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Cases
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Which options do they face in starting up their company, who invest their company in each stage.
How to measure the value of your project? The value of your start-up?
Now you know the value, how to structure ow? How to get an investor? They have different views and
goals about your venture.
Crowdfunding. Not much literature about this yet, but we will look why it is so important and what are
the challenges investing in firms based on crowdfunding
Employee compensation in the early stages and how do you split equity, the ownership of the firm.
How do you pay employees if you dont have cash yet
Exit strategy (IPO), research and finance sees this as most important. If you start a new venture, you
need to raise capital, you need exit strategy; at some point you have to make the decision: sell your
company, open the capital/ownership of the company or you make the shares tradable. Why exit
strategy so important? Answer (class) investors want to know what they get back from the company if
they invest in it. Answer (teacher): some point every company have to make a big step. Besides, the
investor want something back (liquidity) in the end of the process to make the investment profitable.
Notes: new ventures are not like large corporations, see 5 points above)
8 Important differences
1. Interdependence between investment and financing decisions
o In CF, they are treated as independent.
o In the case of large companies, there are three types of dependence and different managers,
everyone has their own rule. In the case of entrepreneurial finance, in each step, in each stage of the
process of creating the firm, you face new challenges and new financial sources and based on every
decision you make in each stage, you go after source A or source B to raise capital and you talk
about those sources later.
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Value that Entrepreneur puts in a project and value that shareholders add
o The value that entrepreneurs put in a project and the value of shareholders
o They have different views of the world, the product. But also different discount factors,
see time in a different way, different value of time and different expectations how
profitable the project is.
o In public corp., the focus is on returns to shareholders.
o Entrepreneurs are not always interested in maximizing share value or the value of the company
itself, but they are interested in something else (he doesnt say what)
of debit) that amount + some assets (so you go broke). In the case of equity, you share the losses; your loss is
their loss as well. So in some case, raising debt in the early stage is too risky.
Sources of venture financing
- Secured Lenders
o They provide debt capital to businesses with collateral.
- Venture Leasing and Trade Credit
o For ventures that need equipment and supplies.
o So you use the machinery or supply and promise the other party that you will pay for it when
you have enough money and till that time you pay an amount per month/year
- Government Programs
o Subsidize credits to some projects (energy, oil winning, water, etc.)
o Not only money, but also equipment, building, assistance, etc.
- Banks (Private Debt)
- Public Debt (Bonds)
o Bonds = its debit but its tradable
- Initial Public Offering (IPO)
o You make everything tradable.
o Firm sells registered equity shares
Sources & Stages
And what about crowdfunding? Definition crowdfunding: its a way of inviting investors to give a small
amount to your business. Fits best in R&D stage and start-up stage. There are two types of crowdfunding, debt
and equity crowdfunding. Most common is equity crowdfunding: they give you a small amount and you give a
small share of the company of a small share of the idea to this person.
Website to get in contact with Angel investors: www.angellist.com
Basic concepts of finance
- Cash income is different from accounting income
o When he talks about profit, he doesnt talk about revenues less costs. Hes talking about
cashflows. Whats the difference between accounted income (revenues costs) and cashflows?
Answer: when you subtract the costs from the revenues, not everything thats in there is profit
or adds value, because part of this profit must be re-invested to keep the firm going.
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Cashflow is the net income minuses taxes and minus what you put in your assets minus how
much you must invest in each period (see formula below)
Accountants aim to match revenues and expenses.
Managers and investors focus on the difference between cash inflow and cash outflow (cash flow).
Formula:
You want to have a discount rate because you want to have the cash as soon as possible
Net Present Value (NPV)
- Managers measure profitability on the basis of the Net Present Value (NPV):
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Market value and NPV reflect risk and time value and what investors are ready to pay
You want to have a discount rate because you want to have the cash as soon as possible
Problem with NPV:
o For large corporates, when you evaluate a project you are assuming that its taking the whole
path as mentioned before. However, in a new venture, there are so many deviations from this
path, that makes the expectation about the cash flow unrealistic
o The expectation about the cash flow for the entrepreneur could be completely different than the
expectations of the investor have on the cashflow. So the interpretation of the NPV for the
entrepreneur and the investors is different. Also the discount rate could be different because
they see the value of time differently.
