Entrepreneurial Finance

Chapter 1
Introduction to
Entrepreneurial
Finance
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Learning Objectives
• Understand how new venture finance is different from
corporate finance.
• Understand the centrality to new venture finance of the

objective of maximizing value for the entrepreneur.
• Briefly describe the evolution of thinking about the nature of

entrepreneurship and how entrepreneurship relates to new
venture finance.
• Describe the process of new venture formation from inception

of the idea to harvesting of the investment.
• Recognize that studying new venture finance can contribute to

better decision-making and increased potential for success.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

Intellectual Challenge
• Diversification of risk affects investment value.
• Investment and financing decisions are interdependent.
• Outside investors may be actively involved in a venture.
• The parties have different information (and beliefs).
• The parties have different incentives from each other.
• New ventures are portfolios of real options.
• Value to the entrepreneur is different from value to

shareholders.

After This Course,
You Should Be Able To:
• Construct new venture financial models
• Assess the timing and amounts of financial needs
• Estimate risks and expected returns of financial claims
• Value financial claims in light of diversification
• Evaluate alternative new venture strategies
• Estimate the effects of complex options on value
• Design and negotiate “deals”
• Address information and incentive problems
• Understand the institutions of new venture finance
• Develop a business plan to attract outside funding

The Finance Paradigm
• More of a good is preferred to less.
• Present wealth is preferred to future wealth.
• Safe assets are preferred to risky assets.

Types of Financial Decisions
• Investment Decisions
• Financing Decisions
• Mixed Decisions

New Business Formations & Terminations
Ne w Su cce s s o r T o tal Ne t S t a r t - Pe r ce n t Pe r ce n t
Ye ar C o m p a n ie s C o m p a n ie s S t a r t - u p s T e r m in a t io n s Fa ilu r e s ups T e r m in a t io n s Fa ilu r e s
1990 7 6 9 ,0 0 0 1 4 6 ,0 0 0 9 1 5 ,0 0 0 8 4 4 ,0 0 0 6 0 ,7 4 7 7 1 ,0 0 0 9 2 .2 % 6 .6 %
1991 7 2 6 ,0 0 0 1 3 8 ,0 0 0 8 6 4 ,0 0 0 8 2 1 ,0 0 0 8 8 ,1 4 0 4 3 ,0 0 0 9 5 .0 % 1 0 .2 %
1992 7 3 7 ,0 0 0 1 3 8 ,0 0 0 8 7 5 ,0 0 0 8 1 9 ,0 0 0 9 7 ,0 6 9 5 6 ,0 0 0 9 3 .6 % 1 1 .1 %
1993 7 8 0 ,0 0 0 1 3 6 ,0 0 0 9 1 6 ,0 0 0 8 0 1 ,0 0 0 8 6 ,1 3 3 1 1 5 ,0 0 0 8 7 .4 % 9 .4 %
1994 8 0 7 ,0 0 0 1 3 7 ,0 0 0 9 4 4 ,0 0 0 8 0 3 ,0 0 0 7 1 ,5 2 0 1 4 1 ,0 0 0 8 5 .1 % 7 .6 %
A ve r ag e 7 6 3 ,8 0 0 1 3 9 ,0 0 0 9 0 2 ,8 0 0 8 1 7 ,6 0 0 8 0 ,7 2 2 8 5 ,2 0 0 9 0 .7 % 9 .0 %
Terminations with loss to creditors as

Terminations as a percent of start-ups
a percent of start-ups
100% 12%
90% 10%
8%
80%
6%
70%
4%
60% 2%
50% 0%
1990 1991 1992 1993 1994 1990 1991 1992 1993 1994
Source: Case, J., "The Dark Side" Inc. Magazine, 1997, http://www.inc.com/incmagazine/archives/27960801.html, based on The State of Small Business: A Report of the President, 1994, U.S.
Government Printing Office, Washington, D.C., 1995.
The Objective
Maximum Value for the

Entrepreneur

Caveats
• Investment value is not the only factor an entrepreneur or
investor can consider.
• The CAPM-based valuation models used in the book do not

fully describe how investors view risk.
• Risk and expected return can be estimated, but not

measured with precision.
• Not every new venture investment or financing decision

should be carefully modeled and evaluated.
• Examples in the book are not intended to suggest that any

party to a deal should try to capture all of the value for
themselves.
Chapter 2
Overview of New
Venture Financing
Learning Objectives
• Learn new venture financing terminology.
• Understand the value of tying financing to performance
milestones.
• Recognize the distinguishing characteristics of the various
stages of new venture development.
• Identify the financing sources available to a new venture and
the factors favoring one financing source over another.
• Learn the basic structures and availability of various
financing sources.
• Identify the key elements of deal structure and the functions
they serve.

Some Milestones for
New Venture Planning
• Completion of Concept and Product Testing
• Completion of Prototype
• First Financing
• Completion of Initial Plant Tests
• Market Testing
• Production Start-up
• First Competitive Action
• First Redesign or Redirection
• First Significant Price Change
Block and MacMillan (1992)

Stages of New Venture Development
• Development Stage
• Start-up
• Early Growth
• Rapid Growth
• Exit

Stages of New Venture Development
Figure 2-1
Dollars
Revenue
Net Income
0 Cash Flow
0 Time
Development Start-up Early Growth Rapid Growth Exit

Sequence of New Venture Financing
• Bootstrapping
• Seed Financing
• R&D Financing
• Start-up Financing
• First-stage Financing
• Second-stage Financing
• Third-stage Financing
• Mezzanine Financing
• Bridge Financing
• LBO, MBO, IPO

Sources of New Venture Financing
• Self, Friends, and Family
• Business Angels
• Venture Capital Investors
• Small Business Investment Companies (SBICs)
• Trade Credit and Factoring
• Asset-based Lending
• Mezzanine Capital
• Private Placements of Equity (Relational Investors)
• IPOs
• Public Debt
Sources of New Venture Financing Figure 2-2
Sources of New Venture Financing
Development Start-up Early Rapid Exit

Growth Growth
Entrepreneur
Friends and Family
Angel Investors
Strategic Partner
Venture Capital
Asset-based Lender
Equipment Lessor
SBIC
Trade Credit
Factor
Mezzanine Lender
Public Debt
IPO
Acquisition, LBO, MBO
Black shading indicates primary focus of investor type.

Gray shading indicates secondary focus, or focus of a subset of investors.

Venture Capital Commitments
by Source
Figure 2-3 Part I
1978 Individuals
32%
Pension funds
Insurance 15%
16%
Endowments
9% Foreign
18%
Corporations
10%

Venture Capital Commitments
by Source
Figure 2-3 Part II
1991 - 1995 Pension funds
Insurance
46%
12%
Endowments
19% Corporations Individuals
Foreign 12%
5% 6%

Investment by Industry - 1997
Figure 2-4
Distribution/ Retailing Environmental
Pharmaceuticals Semiconductors
3.0% 1.0%
1.8% 0.8%
Electronics
Computers Software/ Information
3.6%
Industrial 3.2% 24.7%
Business 4.5%
Services 4.7%
Medical
Instruments
5.0%
Consumer
6.6%
Biotechnology
Communications
6.7% Healthcare
22.8%
11.4%

How Changes in the Stock Market Affect
New Equity Capital Raising
Figure 2-6
200%
Percent Change from Prior Year
150%
100%
50%
0%
70
72
74
76
78
80
82
84
86
88
90
92
94
19
19
19
19
19
19
19
19
19
19
19
19
19
-50%
-100%
Year
Change in Equity Financing Change in S&P 500 Index

Number of Debt Issues by Proceeds of
Issues: 1990-94
Figure 2-7
500
Convertible--Noninvestment Grade
450
Convertible--Investment Grade
400
Straight--Noninvestment Grade
Number of Issues
350
300 Straight--Investment Grade
250
200
150
100
50
0
2-9.99 10-19.99 20-39.99 40-59.99 60-79.99 80-99.99 100- 200- 500+
199.99 499.99
Gross Issue Proceeds in Millions

Deal Structure
• “The Deal”
• Term Sheet
• Pre-money Valuation
• Post-money Valuation
• Investment Agreement
– Representations and Warranties
– Covenants and Undertakings
– Affirmative Covenants
– Negative Covenants
– Registration Rights
– Preemptive Rights
– Ratchets or Anti-dilution Provisions

Chapter 3
The Business Plan
Learning Objectives
• Learn how and why business plans of new ventures are
different.
• Know what to include and what to leave out.

• Understand the relationship to strategic planning.
• Use milestones and financial projections in the plan.
• Use the plan to signaling the entrepreneur’s beliefs,
commitment, and capabilities.
• Understand how the plan can facilitate negotiation with outside

investors.

What is a Business Plan?
• A written document
• Summarizes the purpose and overriding strategy of the
venture
• Provides details on operation, financing, marketing, and

management
A set of hypotheses about an opportunity

What Makes the Business Plans of
New Ventures Different?
• Forecasts and projections usually are less precise.
• A greater investment in planning may be warranted.
• Deviations from plans are likely to be due to wrong
assumptions.
• Not very useful for evaluating manager performance.
• More likely to be relied on externally.
• More likely to be used to attract investment capital.
• Often require greater breadth of coverage.
• Unconstrained by previous decisions.
Do the Planning Before the Writing
• Preparing a business plan is not the first step.
• The plan can commit the entrepreneur to an undesirable
strategy.
• Consider aspects of strategy simultaneously, not

sequentially.
• Do not lose sight of the objective.

• Analysis of strategic alternatives does not belong in the
business plan.
• Be prepared to respond to alternative proposals.

