1.6 Entrepreneurial v. Corporate Finance • NV finance uses the same tools as corporate finance but are more difficult to apply: • Valuation of the business highly ambiguous • Usually multiples of revenues or pre-tax cash flows • Determined by the agreement between buyer and seller • Out-year projections almost incredibly high in many cases and therefore ignored in formal valuation calculations • “Pre-money” and “post-money” valuations

  13. 1.6 Entrepreneurial v. Corporate Finance • NV finance uses the same tools as corporate finance but are more difficult to apply: • Non-separable investment and financing decisions • Project investment usually involves use of Net Present Value of before-income-tax cash flows to make the decision, then how to finance the investment

  14. 1.6 Entrepreneurial v. Corporate Finance • NV finance uses the same tools as corporate finance but are more difficult to apply: • Risk diversification is similar from the perspective of the venture capital fund investor but not for non-fund investors. • Harvesting value agreement as a component of the investment decision • Corporate control: the manager / investor distinction becomes blurred • Focus on maximizing value for the entrepreneur and not other investors. • Issues of optimal capital structure irrelevant; no debt • Dividend policy irrelevant; no dividends

  15. 1.6 Entrepreneurial v. Corporate Finance • NV finance uses the same tools as corporate finance but are more difficult to apply: • There is no risk diversification for the entrepreneur as for the outside investor and therefore cost of capital is higher: since km < ke, NPVm > 0 and NPVe < 0 so outside investors are needed who require a lower rate of return due to the ability to diversify.

  16. 1.7 Objective: Maximize Value for the Entrepreneur • Entrepreneurs overtly have an objective to maximize their own wealth. • Corporate finance CEO’s work for the investors’ interests, except for recognition of principal-agent conflicts. • Investors want entrepreneurs to maximize their own value as long as the same incentive achieves value creation goal of outside investors. • In NVF, we differentiate the inside and outside investors’ interests.

  17. 1.8 NV Financing Trends Stage of NV Development: 1. Development 2. Start-Up 3. Early Growth 4. Rapid Growth 5. Exit or Buyout

  18. 1.8 NV Financing Trends See PriceWaterhouseCoopers / National Venture Capital Association Investment by Stage of Development Report 1995 – 2006 See PriceWaterhouseCoopers Global Private Equity Report 2005

  19. 1.9 Why Investors Seek to Finance NV’s Investors seek to finance NV with tremendous risk to realize a rate of return on investment that is more than commensurate to the investment as compared with alternatives such as the S&P 500.

  20. 1.9.1 Concept of Efficient Markets and Portfolio Returns Efficient Markets Hypothesis: states that stock prices instantaneously reflect all relevant and available information, and therefore only new information will affect stock prices. Weak Version: you cannot earn excess returns using past information Semi-Strong Version: you cannot earn excess returns using public information Strong Version: you cannot earn excess returns using any information, public or inside information

  21. 1.9.1 Concept of Efficient Markets and Portfolio Returns Efficient Markets Hypothesis Statistical Test: St = α0 + α1St-1 + εt where: St: stock price at time t St-1: stock price at time t-1 or previous period εt: innovation or new information at time t For efficiency, α0 = 0 andα1 = 1. so that St - St-1 = εt, or, the difference in stock prices from one day to the next is due solely to new, unpredictable information. This is the stock market “random walk” hypothesis.

  22. 1.9.1 Concept of Efficient Markets and Portfolio Returns Efficient Markets Hypothesis: The bottom line is that you cannot consistently earn a rate of return above the market return for a similar level of risk. S&P 500 Portfolio Returns and Risk Statistics: Long-Run Annual Total Return: 12% Relative Risk (σ/E(kS&P 500): 22%/12% = 1.83 Sharpe Ratio (E(kS&P 500- Rf)/ σrisk prem. : 8.5%/23%=0.36 90-Day Treasury Bill: Relative Risk (σ/E(kT-Bill): 3.2%/3.8%=0.80 Sharpe Ratio: 0.60

  23. 1.9.1 Concept of Efficient Markets and Portfolio Returns Investors in NV’s seek return / reward trade-off’s that can “beat the market,” that is, earn returns than are more than proportional to the risk level. Sharpe ratios (risk-to-reward ratios) for stocks are not that exciting as they are more attractive for US Treasury Bills.

  24. 1.9.2 Returns to NV Investments Investors in NV’s seek return / reward trade-off’s that can “beat the market,” that is, earn returns than are more than proportional to the risk level. Sharpe ratios for stocks are not that exciting as they are more attractive for US Treasury Bills.

  25. 1.9.2 Returns to NV Investments Review Colin M. Mason and Richard T. Harrison (2002), “ Is It Worth It? The Rates of Return from Informal Venture Capital Investments,” Journal of Business Venturing 17, 211-236. Review John Cochrane (2005), “The Risk and Return on Venture,” Journal of Financial Economics, 3-52.

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