3.
Real price = you are not considering the inflation to account, there is zero inflation, so
price is constant (= fixed).
o Nominal price = if overall prices changes, you have to adjust the price in order to deal
with these inflations
It depends if you need real or nominal terms.
4.
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6.
Intervals: days or weeks (you have too less information, you have no average, there is too much
error/noise in your estimates), months (new ventures), quarters (large corporations), years (large
corporations)
7.
Financial statements (3/5)
Income statement describes revenues and expenses of a certain period.
If you pay dividends, you taking cash out of your company (so then decrease of your cash flow)
Question 1: what if you have negative free cash flow but you need cash to operate my business? So
are you going to increase or decrease your debt or giving out more shares? Answer: if you increase
debt, youre getting more cash in your company. If you pay debt, it means that youre taking out
cash of your company to pay that debt. If you pay dividends, you end up with less cash in your
company. The whole point of the cash flow statement is to show if you have some cash left in your
company. If you dont have cash, it means you are in trouble; you need more debt, but if they see
youre running out of cash, no creditor want to invest in your company anymore.
So: If he talks about financial needs, he talks about how much cash is missing to close the financial
statements/balance
Suppose the business is running out of cash, you have two solutions: increase debt of getting more
equity or more shareholders.
o Question 2: What is problem of raising debts too much? Answer: you need to pay interest,
so youre hurting your net income.
o Question 3: What is problem of bringing more shareholders to the company? Answer: the
value of your own share goes down, so youre reducing the value per shareholder and the
value of your own share as well (3 shareholders, you got 25%, but now 4 shareholders, so
now you got 20%)
Note: a lot of companys dont issue equity to pay day-to-day business operations, but to buy other
companies or for acquisition
Two approaches
o Yardsticks: data on comparable firms that are very similar to yours! Not only products, but
also same technology, etc. For example look at how their revenue and sales is over time
and look at yours as well
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Yardstick companies
First you look for other companies that sell the same products of yours
It may not sell the same product, but use the same technology or kind of innovation that your future
costumers will use as well.
o For example: Apple launches iPad, so how do you know how many you will sell? There are no
other companies selling this. How to fix this? Answer: look at the amount of people that use
both laptop and smartphone (iPad combines both )
Comparison may be based on:
o Target market
o Uniqueness of the product
o Type of technology
o Adoption rates
o Distribution channels
Find the best match(es).
You see differences in sales, but the % of the latest firm (GPS Industries Inc.) is much higher (85,7%) than the
others, so this is also very important: why do they grow so fast?
Example 2: Movies
Also here: Netflix uses the sales and revenues of Blockbuster to know whats the market size and then they
adjust another sales channel to capture this market
Caveats
Another companys sales might show you an optimistic sale cap.
You may sell the same products, but its delivered in a different way (Netflix example). You
can gain market share by changing the delivery
Market share of established brands(market share of Blockbusters doesnt matter because they dont
take all the market share (see Netflix))
o Can we beat the competitors?
o
Fundamentals
For yardstick companys, you have information about sales, sales per store, revenues, etc. However, you
dont know why the sales of the company are growing or decreasing. In the case of fundamentals is to
built a model to understand why the sales of the specific company/product grow over time
Determinants of other companys sales. For example: you look at Coca Cola and see that the population
of potential Coca Cola users (for example kids from 12-18 years old) are decreasing and also the youth
are not drinking Coca Cola anymore, but when this 15 years old are 30 years old, they start drinking
Coca Cola again. So this is a fundamental; you use age as determinant of a companys sale.
o Location
o Costumer demographics
o Population growth
o Market segments
o Saturation (durable goods)
Everybody has a car, but because the car company is keeping improving their cars,
you still want to buy a new durable good. Slide changes are necessary to keep selling
We need a model:
Expected sales growth is the minimum of two approaches (unique & supply).
