the future of new venture finance: transformation from art to science richard smith may 2002 peter...

The Future of New Venture Finance: Transformation from Art to Science

Richard Smith

May 2002

Peter F. Drucker Graduate School of Management

Claremont Graduate University

Venture Finance Institutehttp://www.cgu.edu/drucker/vfi/

http://www.cgu.edu/drucker/vfi/

New Venture Opportunity Cost of Capital and Financial Contracting

Frank Kerins

Washington State University

Janet Kiholm Smith

Claremont McKenna College

Richard Smith

Claremont Graduate University

“Good ideas and good products are a dime a dozen. Good

execution and good management - in a word, good people - are

rare.”

--Arthur Rock

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Per

cen

t o

f F

inan

cial

Ass

ets

1980 1985 1990 1995 1999

Year

Trends in Mix of Financial Assets Held by Families:the Emergence of Portfolio Investing

Other Pooled InvestmentPension FundsMutual FundsCorporate EquityOther Direct InvestmentCredit Market InstrumentsChecking and Savings Deposits

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14

Organizational Structure of Venture Capital Investment

Portfolio Companies–Value creation

– Generate deal flow – Screen opportunities– Harvest investments

– Negotiate deals– Monitor and advise

General Partners

Venture Capital Fund

– Pension plan– Endowments– Life insurance companies

– Corporations– Individuals

Limited Partners

Effort and 1% of capital

Annual Management

Fee 2-3%

Carried Interest 20-30% of Gain

99% of Investment Capital

Capital Appreciation 70-80% of Gain

Investment Capital and

Effort

Financial Claims

NAV and Value of Illiquid Equities of Letter Stock Funds

$0

$50

$100

$150

$200

$250

$300

$350

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979

Year

Mil

lio

ns

of

Do

lla

rs

Total Net Asset Value

Restricted Shares and Venture Capital

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

Mil

lio

ns

of

Do

llar

s

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

Year

Venture Capital New Commitments(1969 - 2001)

Sources: Statistical Abstract of the U.S. (various issues), Venture Economics Investor Service, Sahlman (1990), National Venture Capital Association.

$1

$10

$100

$1,000

$10,000

$100,000

$1,000,000

Mil

lio

ns

of

Do

llar

s

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

Year

Venture Capital New Commitments(1969 - 2001)

Sources: Statistical Abstract of the U.S. (various issues), Venture Economics Investor Service, Sahlman (1990), National Venture Capital Association.

11.1%

47.4%33.5%28.0%

17.8%

165.3%

37.6%

-32.4%

18.2% 16.9%14.7%

-40.0%

-20.0%

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

140.0%

160.0%

180.0%

1994 1995 1996 1997 1998 1999 2000 2001 20-YearVC

Avg.

PrivateEquityAvg.

S&PAvg.

Source: National Venture Capital Association, Venture Economics

Annual and Cumulative Returns of Venture Capital Fund Investments

Implications of VC History

• Capital starvation before 1979 due to ICA/SEC regulation.



• Expected returns higher than needed after 1979.




• Rapid growth in demand from institutional investors.





• Inability of established VCs to respond.





• Inability of established VCs to respond.

• Compounding effects of the Internet boom.

April 2000 to Today

Commitments to Venture Capital Funds

0

100

200

300

400

500

600

700

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Nu

mb

er

of

Fu

nd

s

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

Mil

lio

ns

of

Do

lla

rs

Total FundsNew FundsTotal CommitmentsCommirments to New Funds

Four principles of value-maximizing deal structure


• Limit risk and enhance expected return by structuring financing around objective milestones that are related to risk.



• If the entrepreneur and the investor have similar expectations, allocate most of the risk to the investor.




• Shift risk to the better informed or more optimistic party.




• Shift risk to the better informed or more optimistic party.

• Use risk allocation to align the interests and incentives of the parties

Complete Success

Success in Three Application

Success in Two Application

Invest Success in One Application

Complete Failure

Investment

$5,000,000

NewCo's Business Plan

Subjective Probabilities

Conditional Values

Expected Values

Complete Success 10% $25,000,000 $2,500,000

Success in Three Application 5% $15,000,000 $750,000

Success in Two Application 20% $5,000,000 $1,000,000

Invest Success in One Application 15% $3,000,000 $450,000

Complete Failure 50% $0 $0

Investment

$5,000,000 Total $4,700,000

NewCo's Business Plan

$25,000,000

Success

$15,000,000

SuccessFourth

Application$5,000,000 $15,000,000

SuccessThird

ApplicatonFail

$3,000,000 $5,000,000

SuccessSecond

ApplicationFail Abandon

$3,000,000First

ApplicationFail Abandon

$0

Fail Abandon

Incremental and Cumulative Investment

First Round Second Round Third Round Fourth Round $1,000,000 $1,000,000 $1,000,000 $2,000,000$1,000,000 $2,000,000 $3,000,000 $5,000,000

NewCo's Real Options

Valuing the Real Options

• Model the venture cash flows based on the agreed deal structure.

• Use risky discount rates to value the real options.

• Work back recursively through the decision tree to determine current value and required ownership.

• Use the model to evaluate alternative structures for the purpose of aligning interests and maximizing value.

Valuation: Corporate Setting

• Discount expected cash flows at a rate determined by market opportunity cost (CAPM)

• Infer discount rate from betas of comparable market assets

• Implicit assumptions:– Same standard deviation of holding period returns

– Same correlation with market

– (Ultimate) Investor is (can be) well-diversified

Problems of New Venture Valuation

• VCs represent well-diversified investors, entrepreneurs cannot be well-diversified.

