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					Entrepreneurial Finance
 And Venture Capital
    Professor XXXXX
 Course Name / Number
    Entrepreneurial Finance
                                Rapidly growing public or private firms
    Entrepreneurial
                          Large external funding needs and imperfect access
        growth
                                      to public financial markets
      companies
                           Often based on proprietary technology or unique
                                              service


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



       Entrepreneurial growth companies very reliant on equity finance
2
    Sources Of Start-Up Capital For A
    Sample Of 132 Small Companies
                                                         Mean                    Standard
     Capital Sources                                    percent                  deviation
     Equity:
       Personal equity                                           35.6%                     40.8%
       Partnerships                                                 5.2                      17.9
       Issuance of stock                                            3.2                      14.5
       Miscellaneous                                                2.7                      13.6
           Total Equity                                          46.7%
     Debt:
       Institutional loans                                       43.8%                        40.5
       Loans from individuals                                       5.3                       19.1
       Issuance of bonds                                            1.1                        8.6
       Miscellaneous                                                2.7                       12.8
           Total debt                                            52.9%
    Source: Richard B. Carter and Howard E. Van Auken, “Personal Equity Investment and Small
3   Business Financial Difficulties,” Entrepreneurship: Theory and Practice 15 (Winter 1990), pp. 51-60.
    Global Venture Capital Investment
    and Fund Raising, 1995-2001
                      Funds Raised       Investment       Hi-Tech Investment

     300
     $Bn

     250

     200

     150

     100

      50
        0
             1995       1996      1997       1998      1999       2000      2001


    Source: 3i/PriceWaterhouseCoopers in Global Private Equity 2002: A Review of
    the Global Private Equity and Venture Capital Markets [www.pwcmoneytree.com ]
4
    Impact of Three Decades of U.S.
    Venture Capital Funding
                              Cumulative VC VC-Backed Firms                   Employment in
                                Investmt,     Sales, 2000                      VC-Backed
        State                1970-2000 ($mn)    ($ mn)                         Firms, 2000
        California                     $108,810                 $207,616               1,415,748
        Massachusetts                     25,986                  48,848                 381,433
        Texas                             17,189                 158,183                 676,158
        New York                          16,070                   65,848                369,314
        Colorado                            9,881                  14,565                  62,971
        New Jersey                          9,138                  38,151                260,114
        Washington                          7,383                  75,392                263,585
        Virginia                            7,215                  35,689                207,777
        Pennsylvania                        7,187                  58,037                424,652
        Georgia                             6,435                  62,797                338,188
        Total U.S.                     $273,300             $1,300,000 *             7,600,000 *
    * Represents 13.1% (sales) and 5.9% (employment) of 2000 U.S. national totals
5   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).
    U.S. Venture Capital Techniques
    and Practices
                 Institutional venture capitalists vs. “angel capitalists”
        SBICs, financial and corporate venture capital, venture capital limited
                                      partnerships
                                        – VC firms launch multiple funds over time.
                                        – Typically raise $100 million-$1billion via
    Venture Capital Limited               subscriptions
         Partnerships                   – Fund invests during years 1-5, Harvests during
                                          years 5-10.

     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,
6   PriceWaterhouseCoopers and National Venture Capital Association ( www.nvca.com).
    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
7
                          capital industry.
    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.

                          Preserves cancellation option for venture capitalist
                                             at each stage
         Staged
       financing           Same venture capitalists tend to remain throughout
                                        a firm’s development.
8
    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

9
     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?
10
     Average Annual Rate of Return to
     Investors in U.S VC Funds
     %160

      140

      120

      100

       80

       60

       40

       20

        0
            1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
      -20

     Source: Data from Venture Economics as reported in Paul Gompers and Josh Lerner, “The Venture
11   Capital Revolution,” Journal of Economic Perspectives 15 (Spring 2001), pp. 145-168, fig.2
     The Pricing Of Venture Capital
     Investments
     • Based on company’s development stage, expected future firm
       value and entrepreneur prestige
        – Earlier the development stage, higher the return demanded
     • Expected future market value based on firm’s 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

                                    IPO expected: n = 5 yrs; Exp(NI)=
      An example....                      $4,000,000; P/E = 20

      Venture capitalist to
      provide $5 million                A = $5,000,000; r = 50%.
12
     The Pricing Of VC Investments
     • Step 1: compute value of VC stake at exit date:

         FV = A (1+r)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 3:compute fraction of firm’s 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.
13
                             Very expensive financing!!
     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



14
     Nations’ Legal Systems the Size
     of its Venture Capital Industry?
                                                                         Venture capital
          Country                   Family of legal origin              investment, 2000
                                                                      $US Bn     % of GDP
          Israel                     English common law                  $3.2             3.17%
          Singapore                  English common law                  1.2               1.41
          Hong Kong SAR              English common law                  2.2               1.38
          United States              English common law                 122.1              1.33
          Sweden                    Scandinavian law/Civil               2.1               0.88
          United Kingdom             English common law                  12.2              0.85
          Canada                     English common law                  4.3               0.68
          France                       French civil law                  4.9               0.34
          Italy                        French civil law                  2.8               0.24
          Switzerland                 German law / Civil                 0.6               0.23
          Germany                     German law / Civil                 4.4               0.21
          Japan                       German law / Civil                 2.0               0.05
          Avg, English common law countries                               --              1.14%
          Avg, all civil law countries                                    --              0.31%
     Sources: Venture capital investment, PriceWaterhouseCoopers; GDP data, World Bank Group; Family of
15   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.
     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 1998’s total investment; now over half
        – New investments targeted at internet; shifting to start-up
      Sources: PriceWaterhouseCoopers and European Private Equity and Venture Capital
16    Association (www.evca.com).
     European Private Equity
     Investment 1989-2002
            35
     € Bn