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scenario its the opposite; I may have enough cash to keep investing in my company, however
there wont be enough demand for my product
When Im projecting my revenue, it says that I should either consider supply constrains or demands constrains
and take the minimum of both. But should I look to all the supply and demand side or look at both? Answer: in
your scenario, you need to take account both the supply and demand side constrains in order to see what to be
the minimum price of your product and then you know that your revenue will have a specific quantity times a
price of a product (point where supply and demand meet, basics of Economics..)
Uncertainty (=last point of forecast)
Every point estimate has a standard error
o Means: if I estimate the average sale is 100, however this estimate has a standard
error/standard deviation of 30. When you actually start your company, I have 95% chance that
my sales per year will be between 160 and 40. So from my two point estimate, you can use the
confidence intervals which give you a good scenario and a bad scenario. In both cases you can
calculate the financial needs. The idea is that the distance between the optimistic and the worse
case scenario is that the larger the distance, the larger the uncertainty I have in my forecasts.
Every model has weak and strong parameters.
o How sensitive the forecast is to each parameter.
Every forecast has lows and highs (scenarios):
o How close they are? The closer the better! (see above)
o What is the probability of each one happening?
o Whats the worse case scenario?
You only invest in a project/firm if the worst case scenario it is still profitable. BUT if
the probability that the worst case scenario is going to happen is 1%, then you can
take the risk ofcourse (other percentages as well, but just an example). SO the
probability of a scenario to happen is also important!
So now you know how to read and do your financial statements, you know broadly how to do your revenue
forecast, so you put your revenue forecast in your financial statements and your financial statements pop-up the
other variables for your forecast. Now you can asset your financial needs or how much cash you need to get your
project go.
Financial needs
Important: to keep your firm running; a firm should NEVER run out of cash. If you dont have cash,
you need to find a way to raise debt
o But; if you only have cash and you have no debt or dividends to pay or no investments (with
investments you gain equity), your money is a waste. Cash has no value then. Why do firms
accumulate so much cash if it has no value? Answer: for uncertainty, maybe they need a huge
amount of cash for a next investment so you can use this cash without raising more capital.
The higher the uncertainty in your forecast and projections, the higher the amount you should
save and keep away from investments in order to play safe in the forecast
o Always carry enough to the next milestone.
o Running short of cash can suggest the venture isnt on track.
There are 2 approaches to assess financial needs:
1. Sustainable Growth Rate
The rate in which the firm at least needs to grow in order to keep alive
2. Cash Flow Breakeven
What is the cash flow that I need every period also in order to keep operating and move to
the next period
Assumption for this model is: variables grow in fixed proportions (all the ratios are constant over time)
SGR = g*
Notes
1. For each euro of asset you have a fixed amount of sales that you can do from this one year asset.
2. For each euro of equity, you have a fixed amount of assets every period.
3. For each euro of sales, you have ex profit and ex euros that are generate of profit per period (not sure -> look
up in theory?)
4. For each euro of net income, you have a rate in which you pay dividend or retain my profits (not sure -> look
up in theory?))
SGR - Example
For example: you start with 100 dollars from your investors and you assume that for each dollar of equity, I have
1.5 in assets (my leverage is constant). This asset is equal to debt + equity, so the amount of debt that youre
presuming is 0.5, so in the end for each dollar of equity, 50 comes from debt and 50 from assets. For each dollar
of asset you generate 3 dollars in sales (so this is another fixed rate that you presume), so from 1.5 in assets you
can generate 450 in sale and you know that for each item that you sell you have a unit profit, namely 10% so you
spent 90% of your asset paying the cost of that good. So net income is 45 dollars.