Alternative Product Market and
Financing Choices
Figure 3-1
Alternative Product Market and Financing Choices:

Net Present Value to the Entrepreneur
Financing Choice
Entrepreneur Entrepreneur Entrepreneur +
Product Market Choice Entrepreneur + Debt + Equity Debt + Equity
Small Scale - Slow Growth $100 $40 $30 $10
Small Scale - Rapid Growth $60 $80 $20 $90
Large Scale - Slow Growth $60 $50 $120 $70
Large Scale - Rapid Growth $20 $40 $80 $100

Contents of the Business Plan
• Focus on the purpose(s) and uses of the plan.
– Include whatever information is relevant and material.
• Make certain the audience is neither overloaded nor left to

speculate.
– Include only what is appropriate and necessary, given the use.
• Identify the key assumptions as assumptions.

– Include the support for key assumptions.
• Highlight the critical elements for success or failure.

• Delineate milestones.
– So users can evaluate success, modify assumptions, expectations, or strategy.
• Include financial projections.

– To test the plan, commit the entrepreneur, facilitate negotiation

Making the Business Plan Credible
• Demonstrate understanding of the technology, market, risks,
needs, and potential rewards.
• Provide evidence of the quality and capabilities of people

involved, and that they can function effectively as a team.
• Provide evidence that key personnel are committed.

– Bonding
– Reputation
– Certification

The Issue of Confidentiality
• Protecting intellectual property
• Preempting rivals and first-mover advantage
• Using non-disclosure agreements
• Relying on reputation

Financial Aspects of the Business Plan
• Differing views on what to include
• Is the future too uncertain to warrant careful forecasting?
• Include in the plan, or as an appendix?
• The importance of supporting assumptions
• Relationship of projections to contract negotiation
• The value of quantifying risk
• Value as a diagnostic tool - to facilitate adaptation
• Updating the business plan

Chapter 4
New Venture Strategy
Learning Objectives
• Understand what makes a decision strategic.
• Understand the interrelationships between financing
decisions and other aspects of new venture strategy.
• Relate strategic decisions to the entrepreneur’s objective

of value maximization.
• Describe strategic alternatives in terms of real options.

• Use decision trees to identify and evaluate real options.
• Use game trees when strategic choices depend on rival
reactions.

What Makes a Plan or Decision
Strategic?
• Strategic decisions are consequential.
• Strategic decisions are both active and reactive.
• Strategic decisions limit the range of possible future actions.

Interactive Financial Strategy
Figure 4-1
The more vertical and Financial
horizontal integration, the Strategy
greater the financial Rapid growth reduces
needs. Type of financing financial flexibility and
Outside investment is  Outside v. entrepreneur requires sacrificing
more likely the larger the  Debt v. equity control to attract outside
firm. financing.
Financial contracts
 Loan covenants
 Options
 Staging
Product
 Price
Product
Organizational  Margin
Market  Quality
Strategy Strategy  Differentiation
Vertical boundaries Targeted sales
Horizontal boundaries growth
 Scale and scope
Rapid growth requires a larger
organization. Economies-of-scope
imply more product lines.

Financial Implications of Product-Market
and Organizational Strategic Choices
Figure 4-2
Product-market
Slow growth Rapid growth
Initially self-financed by Initially self-financed by

entrepreneur, growth entrepreneur, growth
One-level entry financed with operating financed with operating
cash flows cash flows and outside
financing
Organization
Initial financing Initial financing

includes outside equity, includes outside equity,
Integrated entry growth financed with growth financed with
operating cash flows operating cash flows and
outside financing

An Introduction to Options
• Option - A right to make a decision in the future
• Elements of an option
– An underlying asset
– Exercise price (strike price)
– Expiration date
– European or American form
• Basic options
– Call option
– Put option
• Financial options
• Real options
• Complex options
– Contingencies - Option created by some earlier action
– Interdependencies - Options with interdependent values

The Structure of a Call Option
Underlying Asset
Value Expiration
Value
of Asset
Call before
Expiration
E
Value of Underlying Asset

Realized Returns on Options
Buy a Call Write a Call
Gain
Loss
Gain
Loss

Valuing Options
• Put-Call Parity
– Option Pricing Models based on no-arbitrage
– Stock + Put = Call + PV(Exercise Price)
– Role of complete markets
• Financial Options
– Complete markets
– Incomplete markets
• Real Options
– Complete markets
– Incomplete markets
• Complex Real Options (Rainbow Options)

– Discrete scenarios
– Simulation
Real Options - Some Examples
• Defer - Investing now eliminates the option to defer
(learning).
• Expand - An option to defer part of the scale of investment.
• Contract - The flexibility to reduce the rate of output.
• Abandon - Stop investing, and liquidate existing assets.
• Staging - Substitute a series of small investments for one
large.
• Switching - Re-deploy resources or change inputs
(terminate).
• Change Scope - Expand or contract scope.

Techniques for Reasoning Through
Decision Trees
• Focus on the most important decisions.
• Reason forward to construct the tree.
• Track certainties and uncertainties at each decision
point.
• Calculate backwards to evaluate choices.

• Select the tree branch with the highest expected
value.

Decision Tree - Restaurant Example
• Demand may be high (30%), medium (50%), or low (20%).
• Cost of large restaurant is $750,000.
• Cost of small restaurant is $600,000.
• Entrepreneur will invest $400,000, outside investor provides the rest.
• Investor requires 1% of equity for each $10,000 invested.
• If demand is high - PV large is $1,500,000, PV small is $800,000.
• If demand is medium - PV large is $800,000, PV small is $800,000.

• If demand is low - PV large is $300,000, PV small is $400,000.

Accept/Reject Decision to Invest in
Restaurant Business
Figure 4-3
High Demand (.3)
-$400,000 + .65 x $1,500,000 = $575,000
Intermediate Demand (.5)

-$400,000 + .65 x $800,000 = $120,000
Low Demand (.2) -$400,000 + .65 x $300,000 = $-205,000

Large
restaurant High Demand (.3)
-$400,000 + .8 x $800,000 = $240,000
Small Intermediate Demand (.5) -$400,000 + .8 x $800,000 = $240,000

restaurant
Low Demand (.2) -$400,000 + .8 x $400,000 = -$80,000
Do not enter High Demand (.3)

$0
Intermediate Demand (.5)

$0
Low Demand (.2) $0

Evaluation of Accept/Reject Alternatives
• Large-scale entry:
– NPV conditional on high demand = $575,000
– NPV conditional on intermediate demand = $120,000
– NPV conditional on low demand = ($205,000)
– NPV = .3 x $575,000 + .5 x $120,000 - .2 x $205,000
• = $191,500
• Small-scale entry:
– NPV conditional on high demand = $240,000
– NPV conditional on intermediate demand = $240,000
– NPV conditional on low demand = ($ 80,000)
– NPV = .3 x $240,000 + .5 x $240,000 - .2 x $80,000
• = $176,000
• Do not enter:
– NPV = $0

Restaurant Business Investment with
an Option to Delay Investing
Figure 4-4
High Demand (.3)
-$400,000 + .65 x $1,500,000 = $575,000
Large
restaurant Intermediate Demand (.5)
-$400,000 + .65 x $800,000 = $120,000
Low Demand (.2)

-$400,000 + .65 x $300,000 = $-205,000
High Demand (.3)
-$400,000 + .80 x $800,000 = $240,000
Small
-$400,000 + .80 x $800,000 = $240,000
Low Demand (.2)

-$400,000 + .80 x $400,000 = -$80,000
High Demand (.3)

-$400,000 + .65 x $1,300,000
= $445,000
Determine market
Wait demand Intermediate Demand (.5)
-$400,000 + .80 x $700,000
= $160,000
Low Demand (.2)
$0

Evaluation of Option to Delay
• Large-scale entry strategy: NPV = $191,500
• Delay until uncertainty is resolved:
– High demand
• Build large restaurant
• NPV conditional on high demand = $445,000
– Intermediate demand
• Build small restaurant
• NPV conditional on intermediate demand = $160,000
– Low demand
• Do not enter
• NPV conditional on low demand = $0
• NPV of delay strategy:
– = .3 x $445,000 + .5 x $160,000 + .2 x $0 = $213,500
• Value of Option to Delay = $213,500 - 191,500 = $22,000
Restaurant Business Investment with an
Option to Expand Initial Investment
Figure 4-5
High Demand (.3)
-$400,000 + .65 x $1,500,000 = $575,000
Large
-$400,000 + .65 x $800,000 = $120,000
Low Demand (.2) -$400,000 + .65 x $300,000 = $-205,000

Expand -$400,000 + .70 x $1,400,000
High Demand (.3) = $580,000
Small Do not expand -$400,000 + .80 x $800,000

restaurant Intermediate Demand (.5) = $240,000
-$400,000 + .80 x $800,000 = $240,000
Low Demand (.2)

-$400,000 + .80 x $400,000 = -$80,000
High Demand (.3)

$0
Do not enter Intermediate Demand (.5)

$0
Low Demand (.2)

$0
Evaluation of Option to Expand
• Delay until uncertainty is resolved: NPV = $213,500
• Build small, with Option to Expand:
– Conditional on High demand:
• NPV if Expand = $580,000
• NPV if Remain Small = $240,000
• Conclusion: Expand if demand is high
– Conditional on Intermediate demand:
• NPV of Remaining Small = $240,000
– Conditional on Low demand:
• NPV of Remaining Small = ($80,000)
• NPV of Small-scale entry with Option to Expand
– = .3 x $580,000 + .5 x $240,000 - .2 x $80,000 = $278,000
• Value of Expansion Option = $86,500
• Incremental value over Delay Option = $64,500
– The Options are Mutually Exclusive

