Entrepreneurial finance 1 - Wikipedia
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EntrepreneurialfinanceEntrepreneurial financeis the study ofvalue and resource allocation, applied tonew ventures. It addresses key questionswhich challenge all entrepreneurs: howmuch money can and should be raised;when should it be raised and from whom;what is a reasonable valuation of thestartup; and how should funding contractsand exit decisions be structured.
Depending on the industry and aspirationsof the entrepreneur(s) they may need toattract money to fully commercialize theirconcepts. Thus they must find investors –such as their friends and family, a bank, anangel investor, a venture capital fund, apublic stock offering or some other sourceof financing. When dealing with mostclassic sources of funding, entrepreneursface numerous challenges: skepticismtowards the business and financial plans,requests for large equity stakes, tightcontrol and managerial influence andlimited understanding of the characteristicThe problem
of growth process that start-upsexperience.On the other hand, entrepreneurs mustunderstand the four basic problems thatcan limit investors' willingness to investcapital:Uncertainty about the future: in terms ofstart-ups development possibilities,market and industry trends. The greaterthe uncertainty of a venture or project,the greater the distribution of possibleoutcomes.Information gaps: differences in whatvarious players know about a company's
investment decisions."Soft Assets": these assets are uniqueand rarely have markets that allow forthe measure of their value. Thus, lendersare less willing to provide credit againstsuch an asset.Volatility of current market conditions:financial and product markets canchange overnight, affecting a venture'scurrent value and its potentialprofitability.Venture capital as the business ofinvesting in new or young companies withHistory
innovative ideas emerged as a prominentbranch of Entrepreneurial finance in thebeginning of the 20th century. Wealthyfamilies such as the Vanderbilt family, theRockefeller family and the Bessemerfamily began private investing in privatecompanies. One of the first venture capitalfirms, J.H. Whitney & Company, wasfounded in 1946 and is still in businesstoday. The formation of the AmericanResearch and Development Foundation(ARDC) by General Georges F. Doriotinstitutionalized venture capital after theSecond World War. In 1958, the SmallBusiness Investment Companies (SBIC)license enabled finance companies to
leverage federal US funds to lend togrowing companies. Further regulatorychanges in the USA –namely the reductionof capital gains tax and the ERISA pensionreforms- boosted venture capital in the1970s. During the 1980s and 1990s, theventure capital industry grew inimportance and experienced high volatilityin returns. Despite this cyclicality andcrisis such as Dot Com; venture capitalhas consistently performed better thanmost other financial investments andcontinues to attract new investors.
Financial bootstrappingFinancial Bootstrapping is a term used tocover different methods for avoiding usingthe financial resources of externalinvestors. It involves risks for the foundersbut allows for more freedom to developthe venture. Different types of financialbootstrapping include Owner financing,Sweat equity, Minimization of accountspayable, joint utilization, minimization ofinventory, delaying payment, subsidyfinance and personal debt.Sources of entrepreneurialfinancing
External financingBusinesses often need more capital thanowners are able to provide. Hence, theysource financing from external investors:angel investment, venture capital, as wellas with less prevalent crowdfunding,hedge funds, and alternative assetmanagement. While owning equity in aprivate company may be generallygrouped under the term private equity, thisterm is often used to describe growth,buyout or turnaround investments intraditional sectors and industries.
Business angelsA business angel is a private investor thatinvests part of his or her own wealth andtime in early-stage innovative companies.It is estimated that angel investmentamounts to three times venture capital. Itsbeginnings can be traced to FrederickTerman, widely credited to be the "Fatherof Silicon Valley" (together with WilliamShockley), who invested $500 to helpstarting up the venture of Bill Hewlett andFred Packard.