For this 45 dollars you decide to retain 66.7% (2/3) and you paying 33.3 (1/3) on dividends. Question: is this a
smart decision in an early stage of your venture? Answer: Unless the investors say you have to, dont do! Keep
your cash in the company and keep growing, unless you have a kind of agreement. So finally, if you retain 30
dollars from the net income, you increase your initial equity with 30 dollars which means the value of your
company or the value of the equity increase 30%. So thats the sustainable growth rate, so if you go on with this
process, I never need extra cash to keep your business operating. You can keep your business operating only by
the initial investment of 100 dollars.
Why is this so important? Answer: this is so important because if you break down the format that the growths
come from the value of the equity, which depends on the return on equity, which is basically the new income
over the initial equity, you realise that the return on equity is the return on sales (NI (Profit)/Sales) times the
turnover (Sales/Asset) times Assets/Equity. In the end the sustainable growth rate will depend on the leverage or
how much debt you raise per period. So, if this sustainable growth rate depends on the leverage, than if you
increase the leverage you increase the growth of your firm. In other words: to increase the growth of the firm,
you need to increase the leverage or the growth rate.
SGR Formulas
BUT what is the problem of increasing the leverage too much? Answer: if you increase the leverage, you not
necessarily increase the growth rate because it will reduce the return on sales or reduce your net income. So you
hurt your net income by raising debit but on the other hand increasing leverage may increase your growth ways.
So it goes both ways, you need to find some sort of equilibrium in this formula in which given the growth rate
how much leverage you need to keep it go.
Another question: should you aim for a very fast growth rate or for a very small growth rate? Answer: it depends
(like always). If youre not sure about the market size, if you have a lot of uncertainty, you may adopt a small
slow growth, because you want to see little by little how you can catch the market. However, think about the
iPad of Apple; when they launched the iPad they knew new tables will come on the market within a few months,
so the strategy could not be like: release the iPad in only one country, see what happens and then release the
others. So they must have a fast growth strategy in order to kill the competitors and have a unique profit for a
very short period of time.
Principle:
o What is the cost of selling an additional unit?
A few units wont cover fixed costs
Cash flow BEP Example
So you keep growing to the point in which the cash outflows break evens with the revenue. From this point, you
know that youre firm is not shutting/breaking down anymore. However, if you take the revenue minus expense
approach, you may find that this break even point (BEP) is much larger and this could be a mistake, because it
could be too conservative if your decisions are based on notion of profit rather than this notion of cash flow.
But now the question is: what happens in the beginning of a new venture in terms of cash flows? Answer: you
never start with positive cash flows, you usually have a lot of negative cashflows to you reach the point of
positive profits. So what happens is that it doesnt matter if in year or two you have negative cashflows if you
know that based on your revenue forecasts, you will reach the break even point. So if your forecast show that
you have negative cashflows in the first and second year, BUT in in the third, fourth or fifth year you reach the
breaking point, you can keep operating, so you dont need financial needs.
Financial needs
The venture might not reach the BEP in the first years, so additional cash is needed.
Breakeven analysis can be combined with revenue forecast, telling when the BEP will be reached.
You start with revenues and then you direct to costs. The idea is that your estimated cash flows are discounted
that bring the value of those future cash flows to the present. What are the factors that influence the discount
rate?
Rate of risk free investments (government bonds)
Uncertainty
e.g. you have negative cash flows first and you see that your cash flows are growing, then you can estimate a
growth rate. And then you can formulate an exit strategy.
TV = terminal value
If PV I > 0 then you have a positive NPV -> people will want to invest.
If NPV = 0 or negative no one will invest.