Evaluation of Option to Abandon
• Large-scale entry with Abandonment option:
– Convert to office with $600,000 value
– NPV of converting for entrepreneur = ($10,000)
– NPV with Abandonment Option:
• = .3 x $575,000 + .5 x $120,000 - .2 x $10,000 = $230,500
– Would pay up to $39,000 extra for location that is convertible
• Small-scale entry with Expansion and Abandonment Options:
– Convert to office with $300,000 value
– NPV of converting for entrepreneur = ($160,000)
– NPV with Abandonment Option:
• = .3 x $580,000 + .5 x $240,000 - .2 x $160,000 = $262,000
– Abandonment has negative value for the small restaurant
– A result of discreteness of the analysis
• Conclusion: Build small with Expansion Option
– NPV = $278,000
Game Trees
• The Basics
– Players
– Order of play
– Information set
– Available actions
– Payoff schedules
• Strategic interaction
– Cooperative and Non-cooperative games
– Sequential-move game - Game tree
– Simultaneous-move game - Payoff matrix
• Nash equilibrium
• Sub-game perfection

Evaluating Strategic Games
• Develop the tree
• Prune branches involving dominated strategies
• Specify assumptions about rival actions and
reactions

Entry Decision Game Tree
Figure 4-6 Kelly’s Erin’s
Payoff Payoff
Enter
$380,000 ($100,000)
Erin’s
Pub
Stay Out
$425,000 $0
Large
Enter
$250,000 $200,000
Kelly’s Small Erin’s

Bar Pub
Stay Out
$400,000 $0
Large
Wait $300,000 $100,000
Kelly’s Small $190,000 $210,000
Enter
Bar Stay Out
Erin’s $0 $300,000
Large
Pub $370,000 $0
Kelly’s Small
Stay Out $350,000 $0
Bar Stay Out
$0 $0

Examples of Real Options
Option Description Examples
To wait before taking an action When to harvest a stand of trees,
Defer until more is known or timing is introduce a new product, or replace
expected to be more favorable an existing piece of equipment
To increase or decrease the Adding or subtracting to the daily

Expand or scale of a operation in response flights on an airline route or adding
contract to demand memory to a computer
To discontinue an operation and Discontinuing a research project,

Abandon liquidate the assets closing a store, or resigning from
current employment
To commit investment in stages Staging of research and

Stage giving rise to a series of valuations development projects or financial
investment and abandonment options commitments to a new venture
To alter the mix of inputs or The output mix of refined crude oil
Switch inputs outputs of a production process products or substituting coal for
or outputs in response to market prices natural gas to produce electricity
To expand the scope of activities Extending brand names to new

Grow to capitalize on new perceived products or marketing through
opportunities existing distribution channels
Chapter 5
Financial Forecasting
Learning Objectives
• Learn the elements of the cash flow cycle.
• Understand the four critical determinants of a firms financial
needs: minimum efficient scale, profitability, cash flow, and
sales growth.
• Learn how to prepare a sales forecast for an established
firm.
• Learn how to prepare a sales forecast for a new venture.
• Develop a financial model of a venture using pro forma
analysis to integrate income statement, balance sheet, and
cash flow items.
• Identify publicly available data sources to provide an
objective basis for underlying assumptions of the financial
model.
© 2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 6

Benefits of Financial Forecasting
• A disciplined means to evaluate the cash needs of a
venture
• An aid to determine whether a proposed venture deserves

the entrepreneur’s investment of capital and effort
• A means to compare the expected values of strategic

alternatives
• A way to demonstrate project merits to investors and to

use in negotiating ownership
• A way to identify appropriate benchmarks for assessing

project development

The Firm as a Cash Conversion
Process
Process
Cash Future
Firm
Cash

The Cash Flow of a Business Venture
Capital
(equity and debt)
Infusions
Beginning cash
Reinvestment
Expenditures (to retained earnings)
Employees Materials Fixed Assets
Production
Inventory Credit Sales
Cash sales Accounts

Receivable
Ending Cash Collections
Equity Returns Debt Service Taxes

Key Determinants of Financial Needs
1) Minimum efficient scale and capital
intensity
2) Profitability
3) Cash flow
4) Sales growth

Manufacturer’s Long Run Average Cost
(LRAC)
Figure 6-2
Dollars
Q Q* Quantity

Factors that Increase
a Firm’s Cash Needs
• Competition in markets where the minimum efficient scale
(MES) of an enterprise is large
• Low profit margins
• High rates of sales growth
• Increased reliance on depreciation of assets and less on
expensing of assets
• Expectation of low cash flow levels
• Increased trade credit offered (accounts receivable as a
fraction of assets is high)
• Decreased trade credit used (accounts payable as a fraction
of assets is low)

Introduction to Pro Forma Analysis
Assumptions for a simple asset-driven
business model:
• Sales = 2 x Beginning Assets
• Net Income = Sales x 0.1
• Retained Earnings = Beginning Assets x 0.06
• Dividends = Net Income - Retained Earnings
• Ending Assets = Beginning Assets + Retained Earnings

Asset-driven Pro Forma Model
Assets
S/A
Retained
Sales
Earnings
ROS
Retention
Net Income
Dividends

Five Year Pro Forma Analysis
for a Simple Business Venture
Figure 6-3
Y ear B e g in n in g S a le s Net R e t a in e d D ivid e n d s E n d in g
A s s ets In c o m e E a rn in g s A s s ets
1 $1,000,000 $2,000,000 $200,000 $60,000 $140,000 $1,060,000
2 $1,060,000 $2,120,000 $212,000 $63,600 $148,400 $1,123,600
3 $1,123,600 $2,247,200 $224,720 $67,416 $157,304 $1,191,016
4 $1,191,016 $2,382,032 $238,203 $71,461 $166,742 $1,262,477
5 $1,262,477 $2,524,954 $252,495 $75,749 $176,747 $1,338,226
Assumptions:
Sales = 2 x Beginning Assets
Net Income = Sales x 0.1
Retained Earnings = Beginning Assets x 0.06
Dividends = Net Income - Retained Earnings
Ending Assets = Beginning Assets + Retained Earnings

Integrating Pro Forma
Financial Statements
• Basic Pro Forma Financial Statements (and some others)
– Sales Forecast
– Income Statement
– Cash Flow Statement
– Balance Sheet
• The statements are interdependent

– Income Statement changes affect Balance Sheet and Cash Flow (e.g.,
higher profit may lead to increased cash balances).
– Balance Sheet changes affect Income Statement and Cash Flow (e.g.,
borrowing leads to interest expense and reduces taxes).
• A financial model should integrate the statements

Integration of Financial Statements:
The Circular Flow
Figure 6-4
Beginning
Balance
Sheet
Cash Ending
Income
Flow Balance
Statement
Statement Sheet
Sales
Forecast
Assumptions

Key Questions to be Answered
in a Sales Forecast
1) When will the venture begin to generate revenue?
2) How rapidly will revenue grow?
3) Over what span of time (3 years, 5 years, 10 years, etc.)

should the forecast be made?
4) What is an appropriate forecasting interval (weekly, monthly,

annually, etc.)?

Forecasting the Sales
of an Existing Business
• The forecast can be based on the existing track
record of the business
• Some considerations
– Forecasting in levels or changes
– Forecasting in real or nominal terms
– Weighting of historical data
– Forecasting based on underlying factors for which
forecasts exist

Combining Growth Rates and Current Sales
Levels to Forecast the Sales
of an Existing Business
Year -6 -5 -4 -3 -2 -1
Sales (millions) $2.0 $2.4 $2.7 $2.6 $2.6 $2.9
Sales Growth +20% +12.5% -3.7% 0% +11.5%
Inflation +3% +6% +7% +4% +2%
Change in Real GDP +3% +1.5% -1% -1% +2%
Average Sales Growth = 8.06%

Range = -3.7% to 20%

Forecasting in Real Terms
Year -6 -5 -4 -3 -2 -1
Sales Growth +20% +12.5% -3.7% 0% +11.5%
Inflation +3% +6% +7% +4% +2%
Real Sales Growth +17% +6.5% -10.7% -4% +9.5%
Average Real Sales Growth = 3.66%

Range = -10.7% to 17%

Using Weighting to Improve a Forecast
Year -6 -5 -4 -3 -2 -1
Weight Factor 1/15 2/15 3/15 4/15 5/15
Weighted Growth 1.13% 0.87% -2.14% -1.07% 3.17%
Weighted Average Real Sales Growth = 1.96%

Using Regression Analysis to Forecast
Regression Model:
Expected Real Sales Growth = 3.34% + 5.24 x Change in Real GDP
Year -5 -4 -3 -2 -1
Change in Real GDP +3% +1.5% -1% -1% +2%
Expected Sales Growth +15% +7.5% -5% -5% +10%
Difference +2% -1% -5.7% +1% -0.5%

Forecasting for a New Venture
• No track record on which to rely
• Yardstick approach
– Comparable firms in relevant dimensions
– IPO prospectuses
– Other data sources
• Fundamental analysis
– Market and market share
– Engineering cost estimates
– Demand-side approach - How much customers would buy
– Supply-side approach - How fast the venture can grow
– Credibility and support for assumptions
• Mixed approach

General Rules of Financial Forecasting
Part 1
• Build and support a schedule of assumptions.
• Begin with a forecast of sales.
• If sales growth is expected to track inflation, consider
forecasting sales in real terms.
• When using historical data to forecast, consider a weighting
scheme that focuses on the firm’s most recent experiences.
• For new ventures, choose several “yardstick” firms to use in
developing underlying assumptions regarding expected
performance.
• Integrate the pro forma balance sheet and income
statement variables through a financial model.
General Rules of Financial Forecasting
Part 2
• Consider time span. To assess financial need, project at least
until the firm expects follow-on financing. To determine
venture value, extrapolate to the point of harvest.
• Determine the planning horizon of the venture to establish
forecasting intervals.
• Test the model’s rationality by tracing line items across
financial statements.
• Apply sample scenarios and compare outcomes to estimates.
• Try a basic sensitivity analysis to ensure that the model yields
reasonable results when magnitudes and growth rates of key
variables change.

