Entrep Finance Lecture Notes Week 17 PDF

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Week 1: Introduction to Entrepreneurial FinanceEntrepreneurial Finance (EF) – provision of funding to young, innovative, growth-oriented companies  Young: < 10 years  Innovative: tech or business model  Growth-oriented: different from SMEs (small-medium-enterprises)EF sits at the intersection ...

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Week 1: Introduction to Entrepreneurial Finance Entrepreneurial Finance (EF) – provision of funding to young, innovative, growth-oriented companies  Young: < 10 years  Innovative: tech or business model  Growth-oriented: different from SMEs (small-medium-enterprises) EF sits at the intersection of Corporate Finance and Entrepreneurship EF is the epicentre of a clash of two worlds – entrepreneurship and finance Combining the perspective of entrepreneurs and investors may reveal new horizons which can result in creation of innovative companies that disrupt industries and business models, generate wealth and improve peoples lives

Three Fundamental Principles: 1. Entrepreneurship as a recombination of existing resources to create new sources of value (J. Schumpeter) i. Entrepreneurs need to convince resource owners to provide them ii. Financing is a key resource because money allows the entrepreneurs to acquire other resources iii. GATHERING RESOURCES AND COMBINING THEM IN A NOVEL AND VALUABLE WAY 2. The entrepreneurial process is inherently uncertain (F. Knight) i. Risk: outcome of a process is not known in advance but there is reliable information about the underlying probability distribution of outcomes

ii. Uncertainty: range of outcomes and their probabilities are themselves unknown

Entrepreneurial process lacks reliable information about the range or likelihood of outcomes 3. Entrepreneurship consists of experimentation and dynamic flexibility (J. March) i. ‘Exploration’ by entrepreneurial companies vs. ‘Exploitation’ by established companies ii. Organisational structure matters for incentives and the ability to ‘pivot’ (adapt dynamically to market feedback) The first principle implies that the money offered by investors will play a vital role in the development of the venture The second principle says that investors will have to live with uncertainty at every step of the process The third principle suggests that investors too, need to be flexible when working with entrepreneurs.

Together, these principles imply that the process of financing start-ups proceeds in stages, where at every stage one faces uncertainty, experimentation and learning.

Why is EF challenging? 

Entrepreneur P.O.V o Getting funded is hard o Bewildering diversity of investors with different characteristics and so difficult to reach out to

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Investor P.O.V o Swamped with proposals – most of them are bad/or a poor fit o Long and costly investment process to get their money back  

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Established businesses may be able to talk to their banker, but for entrep. there is not a banker they can talk to. They need to look for different type of investors, each with their own decision processes and objectives. Once they are in-front of investors, entrepreneurs have to pitch their businesses, often at a point in time where all they have are ideas but no proofs. If they actually manage to convince investors, they need to answer myriad questions about how much they need and for what purposes - they have to negotiate a price for the investment Even after the money arrives, investors can be demanding and or may actually want their money back Managing investors is challenging Both worry about the same challenges - finding a good match, striking a good deal, surviving the ride, and finding their way to a successful exit

Why is EF important? 

Entrepreneur P.O.V o Money is a key resource o Investors impact company

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Investor P.O.V o Search for returns, portfolio diversification, or strategic objectives o Pass on knowledge and expertise

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Economic and Social P.O.V o Market-driven selection system o Create jobs, innovation, and economic growth

The Drivers of Long-Term Growth:  Start-ups that have received VC funding have higher TFP than a control group of start-ups without it  VC generates more innovative outputs than corporate R&D spending

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Increases in local VC-funding increase the local start-up rate, employment and aggregate income o EF leads to economic growth  

Driver of economic growth since they advance new technologies, products and business models Innovation and R&D increase TFP leading to EG

Which Companies Create Jobs?  What matters is net job creation – jobs created less jobs destroyed  Young firms make a very significant contribution to net job create, but cannot be said for small firms  Only few gazelles (fast growing start-ups) eventually become large companies as many die out during their growth  Start-ups create jobs and drive innovation  VC-backed start-ups account for 5.5% of all US employment The FIRE Framework: PROCESS OF HOW ENTREPRENUERS AND INVESTORS INTERACT THROUGHOUT THE INVESTMENT CYCLE 

Fit – matching process of how entrepreneurs and investors find each other and assess their mutual fit o Entrepreneur and investor face a search challenge  Who are relevant partners, networking, information gathering, processing o Entrepreneur and investor face a selection challenge  Screening and signalling by both parties  Deep DD; track records, credibility, ‘clicking’

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Invest – closing a deal, where the entrepreneur obtains money from the investor in exchange for a financial claim, with conditions specified in a contract o 4 main forces impacting the deal:  Entrepreneur needs – company requirements and own preferences  Investor needs – own preferences (see FUEL framework)  Expectations – on the venture’s future  Market conditions – parties’ relative bargaining power

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Ride – path forward, where the entrepreneur and investors navigate through the process and encounter challenges o Entrepreneur and investor help grow the company  Learning – discover about the company, the market, and each other  Adjust – pivot strategy, build/destroy trust  Governance – who chooses when there is a disagreement  Role of board – of directors