• The entrepreneur’s required rate of return depends on total risk and achievable diversification.

• Little data is available on risk attributes of comparable investments.

• Equilibrium holding period returns and standard deviations are endogenous.

Ability to Diversify and Opportunity Cost of Capital

• Well-diversified investor

• Undiversified entrepreneur FMMurEntreprene

VentureFurEntreprene

Venture rrrr /

FMMInvestorVentureMVentureF

InvestorVenture rrrr /,

Estimation of Undiversified Entrepreneur’s Opportunity Cost of Capital

• Direct use of market transactions not possible.

• CEQ avoids endogeneity problem

– Estimating from market returns data (per unit of value to diversified investor).

F

FMM

CVenture

urEntrepreneVenture r

rrC

PV

Venture

1

)(

F

MVenture

FInvestor

VentureVenture

urEntrepreneVenture

r

rrC

PV

1

)(

,


• Expected cash flow (capital market equilibrium).

• Entrepreneur’s opportunity cost of capital

))(1( FMVentureFInvestorVentureVenture rrrwC

1urEntreprene

Venture

VentureurEntrepreneVenture

PV

Cr


• CEQ of Underdiversified entrepreneur– Underdiversified investment

– Estimating from market returns data

MF

FMM

C

PortfoliorEntreprene

Venture wr

rrC

PV

Portfolio

1

)(

))(1()1( FMVentureFInvestorVentureMMarketPortfolio rrrwrwC

)2)()( ,22

VentureMInvestorVentureMMVentureVenture

InvestorVentureMMC wwww

Portfolio

Data

• US IPOs from 1995 through 2000

• MeasurementDescription of Sample

Industry Firms in Sample

Observations in Sample

Average Firm-Years

Biotechnology 151 501 3.3 Broadcast and Cable TV 44 105 2.4 Communication Equipment 88 247 2.8 Communication Services 158 407 2.6 Computer Network 35 130 3.7 Computer Services 200 440 2.2 Retail Catalog And Mail Order (Internet) 19 39 2.1 Software 297 754 2.5 Total 992 2623 2.6

Descriptive Evidence

• Parameter Estimates: Mean– Standard deviation of returns (annualized) 120%

– Ratio of firm standard deviation to S&P 500 4.88

– Correlation with S&P 500 0.20

– Equity beta with S&P 500 0.99

• Aggregations: – Calendar year

– Industry

– Age (years after IPO)

– Financial Condition (revenue and income status)

– Size (Employees)

Descriptive Evidence

• Total risk (standard deviation of returns):–Decreases with firm age, size, and financial condition

–Differs across industries and over calendar years

• Total risk to market risk:–Decreases with firm age, size, and financial condition

• Beta– Increases with firm age and size

–High in year of IPO and transition to profitability

• Correlation– Increases with firm age, financial condition, and size

Category Grouping Standard Deviation

Correlation Beta Well-diversified Investor

Cost of Capital

Underdiversified Entrepreneur Cost of Capital

Net Gross 100% 35% 25% 15% Industry Biotechnology 104% 0.15 0.78 8.68% 13.35% 45.9% 34.7% 29.7% 22.4% Broadcast and Cable TV 87% 0.24 1.04 10.24% 15.30% 36.3% 27.4% 23.9% 19.1% Communication Equipment 120% 0.22 1.32 11.92% 17.40% 53.3% 42.3% 37.2% 29.2% Communication Services 104% 0.24 1.25 11.50% 16.88% 44.4% 34.6% 30.4% 24.1% Computer Networks 93% 0.21 0.98 9.86% 14.83% 39.4% 29.8% 25.8% 20.2% Computer Services 144% 0.17 1.22 11.34% 16.68% 69.9% 56.4% 49.6% 38.2% Retail Cat. and Mail Order (Internet) 106% 0.22 1.17 11.00% 16.25% 45.8% 35.5% 31.1% 24.4% Software 137% 0.20 1.37 12.22% 17.78% 64.1% 51.6% 45.6% 35.5% Firm Age Since IPO Year of IPO 212% 0.04 0.39 6.40% 8.25% 158.7% 133.1% 118.6% 89.6% 1 to 5 Years After IPO 104% 0.23 1.11 11.10% 16.38% 46.6% 34.6% 30.3% 23.9% Financial Condition No Revenue 119% 0.17 0.98 9.90% 14.88% 54.0% 42.1% 36.6% 27.9% Revenue, Negative Income 135% 0.20 1.33 12.00% 17.50% 62.5% 50.4% 44.4% 34.5% Positive Income 100% 0.20 1.00 10.00% 15.00% 42.7% 32.6% 28.3% 22.0% Employees 0-25 Employees 126% 0.12 0.73 8.40% 13.00% 59.5% 46.2% 39.8% 29.5% 26-100 Employees 128% 0.15 0.98 9.90% 14.88% 59.6% 46.8% 40.7% 30.9% Over 100 Employees 113% 0.23 1.31 11.80% 17.25% 49.3% 38.9% 34.2% 27.0%

Results

the future of new venture finance: transformation from art to science richard smith may 2002 peter...

Documents

deal structure slide

arthur rock slide

deal structure limit

expected return

shift risk

gain investment capital

icasec regulation

principles of value