New Company Assumptions
Figure 6-5: Part I
1) Development will require 18 months, during which no sales will be made.
2) Initial sales of $10,000 in the 19th month.
3) Sales will grow 8% per month in real terms for three years and at the inflation rate
thereafter.
4) Cash operating expenses during the development period of $15,000 per month, plus
inflation.
5) Inflation at 9 percent per year.
6) A $200,000 production facility will come on line at the end of month 18. The facility is
to be leased by the company for the first 5 years of operation, with monthly payments
of $3,000.
7) Gross profit of 60% of sales revenue on materials costs with trade discounts.
8) Selling expenses of 15% of sales.
9) Administrative expenses of $2,000 per month beginning in month 19, growing at the
inflation rate, plus 15 percent of sales (Included in development period operating
expense total).
New Company Assumptions
Figure 6-5 Part II
10) Entrepreneur’s salary of $3,000 per month through the first full year of sales
(included in initial operating expenses), increasing thereafter by $500 per month.
11) Corporate tax rate of 45%. No loss carry forward.
12) All sales are for credit. The average collection period is 45 days. No discount for
prompt payment.
13) The inventory turnover rate is 5 times per year, measured against ending
inventory.
14) The company desires to maintain the greater of 30 days’ sales in cash or
$10,000.
15) All materials are purchased on credit, with terms of 2/10 net 30. The company
anticipates paying in time to receive the discount. The payables period is 10
days.
16) The entrepreneur will borrow any funds necessary at a rate of 1% per month.
17) Initial investment by the entrepreneur of $200,000. Additional financing as
needed by borrowing on a line of credit.

New Company Sales Forecast
Figure 6-6
(Forecast generated monthly, selected months shown)
M o n th S a le s
1 $0
12 $0
18 $0
19 $ 1 0 ,0 0 0
24 $ 1 5 ,2 5 3
30 $ 2 5 ,3 1 4
36 $ 4 2 ,0 1 2
42 $ 6 9 ,7 2 4
48 $ 1 1 5 ,7 1 7
54 $ 1 9 2 ,0 4 7
60 $ 2 0 0 ,8 5 3
66 $ 2 1 0 ,0 6 3
72 $ 2 1 9 ,6 9 5
78 $ 2 2 9 ,7 6 8

Chapter 6
The Framework of
New Venture Valuation
Learning Objectives
• Know the difference between a “hurdle rate” and a realized
rate of return.
• Know why hurdle rates for new ventures usually are higher
than realized rates of return.
• Know the difference between a hurdle rate and the

opportunity cost of capital.
• Know how to use the Capital Asset Pricing Model to

estimate cost of capital.
• Know how to use the risk-adjusted discount rate and

certainty equivalent forms of the CAPM.

Learning Objectives (continued)
• Know the limitations of the CAPM for new venture
valuation
• Know the differences between the CAPM and the Option

Pricing Model and be able to reconcile their use.
• Know how diversifiable risk affects expected returns.

• Know why the valuation of the entrepreneur is likely to be
different from that of the investor, and how to use the
information in deal negotiation.

The Many Uses of Valuation
• Strategic Planning
• Estate Planning
• Partnership formation and dissolution
• Initial public offering (IPO)
• Stock options and Employee stock ownership plans
(ESOPs)
• Mezzanine financing
• Negotiating a merger or sale of a venture

Valuation Myths
• Beauty is in the eye of the beholder.
• The future is anybody’s guess.
• Investors in new ventures demand very high expected
rates of return to compensate for the risks.
• The outside investor determines what the venture is worth.

Hurdle Rates For Venture Capital
Rates of Return (ROR) Sought by Venture Capital Investors
Stage Annual ROR% Typical Expected Holding

Period (Years)
Seed and start-up 50 - 100% or more More than 10
First stage 40 - 60% 5 – 10
Second stage 30 - 40% 4–7
Expansion 20 - 30% 3–5
Bridge and mezzanine 20 - 30% 1-3
LBOs 30 - 50% 3-5
Turnarounds 50% + 3-5
Jeffrey A. Timmons, New Venture Creation, 4th ed., (Irwin: Chicago) 1994, p. 512.

Venture Capital Realized Rates of
Return (based on various studies)
• 14% - 92 firms in ‘60s and ‘70s.
• 23% - before fees, 100 firms in the ‘60s
• 16% - public fund stock returns from 1959 to 1985.
• 27% - 11 firms from 1974 to 1979.
• 13.5% - from 1974 to 1989.
• 20.7% - from 1987 to 1996.
How are the hurdle rates reconciled with
realized rates?

Valuation Methods
• Value = Present value of future cash flows
• Two conceptually equivalent approaches
– RADR - Risk-Adjusted Discount Rate
Ct
PV  
t (1  rt ) t
– CEQ - Certainty Equivalent Cash Flow

Ct  RDt
PV  
t (1  rF ,t ) t
The choice of method depends on information availability.

Issues for RADR Valuation
• What cash flows should be valued?
• What discount rate should be used?

Factors Affecting the Discount Rate
for RADR Valuation
• Compensation for deferring consumption (time value)
• Compensation for bearing risk (risk premium)
• A measure of risk - the standard deviation of holding
period returns.
• The discount rate is not a matter of personal risk
tolerance.
– It is market determined
– It is based on opportunity cost
• The discount rate depends on the ability of an investor to

diversify.

Estimating the Discount Rate
• Opportunity cost of capital
• What discount rate should be used?
rj ,t  rF ,t  RPj ,t
• CAPM
RPj ,t   j , M (rM ,t  rF ,t )
 j ,M  j
j 
M
All measures are based on holding period returns.

The Feasible Set and the Efficient Set
of Risky Portfolios
Figure 8-2
Preferred portfolio of highly risk-averse investor
Preferred portfolio of risk-tolerant investor

Return
Efficient Set
Feasible Set
Risk
(Standard Deviation)

The Efficient Set, the Market Portfolio,
and the Capital Market Line
Figure 8-3
New preferred portfolio of highly risk-averse investor
New preferred portfolio of risk-tolerant investor
Return
Capital Market Line
rM
Efficient Set
Market Portfolio
rF
M Risk

How Portfolio Risk Depends on the
Number of Assets in the Portfolio
Figure 8-4
Risk
Portfolio
Diversifiable
Risk
M Non-diversifiable
Risk
Number of Assets in Portfolio

The Capital Asset Pricing Model
Figure 8-5
Return Security Market Line
rM
Market Portfolio
rF
1.0 Beta

Measures of Cash Flow
Expected Actual Cash Flow
Operating Cash Flow
Operating Cash Flow = EBIT + Depreciation Expense - Capital Expenditures -
Increase in NWC
Cash Flow to All Investors (both stockholders and creditors)
Total Capital Cash Flow + EBIAT = Operating Cash Flow - Actual Taxes
Cash Flow to Creditors (expected in light of default risk, potential
prepayment, potential additional borrowing)
Debt Cash Flow = Expected Interest Payments + Expected Net Debt Service
Cash Flow to Stockholders (expected in light of expected cash flows to
creditors)
Equity Cash Flow = Operating Cash Flow - Expected Interest Payments -
Expected Net Debt Service - Expected Actual Taxes
Other Measures of Cash Flow
Contractual Cash Flow to Creditors (assuming no default or prepayment)
Contractual Cash Flows to Creditors = Contractual Interest Payments + Contractual
Net Debt Service
Unlevered Free Cash Flow (expected if no debt financing)
Unlevered Free Cash Flow - Operating Cash Flow - Theoretical Taxes as Unlevered
Matching Cash Flows to Discount
Rates for Various Financial Claims
Figure 8-6
Financial Claim Cash Flow Discount Rate Comment

Cash Flows to All Total Capital rA = rF + A(rM – rF) The required rate of return on assets is used to value
Investors Cash Flow with cash flows that are actually expected to be received
Actual Financing by all claimants given the target capital structure of
the venture. The effect of tax deductibility of
interest payments is reflected in the cash flows.
Unlevered Free Total Capital WACC = (D/V)*(1-t*)rD + (E/V)*rE The Weighted Average Cost of Capital (WACC) is
Cash Flow to All Cash Flow with used to value hypothetical cash flows as if the
Investors All Equity venture were financed entirely with equity. In this
Financing case, the tax benefit of debt financing is reflected as
an adjustment to the cost of debt capital. The
correct tax adjustment is not the corporate tax rate,
but one that measure the net advantage of debt
financing, giving consideration to the offsetting
effects of personal taxes.
Cash Flow to Debt Cash Flow rD = rF + D(rM – rF) The cost of capital for debt depends on the extent to
Creditors which debt service payments are subject to market
risk.
Cash Flow to Equity Cash Flow rE = rF + E(rM – rF) The cost of capital for equity depends not on the
Stockholders total risk of the equity, but on the market component
of the risk.