Venture capitalVenture capital is a way of corporatefinancing by which a financial investortakes participation in the capital of a newor young private company in exchange forcash and strategic advice. Venture capitalinvestors look for fast-growing companieswith low leverage capacity and high-performing management teams. Theirmain objective is to make a profit byselling the stake in the company in themedium term. They expect profitabilityhigher than the market to compensate forthe increased risk of investing in youngventures. In addition to this, there are also
corporate venture capitalists (Corporateventure capital) that strongly focus onstrategic benefits.[1]Key differences between business angelsand venture capital:Own money (BA) vs. other people'smoney (VC)Fun + profit vs. profitLower vs. higher expected IRRVery early stage vs. start-up or growthstageLonger investment period vs. shorterinvestment horizon
BuyoutsBuyouts are forms of corporate financeused to change the ownership or the typeof ownership of a company through avariety of means. Once the company isprivate and freed from some of theregulatory and other burdens of being apublic company, the central goal of buyoutis to discover means to build this value*.This may include refocusing the missionof the company, selling off non-coreassets, freshening product lines,streamlining processes and replacingexisting management. Companies withsteady, large cash flows, established
brands and moderated growth are typicaltargets of buyouts.There are several variations of buyouts:Leveraged buyout (LBO): a combinationof debt and equity financing. Theintention is to unlock hidden valuethrough the addition of substantialamounts of debt to the balance sheet ofthe company.Management buyout (MBO),Management buy in (MBI) and Buy inmanagement buyout (BIMBO): privateequity becomes the sponsor of amanagement team that has identified a
business opportunity with a price wellabove the team's wealth. The differenceis in the position of the purchaser: themanagement is already working for thecompany (MBO), the management isnew (MBI) or a combination (BIMBO).Buy and built (B&B): the acquisition ofseveral small companies with theobjective of creating a leader (highlyfragmented sectors such assupermarkets, gyms, schools, privatehospitals).Recaps: re-leveraging of a company thathas repaid much of its LBO debt.
Secondary Buyout (SBO): sale of LBO-company to another private equity firm.Public-to-private (P2P, PTOP): takeoverof public company that has been'punished' by the market, i.e. its pricedoes not reflect the true value.ImportanceFinancial planning allows entrepreneurs toestimate the quantity and the timing ofmoney needed to start their venture andkeep it running.Major entrepreneurialfinancial planning
The key questions for an Entrepreneur are:Is it worthy to invest time and money inthis business?What is the cash burn rate?How to minimize dilution by externalinvestors?Scenario analysis and contingency plan?A start-up's chief financial officer (CFO)assumes the key role of entrepreneurialfinancial planning. In contrast toestablished companies, the start-up CFOtakes a more strategic role and focuses onmilestones with given cash resources,changes in valuation depending on their
fulfilment, risks of not meeting milestonesand potential outcomes and alternativestrategies.Determination of the financial need ofa start-upThe first step in raising capital is tounderstand how much capital you need toraise. Successful businesses anticipatetheir future cash needs, make plans andexecute capital acquisition strategies wellbefore they find themselves in a cashcrunch.Three axioms guide start-up fund raising:
As businesses grow, they often gothrough several rounds or stages offinancing. These rounds are targeted tospecific phases of the company'sgrowth and require different strategiesand types of investors.Raising capital is an ongoing issue forevery venture.Capital acquisition takes time and needsto be planned accordingly.Four critical determinants of the financialneed of a venture are generallydistinguished:
Determination of projected sales, theirgrowth and the profitability levelCalculation of start-up costs (one-timecosts)Estimation of recurring costsProjection of working capital (inventory,credit and payment policies. Thisdetermines the cash needed to maintainthe day-to-day business)Typically, venture capitalists are part of afund. Their average size in Europe includesfive investment professionals and twosupports. They generate income throughmanagement fees (on average 2.5%annual commission) and carried interest
("Carry", on average 20–30% of the profitsof the fund).Financial planning also helps to determinethe value of a venture and serves as animportant marketing tool towardsprospective investors.Traditional valuation techniques based onaccounting, discounting cash flows(Discounted cash flow, DCF) or multiplesdo not reflect the specific characteristicsof a start-up. Instead, the venture capitalValuation in entrepreneurialfinance
method, the First Chicago or thefundamental methods are usually applied.Venture capital methodTo determine the future value of a start-up,a venture capital investor is guided by thequestion: What percentage of the portfoliocompany should I have at exit toguarantee that I get the IRR committedwith my investors?The valuation of the future company canbe broken down into four steps:Determination of company's value atexit
Requested fraction (percentage) of theVC at exit?Number of shares to be bought in thecurrent round of financing to get thedesired percentage of the companyEstimation of maximum price per sharewilling to pay in current round offinancingUsually there is more than one round offinancing. Venture capital investorsgenerally prefer staged investments toreduce the money invested at the higherrisk and control entrepreneurs viamilestones. Entrepreneurs benefit fromdilution in future rounds by reducing the
price of the shares to be exchanged forfinancing.Entrepreneurial finance courses areoffered in different universities, forexample at Babson College, the SternSchool of Business, the Kellogg School ofManagement, Peking University HSBCBusiness School, and ESADE. Specialcenters to promote entrepreneurshipwithin universities also cover financetopics, for example the Center forInternational Development at HarvardUniversity, which works to generate sharedUniversity education
and sustainable prosperity in developingeconomies [2]1. Röhm, P., Köhn, A., Kuckertz, A. andDehnen, H. S. (2017) A world ofdifference? The impact of corporateventure capitalists’ investmentmotivation on startup valuation (https://www.researchgate.net/publication/314070583_A_world_of_difference_The_impact_of_corporate_venture_capitalists%27_investment_motivation_on_startup_valuation). Journal of BusinessEconomics. doi:10.1007/s11573-017-0857-5Notes
2. Center for International Developmentat Harvard,[1] (http://www.hks.harvard.edu/centers/cid/programs/entrepreneurial-finance-lab-research-initiative),2011Alemany, L. (2014) "Entrepreneurial Finance:Lecture Slides, ESADE Master in Innovationand Entrepreneurship Year 2013/2014",ESADE, Barcelona.Alemany, L. (2007) Business Angels: There'smore to it than Money for Entrepreneurs,ESADE Alumni Magazine.References
Bartlett, J. and Economy, P. (2002), RaisingCapital for Dummies, Wiley, Hoboken. ISBN0-7645-5353-4.Berkery, D. (2007), Raising Venture Capital forthe Serious Entrepreneur, McGraw-Hill BookCompany, New York. ISBN0-07-149602-5.Gompers, P. and Lerner, J. (2011), The Moneyof Invention, Harvard Business School Press,Boston. ISBN1-57851-326-X.Kocis, J., Bachmann, J., Long, A. and Nickels,C. (2009), Inside Private Equity, Wiley,Hoboken. ISBN0-470-42189-4.Ante, S. (2008) Creative Capital: GeorgeDoriot and the Birth of Venture Capital,Books
Harvard Business School Press, Boston.ISBN1-4221-0122-3.Perkins, T. (2007) Valley Boy: TheEducation of Tom Perkins, Gotham,London. ISBN1-59240-403-0.Feld, B. (2016), Venture Deals: BeSmarter Than Your Lawyer and VentureCapitalist, ISBN1-11925-975-4.Entrepreneurial course at HarvardBusiness School (2011):http://www.hbs.edu/mba/academics/coursecatalog/1624.htmlExternal links
Entrepreneurial course at M.I.T. (2002):http://ocw.mit.edu/courses/sloan-school-of-management/15-431-entrepreneurial-finance-spring-2002/Minor in Entrepreneurship at UniversidadFrancisco Marroquín (2011):https://web.archive.org/web/20110721085215/http://en.ufm.edu.gt/en/content.asp?id=174&tdi=1Joel Stern on Latin AmericanEntrepreneurs:http://newmedia.ufm.edu/gsm/index.php/Sternevainterview
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