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Exit – end of the journey and so when investors obtain a return on their investments o Returns are realised

o When to exit?  Timing constraints of different parties – conflicts? o How to exit?  Success (sale) option: IPO, SPAC, acquisition, sale to financial buyer (secondary/buyout)  Failure: closing down, with or without bankruptcy Staged Financing:  FIRE encompasses staged financing o Money is provided over several rounds every 12/18 months o Milestone-based o Staging vs. tranching  Entrepreneur and investor both face costs and benefits, but often staging is mutually advantageous 

For the entrepreneur: o reduces fundraising cost and dilution o introduces refinancing risk (internal and external)

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For the investor: o creates option value of waiting o increases control through the ‘power of the purse’

Rounds – consecutive and numbered  Each round corresponds to a set of securities, called Series and in alphabetical sequence (A,B,C)  Pre-VC rounds are called Seed

The FUEL Framework: NOT ALL INVESTORS ARE THE SAME – EXAMINES THE DIFFERENCES ACROSS INVESTOR TYPES 

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Fundamental Structure o What is the investor’s fundamental identity, organisational structure and decision-making process and governance structure? Underlying Motivation o What does the investor want, how important are financial and non-financial returns to the investors and how risk tolerant and patient is the investor? Expertise and Networks o What does the investor offer, what does the investor bring and what networks can be drawn upon? Logic and Style o How does the investor operate, what logical criteria does the investor use to select companies, what is the investors style of interacting with companies?

Week 2: Evaluating Venture Opportunities Evaluating a Business Opportunity:  Absolute and relative evaluation 

Importance of conceptual strength – method vs. ‘gut feeling’

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A key exercise for the entrepreneur in order to anticipate investor’s view: o Will the opportunity be able to generate the returns an investor seeks for given risk? o How can the opportunity be refined and improved? o Venture Evaluation Matrix tool

Key Actors:  Customer  Demand  Company  Supply  Entrepreneur  Implementing a Solution Key Perspectives:  Value Proposition (micro)  can the company create value?  Industry (macro)  can the company scale up?  Strategy (dynamic)  can the company capture value? Venture Evaluation Matrix (VEM):

VEM allows to draw conclusions across rows by assessing the attractiveness of the venture in three perspectives: 1. Ability to create value 2. Ability to achieve scale 3. Ability to grow and capture scale

VEM allows to draw conclusions across columns by assessing the competitive advantages of the venture in three domains: 1. Ability to gain access to customers 2. Ability to erect and maintain entry barriers 3. Ability to develop key competences VEM allows assessing the venture’s main risks, also across the three vertical dimensions: 1. Market risk 2. Technology risk 3. People risk Risks --> along the rows of the VE matrix  First row shows that the venture may fail to create enough value because there is no real customer need and no proper solution, or because of an inadequate founder team  Second row points to the risk that the venture is limited in scale - this may happen if the market turns out to be small, if powerful competitors erode too much market share, or if the founders' networks is insufficient.  Third row shows the risk that the venture fails to capture economic value and is unable to generate profits - this happens if the revenue model and the cost model do not allow the venturer to capture the value it creates, or if the founders fail to create a capable organisation.

VEM Logic:  Evaluate the strength of an entrepreneurial idea by assessing how it proves able to generate value o Start with micro perspective, move to the macro perspective and to the ability to be dynamically sustainable 

Derive the opportunity’s competitive advantages and attractiveness

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Assess the long-term economic viability of the opportunity o Solid o Comprehensive o Easy to use

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VEM takes both entrepreneur and investor perspectives into account

Need:

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Know your customer! o What exactly is the customer need?

o How strong is the need, and how well do customers understand it? o How much are the customers able and willing to pay? 

Individual vs. corporate customers; decision process

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Learning from early adopters, iterative exploration

Solution:

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Know your product! o Does the proposed solution solve the customer’s need? o How does the proposed solution compare to the alternatives? o To what extent can the innovation be protected?

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Role of product experimentation, customer vs. solution

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Nature of innovation, compelling or not? o How to come up with the right solution? Design thinking

Team:

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Talent is the scarce resource: o Do the founders have the required skills + experience? o Do the founders have sufficient motivation and commitment? o Is the founder team complementary and cohesive?

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Importance of integrity and trustworthiness

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Solo founder vs. founding teams

Market:

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How big is the opportunity? o How large is the target market? o How fast will the market grow? o How will the customer adapt?

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Transformative vs. incremental innovation

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Adaption process and market timing

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Product life-cycle: S Curve

Competition:

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Know your competitors! o Who are the current + future competitors? o What is the nature of the competition? o How can the venture differentiate itself?

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Co-operation vs. competition

 Nature of barriers to entry and product longevity Network:

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The founder’s network allows to access resources o What is the reputation of the founder team?

o What networks does the team have access to? o How does the team forge and maintain new relationships? 

Importance of network centrality

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Quality of network ties: connectedness, diversity, position

Sales:

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How is the product brought to customers? o How does the venture reach its customers? o What is the distribution strategy? o What are the revenue model and pricing strategy?