Issues for CEQ Valuation
• What cash flows should be valued?
• How are risky cash flows adjusted to their certainty
equivalents?
• What is the discount rate for valuing certain future cash

flows?

The CEQ Form of the CAPM
• CAPM
RPj   j , M (rM  rF )
Cj  (C j , rM )( C / PV j )
 1  rF  j
(rM  rF )
PV j M
(rM  rF )
Cj   (C j , rM ) C
M j
PV j 
1  rF

Chapter 7
Financial Contracting
Learning Objectives
• Understand how and why staging and other real options
affect the values of new venture financial claims.
• Value the financial claims of a new venture using either

discrete scenario analysis or simulation.
• Use financing modeling and valuation techniques to study

game theoretic issues that arise for the parties to a new
venture.
• Construct financial contracts to signal information and align

incentives.
• Evaluate the effects of alternate financial contracts on the

values of the financial interests of the entrepreneur and
outside investor.
Valuation Template 6
Single-Stage Investment - Venture Capital Method
Income Statement Information
Year 0 1 2 3 4 5
Earnings Before Interest and After Tax ($500,000) ($200,000) $400,000 $1,400,000 $2,500,000
Cash Flow Information
External Funds Required to Support Operations $700,000 $700,000 $700,000 $700,000 $700,000 $0
Equity Capital Raised $3,240,927
Beginning Cash Balance $3,240,927 $2,642,564 $2,020,267 $1,373,077 $700,000 $0

Uses of Cash $700,000 $700,000 $700,000 $700,000 $700,000 $0
Cash Invested in Marketable Securities $2,540,927 $1,942,564 $1,320,267 $673,077 $0 $0
Return on Invested Cash $101,637 $77,703 $52,811 $26,923 $0 $0
Ending Cash Balance $2,642,564 $2,020,267 $1,373,077 $700,000 $0 $0
Investor Valuation and Ownership Allocation
Investor Hurdle Rate 50.00% 45.00% 40.00% 35.00% 30.00% 25.00%
Continuing Value Earnings Multiplier 15
Continuing Value of Venture $37,500,000
Required Future Value of Investment $24,610,789
Ownership Share Required 65.63%

Multi-Stage Investment - Venture Capital Method
Income Statement Information
Year 0 1 2 3 4 5
Earnings Before Interest and After Tax ($500,000) ($200,000) $400,000 $1,400,000 $2,500,000
Cash Flow Information
External Funds Required to Support Operations $700,000 $700,000 $700,000 $700,000 $700,000 $0
Equity Capital Raised $1,373,077 $1,373,077 $700,000
Beginning Cash Balance $1,373,077 $700,000 $1,373,077 $700,000 $700,000 $0
Uses of Cash $700,000 $700,000 $700,000 $700,000 $700,000 $0
Cash Invested in Marketable Securities $673,077 $0 $673,077 $0 $0 $0
Return on Invested Cash $26,923 $0 $26,923 $0 $0 $0
Ending Cash Balance $700,000 $0 $700,000 $0 $0 $0
Investor Valuation and Ownership Allocation
Investor Hurdle Rate 50.00% 45.00% 40.00% 35.00% 30.00% 25.00%
Continuing Value Earnings Multiplier 15
Continuing Value of Venture $37,500,000

Required Required
Investor's Required Future Value and Beginning Ending
Equity Share Share Share Value
Third Stage 2.43% 2.43% $910,000
Second Stage 10.30% 10.05% $3,767,723
First Stage 31.77% 27.80% $10,426,803
Ownership Required 40.28% $15,104,527

Determining the Required Shares of
Staged Investment
Equation (1) shows how the required fraction of equity can be
determined when future rounds of financing are anticipated.
Fraction of Equity Required = Ending Fraction of Equity Required x
(1 - Sum of Fractions Required by Investors in Future Rounds) (1)
Using this equation, the required share of the investor in the second
round is 10.30 percent.
10.30 % = 10.05 % / (100 % - 2.43 %)
Similarly, the the required share for the investor in the first round is
31.77 percent.
31.77 % = 27.80 % / (100 % - 2.43 % - 10.05 %)

Staging and Market Capitalization
Investors are disappointed if capitalization does not increase
from one round of financing to the next. Figure 13-2 shows why.
Investment Share of Equity

Round Investment Received Capitalization
First Stage $1,373,077 31.77% $4,321,992
Second State $1,373,077 10.30% $13,330,844
Third Stage $700,000 2.43% $28,806,584

Evaluating the Entrepreneur’s
Investment Based on Expected Returns
• Step 1: Estimate the expected cash return and total risk (standard
deviation of cash flows) of the entrepreneur’s financial interest in the
venture.
• Step 2: Estimate the expect cash return and risk of the
entrepreneur’s investment in the market portfolio.
• Step 3: Use the above results and the correlation between the
venture and the market to estimate the expected cash return and
total risk of the entrepreneur’s total portfolio.
• Step 4: Value the portfolio by the CEQ method (based on its total
risk).
• Step 5: Infer the value of the entrepreneur’s investment in the venture
by subtracting the market value of the entrepreneur’s investment in
the market index portfolio.

Single-Stage Investment with Discrete Scenarios
Valuing Financial Claims with Proportional Allocation
Market Information
Risk-free Rate of Interest 21.67%
Market Rate or Return 76.23%
Market Risk Premium 54.57%
Market Standard Deviation 44.72%
Correlation Between Venture and Market 0.445
Venture Cash Flows
Time 0 1 2 3 4 5
Success Scenario $ (2,500) $ 11,000
Failure Scenario $ (2,500) $ 3,000
Expected Cash Flow $ (2,500) $ 7,000
Standard Deviation $ - $ 4,000
Beta of Venture 1.00
Investor Interest and Value
Share of Investment 48.00%
Share of Equity 48.00%
Cash Flows
Value of Interest $ 1,905
NPV of Interest in Venture $ 705
Valuing Financial Claims with Proportional Allocation
(continued)
Entrepreneur Interest and Value
Entrepreneur's Wealth $2,000
Fraction of Wealth Invested in Venture 65%
Cash Flows of Investment in Venture
Cash Flows of Investment in Market
Expected Cash Flow $ (700) $ 1,234
Standard Deviation $0 $ 313
Portfolio Cash Flows
Standard Deviation $0 $ 2,237
Value of Entrepreneur's Investments
Value of Portfolio $ 1,762
Value of Investment in Market $ 700
Value of Interest in Venture $ 1,062
NPV of Interest in Venture $ (238)

Valuing Financial Claims with Equity Shifted to the Entrepreneur
Market Information
Venture Cash Flows
Time 0 1 2 3 4 5
Cash Flows
Failure Scenario $ (1,200) $ 983

Valuing Financial Claims with
Equity Shifted to the Entrepreneur (continued)
Fraction of Wealth Invested in Venture 65%
Value of Investment in Market $ 700

Single-Stage Investment with Discrete Scenarios:
Valuing Financial Claims with the Entrepreneur's Investment Reduced
Market Information
Venture Cash Flows
Time 0 1 2 3 4 5
Cash Flows

Valuing Financial Claims with the
Entrepreneur’s Investment Reduced (continued)
Fraction of Wealth Invested in Venture 34.75%
Success Scenario $ (695) $ 5,720
Failure Scenario $ (695) $ 1,560
Value of Investment in Market $ 1,305

How Changing the Contract
Affects Value
Investor initially contributes $1.2 million. Entrepreneur contributes $1.3 million,
including $500 thousand of human capital.
Allocation of Investor Investor Entrepreneur Entrepreneur Total

Returns Share of NPV Share of NPV NPV
Equity Equity
Proportional 48.00% $705,000 52.00% -$238,000 $467,000
Sharing
Increased Share 32.75% $100,000 67.25% $32,000 $132,000
to Entrepreneur
Reduce 48.00% $100,000 52.00% $478,000 $578,000
Investment of
Entrepreneur to
27.80% from
52%

Outside Investment Staged, but not Optional:
Valuing Financial Claims with Equity Shifted to the Entrepreneur
Market Information
Risk-free Rate of Interest 8.16% 21.67%
Market Rate or Return 25.44% 76.23%
Market Risk Premium 17.28% 54.57%
Market Standard Deviation 28.28% 44.72%
Correlation Between Venture and Market 0.3174 0.445
Venture Cash Flows
Time 0 1 2 3 4 5
Success Scenario $ (1,500) $ (1,082) $ 11,000
Failure Scenario $ (1,500) $ (1,082) $ 3,000
Expected Cash Flow $ (1,500) $ (1,082) $ 7,000
Standard Deviation $ - $ - $ 4,000
Share of Investment 53.67% 100.00%
Cash Flows
Success Scenario $ (805) $ (1,082) $ 5,280
Failure Scenario $ (805) $ (1,082) $ 1,440
Expected Cash Flow $ (805) $ (1,082) $ 3,360
Value of Interest -1000 $ 1,905

Valuing Financial Claims with Equity Shifted to the
Entrepreneur (continued)
Fraction of Wealth Invested in Venture 34.75%
Success Scenario $ (695) $ 5,720
Failure Scenario $ (695) $ 1,560
Value of Investment in Market $ 1,305

How Staging with Mandatory
Investment Affects Value
Investor contributes $1.2 million. Entrepreneur contributes $1.3 million, including $500
thousand of human capital.