            30


            25


            20


            15


            10


            5


            0
                 1989 90   91   92   93    94    95    96   97    98    99 2000 2001 2002


     Source: Data from PricewaterhouseCoopers and European Private Equity and Venture Capital
     Association, “2 nd Highest Year for the European Private Equity Industry”, European Private Equity &
17   Venture Capital Association website (www.evca.com).
     European High-Tech PE
     Investment by Industry
                                                 2001                           2000
     Sector                            Amount           Percent      Amount            Percent

     Communications: Hardware           € 401             5           € 585              5
     Communications: Carriers           1,518             21          1,590              14
     Internet technology                 822              11          1,843              16
     Computer: Hardware                  238              3            441               4
     Computer: Software                 2,291             32          3,583              31
     Computer: Services                  462              6            636               6
     Computer: Semiconductors            257              3            379               3
     Other electronics related           320              4            977               9
     Medical: Instruments/devices        249              3            413               4
     Biotechnology                       844              12          1,017              9
     Total                             € 7,402           100%        € 11,464           100%


     Source: PriceWaterhouseCoopers, Money for Growth: The European Technology Investment
18   Report 2001 (www.pwcmoneytree.com).
     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
19                         partnerships
     European Private Equity Raised
     by Type of Investor, Year 2000
                                                 Pension funds
                       5.6%                      Banks
                7.4%
                                                 Insurance companies
                               24.2%
                                                 Fund of funds

      10.9%                                      Academic institutions

                                                 Capital markets

                                                 Not available
     4.2%
                                                 Corporate investors

                                                 Private individuals
                                21.7%
                                                 Government agencies
            11.4%
                                        Source: PricewaterhouseCoopers
                                        and European Private Equity and
                       12.9%            Venture Capital Association as
                                        reported in Simon Targett,
                                        “Institutional Investment: Should
                                        Do More,” Financial Times (June
20                                      14, 2001), European Private Equity
                                        Survey, p. 5
     Returns to Categories of European
     Private Equity Investment
                                             Source:
                                             Pricewaterhouse-
                  50                         Coopers and
                         Venture             European Private
                                             Equity and Venture
                         Buyouts             Capital Association,
                  40
                         Generalist          “Pan-European Survey
                                             of Performance: From
                  30                         Inception to 31
     5 YEAR IRR




                                             December 2000”
                                             (http://www.evca.com)
                  20


                  10


                   0


                  -10
                        1982




                                  1987




                                  1991




                                  1999
                                  1995




                                  2000
                        1980
                        1981

                        1983
                        1984

                                  1986



                                  1989



                                  1992

                                  1994



                                  1997
                                  1998
                                  1985



                                  1988

                                  1990



                                  1993



                                  1996
                                      YEAR


21
     Key Difficulties Facing EVC
      Core problem: Inability to develop viable IPO market


      – Several entrepreneurial growth company markets
        developed by European exchanges in late 1990s
      – Germany’s 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!
22
     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 & gov’t, not VC partnerships, are key VC actors
           – India has had some success; $700mn in 1999, mostly tech.
23       Source: World Bank Group (www.worldbank.org )
     VC Investments in Developing
     Countries
                Chart 1. Venture Capital Stock            • VC investment in
     $ mm                                                  developing nations
      8,000                                                has been small.
                        Central & E.Europe
      7,000             Developing Asia                   • Much of what is
                                                           called venture capital
      6,000
                                                           is really subordinated
      5,000                                                debt financing.

      4,000                                               • Lack of financial and
                                                           legal infrastructure
      3,000
                                                           makes VC investing in
      2,000                                                developing very risky.

      1,000                                               Source: Anthony Aylward,
                                                          “Trends in Venture Capital
                                                          Finance in Developing
            0                                             Countries,” IFC Discussion
                                                          Paper no. 36, World Bank
                 1990   1991 1992      1993 1994   1995   (Washington D.C., July 1998)
24
     VC Investments in Developing
     Countries
                                                         Source: Anthony Aylward,
                      Venture Capital Flows              “Trends in Venture Capital
                                                         Finance in Developing
                                                         Countries,” IFC Discussion
      $ mm                                               Paper no. 36, World Bank
                                                         (Washington D.C., July 1998)
      3,500
                     Central & E.Europe
      3,000
                     Developing Asia
      2,500

      2,000

      1,500

      1,000

       500

         0
              1990     1991 1992      1993 1994   1995
25
     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 doesn’t 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 R&D 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

26
        Entrepreneurial Finance
         And 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.

				
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