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Transformative vs. incremental products o Natural resistance to adopt – adoption costs

Production:

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How does the company capture value creation? o What is the development strategy? o What is the scope of activities, and what partnerships are necessary? o How efficient are operations?

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Importance of technical milestones / key inputs

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Choice on the boundaries of the firm

Organisation:

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How to develop and maintain company leadership? o How will the founder team expand and evolve? o What is the governance structure? o What is the talent strategy?

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Developing a cultural imprint

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Talent recruiting and retention

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Founder’s succession

How Entrepreneurs can use the VEM: 

To look at the S+W of their venture, and assess whether: o It is fully convincing o It requires some dose of pivoting o It should be dropped

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Provides a framework for testing the strength of the business opportunity: o Identifies where uncertainty is greatest o It exposes the assumptions that underlie the opportunity o It reflect where the business model is rooted

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Is the opportunity cogent and convincing? o Which parts can be improved or are sinking the project? o Role of the VEM at different stages of development

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If the entrepreneur decides to proceed with contacting investors, they can use the VEM to structure their business plan

Business Plan (BP):

1. A strategic framework for guiding the venture 2. A document for describing it to outside parties BP provides a structured narrative along the VEM logic Main purpose is to describe the venture’s current state and to indicate the direction of travel BP requires:  An overview of the business opportunity  A detailed, but concise, analysis of the main challenges  A set of financial projections VEM and BP:

‘Signalling your venture’:  ‘adverse selection’  consequence of asymmetric information 

When entrepreneurs aim to sell shares in their venture, whose quality is difficult to tell

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Pitching the BP and engaging in DD help reducing asymmetric information and make markets for new ventures viable

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Costly ‘signalling’ can help one party to convince the other party of the veracity of their claim o To be credible the signal must be costly  e.g. entrepreneur must work hard enough to rack up initial sales, rather than simply promise them

E needs to pitch their ideas and require some kind of a business plan. Investors screen their venture proposals, sorting through large number of investment proposals and performing due diligence on the most interesting ones. The goal for this first step is to identify a match between E and I. With that the two parties can proceed to explore the possibility of an investment.

Role of Financial Projections:  Verifying the assumptions underlying the BP

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Focus on operational viability and profitability

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Focus on timing and milestones  e.g. what financial resources are needed?

Financial Projections reflect the underlying BP 

P&L statements identify the underlying profitability

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Balance Sheets identify the growth pattern

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Cash flow statements identify the timing and extent of the funding needs, and allow for testing alternative financial plans o Importance of delaying fundraising to avoid dilution

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Importance of crystallizing entrepreneur’s expectations

How can Investors use the VEM: 1. For a first screening, using the spreadsheet tool 2. For guiding DD, providing a structured approach to a decision 

Investors can make the VEM operational with a simple radar chart that summarises and visualises our assessment: o Comparative advantages and risks (columns) o Assessment of each perspective (rows)

DD – how investors figure out the venture’s business fundamentals, considering how convincing are the assumptions underlying the BP  Time consuming activity  only when investor is already inclined to invest and has negotiated a preliminary deal structure (term sheet) Investor DD:

Customer Dimension:  Need  verified by asking directly to customers

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Market  requires secondary market research Sales  verifying the quality of customer access

Technology Dimension:  Solution  verified by expert testing of the technology  Competition  assessed with primary and secondary market research  Operational efficiency  verifying that milestones are appropriate and can be benchmarked to the operations of competitors Talent/People Dimension:  Evaluating the team  requires fact checking but also evaluating entrepreneurial vision and group work  Networking  evaluated by looking at the professional standing of the founders  Organisation  being able to guide a large org. and transiting leadership to new hands

Lecture 3 – The Financial Plan: Financial Projections – managerial accounting tools that look forward rather than financial accounting tools that serve the purpose of reporting past facts Aims to move investors from appreciating the business concept to seeing its financial potential. Provides key inputs into the valuation, concerning the amount of financing required and the venture’s expected future profitability. Two Key Questions: 1. How financially attractive is the venture a. Financial goals – where to get to 2. What financial resources does the venture need? a. Financial means – how to (financially) get there Do we always need a financial plan?  Balance detail/analysis and realism – should be appropriate to the stage and nature of the venture 

Early stage – quarterly/monthly up to 2 years forward

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Later stage – lower frequency but further out into the future

Getting financial projections takes time and effort, so does every entrepreneur need them?

We would argue that while the level of optimal detail differs across situations, all entrepreneurs who want to engage investors benefit from developing quantitative forecasts From the entrepreneur's perspective, the FP is an important ingredient to illustrate the business strategy underlying the pitch. From the investor's perspective, examining the FP is part of screening Our purpose of the FP is thus to allow the two parties to calibrate their expectations and verify if there is a fit.

Role of Financial Projections Financial Projections  Project Financial Future  Financial Plan  Answer 2 Key Questions  Business Plan  Propose Business Venture How Much Money Do You Need? Financing Gap – growing sales require greater asset base and cause financing gap

Financing Plug – filling of gap with additional short-...