Equity Equity
Single-Stage 48.00% $100,000 52.00% $478,000 $578,000
Investment of
Investor at
72.2%
Multi-Stage 48.00% $100,000 52.00% $478,000 $578,000
Investment of
Investor at
72.2%, not
optional

Game Tree for Staged Investment
Terminal nodes show NPV (entrepreneur, investor) Invest in NPV
Good state: second (1800,500)
Success is stage
Investor NPV likely
accepts offer (1000,100)
Entrepreneur
offers Do not NPV
Nature
multi-stage invest
chooses (400,-200)
investment
Investor NPV
rejects offer (0,0) Invest in NPV
Bad state: second (-200,-1800)
Success is stage
unlikely
Investor NPV
accepts offer (90,10) Do not NPV
Entrepreneur invest (200,-300)
offers
single-stage
investment
Investor NPV
rejects offer (0,0)

Investor Valuation of Discrete Scenarios with Second-Stage Investment Optional:
Value Is Conditional on Good State Occurring, Investor Is Assumed to Exercise Option
Market Information
Venture Cash Flows Probability at
Time 0 2 0 1 2 3 4 5
Success with Success Forecasted 0.5 0.9 $ (1,082) $ 11,000
Failure with Success Forecasted 0.5 0.1 $ (1,082) $ 3,000
Conditional Expected Cash Flow 1 0.9 $ (1,082) $ 10,200
Conditional Standard Deviation 1 0.1 $ - $ 2,400
Assumptions: Good State - Second-Stage Investment Made
Share of Equity Received for Second-Stage Investment 18.00%
Terminal Share of Equity from First-Stage Investment 25.36%
Initial Share of Equity from First-Stage Investment 30.93%
Total Share of Equity if both Stage Investments Made 43.36%
Total Cash Flows
Conditional Expected Cash Flow $ (1,082) $ 4,423
Conditional Standard Deviation $ - $ 1,041
Conditional Net Value of Total Interest at Time of Second-Stage Investment $ 2,518 $ (1,082) $ 3,599

Investor Valuation of Two-Stage Investment with Discrete Scenarios:
Comparison of Alternative States of the World and Second-Stage Investment Decisions
Assumptions: Good State - Second-Stage Investment Made
Total Cash Flows

Conditional Expected Cash Flow $ (1,082) $ 4,423
Conditional Standard Deviation $ - $ 1,041
Conditional Net Value of Total Interest at Time of Second-Stage Investment $ 2,518 $ (1,082) $ 3,599
Assumptions: Good State - Second-Stage Investment Not Made

Total Cash Flows

Success with Success Forecasted 1 0.9 $ - $ 1,856
Failure with Success Forecasted 1 0.1 $ - $ 928
Conditional Expected Cash Flow $ - $ 1,763
Conditional Standard Deviation $ - $ 278
Conditional Net Value of Total Interest at Time of Second-Stage Investment $ 1,478 $ - $ 1,478

Investor Valuation of Two-Stage Investment with
Discrete Scenarios (continued)
Assumptions: Bad State - Second-Stage Investment Made
Share of Equity Received for Second-Second Investment 18.00%
Terminal Share of Equity from First-Second Investment 25.36%
Total Cash Flows

Success with Failure Forecasted 1 0.1 -$1,082 $ 4,770
Failure with Failure Forecasted 1 0.9 -$1,082 $ 1,301
Conditional Expected Cash Flow -$1,082 $ 1,648
Conditional Standard Deviation $0 $ 1,041
Conditional Net Value of Total Interest at Time of Second-Second Investment $50 -$1,082 $ 1,132
Assumptions: Bad State - Second-Stage Investment Not Made

Total Cash Flows

Success with Failure Forecasted 1 0.1 $ - $ 1,856
Failure with Failure Forecasted 1 0.9 $ - $ 928
Conditional Expected Cash Flow $ - $ 1,021
Conditional Standard Deviation $ - $ 278
Conditional Net Value of Total Interest at Time of Second-Stage Investment $818 $ - $ 818

Investor Second-Stage Investment
Decisions
Expected Investor’s Stage- Total Equity Present Conditional

Outcome Two Decision Share Value NPV at Time 2
Success Invest 43.36% $3,599 $2,518
Success Do Not Invest 30.93% $1,478 $1,478
Failure Invest 43.36% $1,132 $50
Failure Do Not Invest 30.93% $818 $818

Entrepreneur Valuation of Discrete Scenarios with Second-Stage Investment Optional:
Investor's Second-Stage Investment Decision is Assumed to be Rational
Market Information
Correlation Between Venture and Market 0 0.445
Venture Cash Flows Probability at
Time 0 2 0 1 2 3 4 5
Success with Success Forecasted 0.5 0.9 $ (1,500) $ (1,082) $ 11,000
Failure with Success Forecasted 0.5 0.1 $ (1,500) $ (1,082) $ 3,000
Success with Failure Forecasted 0.5 0.1 $ (1,500) $ - $ 6,000
Failure with Failure Forecasted 0.5 0.9 $ (1,500) $ - $ 3,000
Expected Cash Flow $ (1,500) $ (541) $ 6,750
Standard Deviation $ - $ 541 $ 3,897
Initial Share of Equity from First-Stage Investment 30.93% 30.93%
Cash Flows
Success with Success Forecasted 0.5 0.9 $ (805) $ (1,082) $ 4,770
Failure with Success Forecasted 0.5 0.1 $ (805) $ (1,082) $ 1,301
Success with Failure Forecasted 0.5 0.1 $ (805) $ - $ 1,856
Failure with Failure Forecasted 0.5 0.9 $ (805) $ - $ 928
Expected Cash Flow $ (805) $ (541) $ 2,722
Standard Deviation $ - $ 541 $ 1,864
Present Value of First-Stage Interest $ 905 $ (500) $ 1,405
NPV of Option to Invest in Second Stage

Entrepreneur Valuation of Discrete
Scenarios with Second-Stage Investment
Optional (continued)
Terminal Share of Equity with Second-Stage Investment 56.64%
Share of Equity with no Second-Stage Investment 69.07%
Success with Success Forecasted 0.5 0.9 $ (695) $ 6,230
Failure with Success Forecasted 0.5 0.1 $ (695) $ 1,699
Success with Failure Forecasted 0.5 0.1 $ (695) $ 2,780
Failure with Failure Forecasted 0.5 0.9 $ (695) $ 1,390
Expected Cash Flow 1 0.9 $ (695) $ 4,028
Standard Deviation 1 0.1 $ - $ 2,043
Standard Deviation $ - $ 584

Staged Investment with
Abandonment Option
Investor contributes $1.2 million. Entrepreneur contributes $1.3 million, including $500
thousand of human capital.

Equity Equity
Single-Stage 48.00% $100,000 52.00% $478,000 $578,000
Investment of
Investor at
72.2%
Multi-Stage 48.00% $100,000 52.00% $478,000 $578,000
Investment of
Investor at
72.2%, not
optional
Multi-Stage 30.93% if $100,000 69.07% if no $833,000 $933,000
Investment of no second second stage
$1.5 million stage investment,
and $1.0 investment, 56.64% if both
million, with 43.36% if stages
entrepreneur both stages
investing $695
thousand in
first stage
Figures 13-11, 13-12

New Venture Simulation with Conditional Second-Stage Investment
Example Iteration of the Model (Dollar figures in thousands, except unit price)
Year 0 1 2 3 4 5
Market Potential 92.41 113.95 155.20 219.55 263.35

Price (dollars) $100 $100 $100 $100 $100
Potential Revenue $9,241 $11,395 $15,520 $21,955 $26,335
Total Investment
Investment $2,500 $0
Cum. Investment $2,500 $2,500 $2,500 $2,500 $2,500 $2,500
Total Income
Sales Revenue $9,241 $11,395 $15,520 $21,955 $26,335
Cost of Sales $7,393 $9,116 $12,416 $17,564 $21,068
Gross Profit $1,848 $2,279 $3,104 $4,391 $5,267
Operating Expenses $1,739 $1,912 $2,242 $2,756 $3,107
Interest Expense $73 $211 $382 $633 $778
Interest Income $0 $0 $0 $0 $0
Net Profit $109 $367 $862 $1,635 $2,160
Total Cash Flow

Beginning Cash $0 $0 $0 $0 $0
Operating Cash Flow $109 $367 $862 $1,635 $2,160
NWC Required $924 $1,077 $2,062 $3,218 $2,190
Free Cash ($815) ($709) ($1,200) ($1,583) ($30)
Borrowing $815 $709 $1,200 $1,583 $30
Repay Loan $0 $0 $0 $0 $0
Ending Free Cash $0 $0 $0 $0 $0

Simulation: Conditional Stage-2 Investment
(cont.) (Note: figures do not relate to prior slide
Total Cash Flow
Beginning Cash $0 $0 $0 $0 $0
Operating Cash Flow $178 $391 $817 $1,660 $2,092
NWC Required $982 $886 $1,774 $3,514 $1,799
Free Cash ($804) ($495) ($958) ($1,854) $293
Borrowing $804 $495 $958 $1,854 $0
Repay Loan $0 $0 $0 $0 $293
Ending Free Cash $0 $0 $0 $0 $0
Loan Balance $0 $804 $1,299 $2,256 $4,110 $3,817
Total Ending Value

Continuing Value $16,734
Plus: Free Cash $0
Less: Loan Balance $3,817
Value $12,916
Total Investment
Investor's First-Stage Investment $2,000
Investor's Second-Stage Investment $0
Entrepreneur's First-Stage Investment $500
Total Equity Share and Return

Investor's Share in First Stage 10.00%
Investor's Share in Second Stage 0.00%
Investor's Total Share 10.00% $1,292
Entrepreneur's Total Share 90.00% $11,625

Abbreviated Example: Iteration of New Venture Simulation Model
With Incremental Effects of Second-Stage Investment Identified
Year 0 1 2 3 4 5
Potential Revenue $9,192 $10,912 $15,895 $22,727 $32,784
Total Investment
Total Income
Sales Revenue $9,192 $10,912 $15,895 $22,727 $30,000
Net Profit $103 $309 $907 $1,727 $2,600
Total Ending Value

Value $15,402
Total Equity Share and Return

Entrepreneur's Total Share 90.00% $13,862
Investment - No Second Stage


Abbreviated Example (continued) (note: figures do
not relate to prior slide)
Income - No Second Stage
Sales Revenue $10,091 $18,815 $30,000 $30,000 $30,000
Net Profit $211 $1,258 $2,600 $2,600 $2,600
Ending Value - No Second Stage

Value $22,366
Equity Share and Return - No Second Stage

Entrepreneur's Share 90.00% $20,129
Incremental Investment - Second Stage

Investment $0 $5,000
Incremental Income - Second Stage

Sales Revenue $0 $0 $5,228 $20,758 $32,610
Net Profit $0 $0 $627 $2,491 $3,913
Incremental Ending Value - Second Stage

Value $18,771
Incremental Equity Share and Return - Second Stage

Investor's Incremental Share 27.00% $12,984
Entrepreneur's Incremental Share -27.00% $5,787

Valuing the Second-Stage Option Claims
by Discounting the Conditional Cash Flows
Market Information
Investor Interest and Value - Conditional Second-Stage Investment Only
Cash Flows
Expected Cash Flow $ - $ (5,000) $ 14,312
Present Value of First-Stage Interest $ 7,121 $ (5,000) $ 12,121

NPV of Interest in Venture $ 7,121

Valuing the Second-Stage Option Claims by
Discounting the Conditional Cash Flows (continued)
Entrepreneur's Wealth $ 2,000



Maximum Achievable Leverage (MAL) $ 3,811
Value of Entrepreneur's Investments - CAPM-based

Present Value of Portfolio $ 5,071
Present Value of Investment in Market $ 1,700
Present Value of Interest in Venture $ 3,371
Value of Entrepreneur's Investments - MAL


Valuing Financial Claims by Discounting All Expected Cash Flows
Market Information
Cash Flows
Expected Cash Flow $ (2,000) $ (2,475) $ 9,112
Standard Deviation $ - $ 2,501 $ 8,483
Present Value of First-Stage Interest $ 3,500 $ (2,288) $ 5,788


Valuing Financial Claims by Discounting All
Expected Cash Flow (continued)
Entrepreneur's Wealth $ 2,000



Maximum Achievable Leverage (MAL) $ 4,919
Value of Entrepreneur's Investments - CAPM

Value of Entrepreneur's Investments - MAL


Valuing Financial Claims by Discounting All
Expected Cash Flow (continued)
Decision Tree
Simulation Results Max. Trials = 1000
Statistics provided for:
Output Decision Tree Node Value

WHEN IS
1 Investor's Second Stage Investment No Condition > 0

2 Investor's Total Share No Condition > 0
3 Entrepreneur's Total Share No Condition > 0
4 Investor's Incremental Share Second Stage Investment Made > 0
5 Entrepreneur's Incremental Share Second Stage Investment Made > 0
Percentiles
Standard Successful
Average Median Skewness Minimum 25% 50% 75% Maximum
Deviation Trials
2525 5000 2501 -0.020 1000 0.000 0.000 5000 5000 5000
8925 6716 8281 0.363 1000 2.80 1190 6716 16441 26227
19421 15982 10559 0.451 1000 25.18 10707 15982 27994 44658
14237 14140 4114 -0.008 505 4593 11427 14140 16952 23185
7540 7441 5401 -0.052 505 -4644 3779 7441 11379 18033
Results of Simulating the Decision Tree
Number of
Variable Mean Standard Cases Where
Deviation Condition is
Satisfied
Investor’s Second Stage Investment -$2,475 $2,501 1000
Investor’s Total Share $9,112 $8,483 1000
Entrepreneur’s Total Share $19,505 $10,842 1000
Investor’s Incremental Share $14,312 $4,187 495
Entrepreneur’s Incremental Share $7,824 $5,429 495
Source: Results generated by Venture.SIMTM decision tree simulation routine

Search Results for Contract Terms that are Most Attractive for Entrepreneur
Assumptions Simulation Results
Second Investor Entrepreneur
First Round Round Probability of Conditional Investor Entrepreneur Conditional
Shares Shares Exercise Exercise NPV Total NPV Total NPV NPV
10% 5% 12,500 0.68 -$1,588 -$2,550 $3,497 $3,065
10% 5% 15,000 0.50 -$745 -$1,802 $4,174 $5,403
10% 5% 17,500 0.40 -$404 -$1,613 $3,066 $5,033
10% 5% 20,000 0.23 -$66 -$1,231 $2,420 $3,819
10% 5% 22,500 0.09 $30 -$935 $3,321 $2,019
10% 10% 12,500 0.68 -$551 -$1,491 $4,538 $2,298
10% 10% 15,000 0.50 $187 -$1,229 $4,005 $4,165
10% 10% 17,500 0.40 $364 -$905 $3,602 $4,488
10% 10% 20,000 0.23 $388 -$915 $2,618 $3,636
10% 10% 22,500 0.09 $256 -$996 $3,842 $1,771
10% 20% 12,500 0.68 $1,175 -$172 $4,071 $811
10% 20% 15,000 0.50 $1,766 -$371 $4,930 $3,148
10% 20% 17,500 0.40 $1,901 -$36 $4,781 $3,272
10% 20% 20,000 0.23 $1,363 -$183 $4,180 $2,775
10% 20% 22,500 0.09 $663 -$864 $4,389 $1,349
10% 30% 12,500 0.68 $3,045 $1,274 $4,124 -$407
10% 30% 15,000 0.50 $3,561 $1,500 $5,177 $1,536
10% 30% 17,500 0.40 $3,302 $932 $5,507 $1,940
10% 30% 20,000 0.23 $2,293 $229 $5,258 $1,803
10% 30% 22,500 0.09 $1,090 -$666 $5,390 $1,018
20% 5% 12,500 0.68 -$923 -$489 $3,258 $2,585
20% 5% 15,000 0.50 $48 $261 $4,447 $4,399
20% 5% 17,500 0.40 $333 $540 $3,259 $4,712
20% 5% 20,000 0.23 $472 $283 $1,912 $3,388
20% 5% 22,500 0.09 $270 $434 $2,667 $1,713
Simulation Tree Results Under Alternative
Market Potential Assumptions
Simulation Results Under Alternative Market Potential Assumptions:
Investor Receives 10% of Round 1 Equity and 30 percent of Total
Equity for Round 2 Investment
$6,000
$5,000
Net Present Value ($000)
$4,000
$3,000 Investor Conditional NPV

Investor Total NPV
Entrepreneur Total NPV
$2,000
Entrepreneur Conditional NPV
$1,000
$0
12,500 15,000 17,500 20,000 22,500
-$1,000
Potential Second Year Revenue ($000)

Chapter 8
Venture Capital
Historical Development of
Venture Capital as an Institution

Venture Capital New Commitments
Venture Capital New Commitments
$50,000
$45,000
$40,000
$35,000
Millions of Dollars
$30,000
$25,000
$20,000
$15,000
$10,000
$5,000
$0
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
Year
Sources: Statistical Abstract of the U.S. (various issues), Venture Economics Investor Service, Sahlman (1990).

Sources Sources
of Venture Capital
of Venture Capital Funds Funds
100%
90%
80%
70%
Foreign Investors
Percent of Total
60% Individuals
50% Corporations
Endowments
40%
Insurance Companies
30%
Pension Funds
20%
10%
0%
1978
1980
1982
1984
1986
1988
1990
1992
1994
Year 1996
Sources: Statistical Abstract of the U.S. (various issues), Gompers and Lerner (1996, 1997).

The Organizational Structure of a
Venture Capital Fund

Organizational Structure of
Venture Capital Investment
General Partners
– Generate deal flow – Negotiate deals
– Screen opportunities – Monitor and advise
– Harvest investments
Effort and Annual Carried

1% of Management Interest 20-
capital Fee 2-3% 30% of Gain Investment
Capital and
Portfolio
Effort
Venture Capital Fund Companies
Financial –Value creation
99% of Investment Capital Appreciation Claims
Capital 70-80% of Gain
Limited Partners
– Pension plan – Corporations
– Endowments – Individuals
– Life insurance companies
Summary of Terms:
Venture Capital Limited
Summary of Terms:
Partnership
Venture Capital Agreement
Limited Partnership Agreement
Venture.com VC Fund, L.P. (the “Fund”)
Terms and Provisions
Purpose
General Partner
Limited Partnership Interests
General Partner’s Investment
Minimum for Closing
Payment of Subscriptions
Term
Allocation of Profit and Loss
Distributions
Service Fee
Organizational Expenses
Conflicts of Interest
Other Restrictions and Limitations

Managing the Investment
Portfolio

Percent of time
Source: Zider (1998)

0%
5%
10%
15%
20%
25%
Soliciting Business
Selecting Opportunities
Allocation Allocation
©2000, Entrepreneurial Finance, Smith and Kiholm Smith

Analyzing Business Plans
Negotiating Deals
Directing and Monitoring

of Venture
Activity
Consulting
Recruiting Management
of Venture Capitalist
Assisting in Outside
Relationships
Time
Exiting
Capitalist Time
Chapter 14
The Venture Capital Investment
Process
Development of Fund Concept
Secure Commitments Generate Deal Flow

from Investors
Year 0
Closing of Fund
First Capital Call
2-3 years Screen Evaluate and Negotiate Additional Invest

Business Conduct Due Deals and Capital Funds
Plans Diligence Staging Calls
Value Creation and Monitoring

4-5 years
– Board service – Assist with external relationships
– Performance evaluation and review – Help arrange additional financing
– Recruitment management
2-3 years Harvesting Investment Distributing Proceeds

or more – IPO – LBO – Cash – Other
– Acquisition – Liquidation – Public Shares
7-10 years plus extensions

Incentive Conflicts and Structures

Key Covenant Classes
Key Covenant of Venture
Classes
CapitalCapital
of Venture Limited Partnerships
Limited Partnerships
Overall Fund Management
Investment in a single firm
Use of debt
Coinvestment by Venture Capitalist’s Other Funds
Reinvestment of profits
Activities of General Partner
Personal investing in portfolio companies
Sale of interest by General Partner
Fund-raising
Outside activities
Addition of General Partners
Types of investments
Restrictions on asset classes
Based on Gompers and Lerner (l997).

Chapter 9
Choice of Financing
A Partial List of Financing Sources for
New Ventures and Private Business
• Asset-based Lending • Registered Initial Public Offering
• Business Angels • Research and Development Limited
• Capital Leasing Partnerships
• Commercial Bank Lending (various forms) • Relational Investing or Strategic
• Corporate Entrepreneurship Partnering
• Customer Financing • Royalty Financing
• Direct Public Offering • Self (bootstrapping)
• Economic Development Program • Small Business Administration
Financing Financing
• Employee-provided Financing • Small Business Investment
• Equity Private Placement Company Financing
• Export/Import Bank Financing • Term Loan
• Factoring • Vendor Financing
• Franchising • Venture Capital
• Friends and Family
• Public Debt Issue
Factors That Affect the
Choice of Financing
• Financial needs of the venture

• Stage of Development
• Financial Condition
• Product-market Considerations
• Organizational Considerations
• Track Record/Reputation/Relationships

Financial Needs of the Venture
• Immediacy of the need
• Size of the immediate need
• Duration of the immediate need
• Cumulative need

Stage of Development
• Completeness of the management team

• Ease of communicating the venture’s merit
• Value of managerial/consulting services
• Importance of flexibility/adaptability

Financial Condition
• Risk/Return characteristics of the venture
• Taxable income status
• Operating cash flow status
• Time to a liquidity event
• Transferability of tax benefits to investors
• Available collateral
• Cash flow cycle

Product-market and Organizational
Considerations
• Importance of rapid growth
• Importance of relationship with a supplier or
distributor
• Dedication of distributors to the product

• Value of centralization of control

Track Record/
Reputation/Relationships
• Track record of the venture
• Importance of future financing needs
• Past failure or financial distress
• Likely failure in the near future
• Reputation of the entrepreneur
• Relationships with financing sources

Some Financing Choices
• Securitization
• Strategic investing
• Franchising
• Venture capital
• Angel investing
• Corporate venture investing
• SBA programs
• Direct public offering
• Factoring
• R&D Limited Partnerships
• Vendor financing
• Public offering

Comparison of Business Angel and Venture Capital Financing
Panel (a) Number of Deals Percent of Deals
with Venture with Venture

with Individual Capital with Individual Capital
Size of Financing Round Financing Financing Financing Financing
<$250,000 102 8 57.63% 4.62%
$250,000-$499,999 43 14 24.29% 8.09%
$500,000-$1,000,000 15 31 8.47% 17.92%
>$1,000,000 17 120 9.60% 69.36%
Total 177 173 100.00% 100.00%
Panel (b) Number of Deals Percent of Deals

with Venture with Venture
with Individual Capital with Individual Capital
Stage of Financing Financing Financing Financing Financing
Seed 52 11 29.38% 6.36%
Startup 55 38 31.07% 21.97%
First stage 29 56 16.38% 32.37%
Second stage 26 46 14.69% 26.59%
Third stage 10 19 5.65% 10.98%
Bridge 5 3 2.82% 1.73%
Total 177 173 100.00% 100.00%
Source: Freear and Wetzel (1990)

Estimates of Financing to Small Businesses and New
Ventures as of 1992.
Source Amount Percent

Principal owner 524.3 31.33%
Angel finance 60 3.59%
Venture capital 31 1.85%
Other equity 215.2 12.86%
Total equity 830.6 49.64%
Commercial banks 313.8 18.75%
Finance companies 82.1 4.91%
Other institutions 50.1 2.99%
Trade credit 264.1 15.78%
Other business financing 82.1 4.91%
Government 8.1 0.48%
From principal owner 68.5 4.09%
Credit cards 2.4 0.14%
Other individuals 24.5 1.46%
Total debt 842.9 50.37%
Total 1673.4 100.00%
Note: Includes all non-farm, non-financial, non-real estate small businesses
Source: Berger and Udell (1998).

Chapter 10
Harvesting
Harvesting Alternatives
• Initial public offering
• Private placement / private sale
• Roll-up IPO
• Management buy-out
• Employee stock ownership plan

The Underwritten IPO Process
• The role of the underwriter
– Issue pricing
– Due diligence
– Certification
– Distribution
– Market making
• Harvesting by going public
– In the IPO
– After the IPO
• Cost of public offering
• Cost of harvesting by going public

The IPO Issue Pricing Process
for a Firm Commitment Underwriting
Figure 16-1
New
Comparable New Information
Firm Values Information from
from Market
Market
Comparable
Transactions
Filing
and IPOs Issue Price
Preliminary Range
reported in
Estimate of reported in
Final
Value Preliminary
Prospectus
Discounted Prospectus
Cash Flow
Valuation
Indications of
New Interest from
Information Roadshow
Information from Due
from Issuer Diligence
“Take down”
Due Diligence
IPO Cost
• Underwriter fee: 5-7 percent of proceeds
• Direct issuing cost: 1-5 percent of proceeds
• Underpricing: 10-15 percent of proceeds
• Total : 16-27 percent of gross proceeds
17-31 percent of net proceeds

Cost of Harvesting by Going Public
• IPO usually is a small fraction of total value.
• Selling shareholders normally harvest in the aftermarket.
• Selling shareholders bear their share of the dollar-valued
cost of the IPO.
• Percentage cost of IPO is less important than percentage

cost of harvesting.

Private Placement / Private Sale
• Exchange modes
– Equity for cash
– Assets for cash
– Equity or assets for equity
• Valuation
– Discounts compared to public market value
– Cost of private sale
• Choice of public or private sale

Roll-up IPO
• The underlying theory of value creation
• The off-setting costs
• Structural solutions
• Net benefit (cost v. share value)
• Examples

Roll-up IPO
Figure 16-3
Owner of
Private
Company A
Exchange of
shares for Public
Owner of new shares, New
Private IPO Market
cash, and Company
Company B Investors
employment
contracts
Owner of
Private
Company C

Family-owned Businesses
and ESOPs
• Leveraged v. unleveraged ESOPs
• Advantages and disadvantages of ESOPs
• Valuation of ESOP shares
– to owners
– to employees

Structure of a Private Leveraged
ESOP
Figure 16-2 Owner/
Entrepreneur
Panel (a) ESOP Initiation
Sell shares to ESOP

trust for cash
Establish ESOP
Company
ESOP Plan Trust
Evaluation
of equity Cash loan
for fee secured by
Company shares
Valuation
Service Bank
ESOP
Panel (b) Annual Retirement Contribution Funding
Annual Funding of
Company retirement ESOP
employee
contribution Trust
retirement
Evaluation Loan
of equity repayment/ Employees
for fee Release of
shares
Valuation
Bank
Service

ESOP
Panel (c) Share Redemption at Employee Retirement
Annual Share
Company Retirement ESOP
redemption
contribution Trust
by Trust
Evaluation
of equity Employees
for fee
Valuation
Service

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Chapter 1

• Understand the centrality to new venture finance of the

• Briefly describe the evolution of thinking about the nature of

• Describe the process of new venture formation from inception

• Recognize that studying new venture finance can contribute to

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

• Value to the entrepreneur is different from value to

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

• More of a good is preferred to less.

• Present wealth is preferred to future wealth.

• Safe assets are preferred to risky assets.

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

Terminations with loss to creditors as

Maximum Value for the

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 1

• The CAPM-based valuation models used in the book do not

• Risk and expected return can be estimated, but not

• Not every new venture investment or financing decision

• Examples in the book are not intended to suggest that any

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Block and MacMillan (1992)

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Development Start-up Early Growth Rapid Growth Exit

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Sources of New Venture Financing

Development Start-up Early Rapid Exit

Black shading indicates primary focus of investor type.

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

Change in Equity Financing Change in S&P 500 Index

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

300 Straight--Investment Grade

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2

The Business Plan

• Know what to include and what to leave out.

• Understand how the plan can facilitate negotiation with outside

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

• Provides details on operation, financing, marketing, and

A set of hypotheses about an opportunity

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

• Consider aspects of strategy simultaneously, not

• Do not lose sight of the objective.

• Be prepared to respond to alternative proposals.

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

Alternative Product Market and Financing Choices:

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

• Make certain the audience is neither overloaded nor left to

• Identify the key assumptions as assumptions.

• Highlight the critical elements for success or failure.

• Include financial projections.

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

• Provide evidence of the quality and capabilities of people

• Provide evidence that key personnel are committed.

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

• Preempting rivals and first-mover advantage

• Using non-disclosure agreements

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 3