Terminal/Continuation Value
Point when expected CF starting growing at a constant rate (g).
o E.g., long-term industry growth rate
Typically at investors exit time ( at the time you want to sell your company or do an IPO)
The shorter the period of CF estimates, the higher the effect of TV on NPV (e.g. a period of three years
will have more weight per year when defining NPV)
Discount rate
Risk premium (from investors point of view the risk premium can be easily calculated)
Distinction between systematic (market) risk and idiosyncratic (nonmarket, firm-specific) risk.
o Diversification reduces idiosyncratic component. -> By increasing the amount of projects in
their portfolio they are reducing the idiosyncratic component. But there is also a part that
investors cant hedge.
Market/Systematic Risk
If something happens in the market then all projects in this market will go down or up. That is something that
you face no matter what. E.g. earthquake or financial crisis.
Each asset will act in a different way. The higher the beta, the higher the systematic risk.
Investors are only interested in systematic risk. There is one critical assumption for this model: that public
tradable assets have an NPV of zero. What happens if a NPV asset or project out there is positive, everybody
wants to invest. Then the price will go up. The cost of investment goes up, so the NPV goes down into zero. Why
zero? Because if the NPV is negative nobody will go after this project. Then you reduce the price so the
investment cost will go down. So the NPV will be zero as well. ITS ALL ABOUT THE LAW OF SUPPLY AND
DEMAND!
Think of an asset that is similar to my asset and has a similar risk as my project that is public tradable. If you
have this information, then you can run a regression between the similar asset and the market (e.g. S&P 500).
CAPM, Example
Monthly Returns of Cisco Stock and S&P 500
Ciscos return tend to move in the same direction, but with greater amplitude
If I include an asset with a Beta greater than one, I increase the risk of my portfolio. I compensate by adding
assets that have a Beta smaller than one. If I only have Betas in my portfolio that equal one, there is no
effect of risk or adding that asset. How about if the Beta is less than zero? That means that the market goes
one way, the asset will go the opposite way. This is to hedge risks against the market.
CAPM, Example
is the slope of the best-fitting line and measures the expected change in Ciscos return per 1pp change
in the market return.
Deviations from the best-fitting line correspond to diversifiable, non-market risk.
The
define
other
Open circles? You try to calculate the NPV of a project to convey investors. But you need the beta to calculate
the NPV. The net present value and beta are both defined at the same time. You may have many solutions for two
variables using one equation. You have to have some kind of strong assumptions when calculating NPV. Try to
argument the best scenario.
Dont have to calculate risk-premium, its only about risk free rate.
CEQ, example
Deal or No Deal, the game show. Same as choice between given amount or flip the coin
o 26 briefcases each of which contains an amount from $0.01 to $1 million.
o Contestant chooses 1 of the 26, which remains close until the end.
Its expected value is $131,478.54
o Over a series of 9 rounds, briefcases are opened and the expected value of the first changes.
o At a certain point, the banker offers a certain payment that is less than the expected value in the
first briefcase.
If contestants CEQ is less than bankers offer, game is over.
How to estimate the discount (RD)?
Youre interested in the cash flows of your project and the average market return. So the whole industry. Its not
that simple. When you build your scenarios (economy goes well, stays the same or goes bad. 3 scenarios). Then
you know what your sales will be in the three scenarios. The relation between market outcomes are based on
assumptions and how you tackle the market. The way you compete against other brands. So more theoretical
assumptions than regression.
What is difficult in this approach is that it is hard to calculate the correlation between the market return.
Cash flows can be negative. There is no bound. But the correlation coefficients minimum and maximum is -1
and +1. So suppose your model says 0.7, it can also be that rho can be 0.5 or 0.9, because rho is bounded.
Up until now you have forecasted cashflows and discounted them.
In the following method you ignore those cashflows and then you estimate this present value. Using multiples or
explanatory variables. Remember from multiple regression model the dependent and independent variables.
There are two ways of estimating present value. You use this method to estimate the last part that is related to
the terminal value. In which you expect that the firm grows at a constant rate. So you can compare your firm to
another firm in the market. Most of those multiples are based on revenues or earnings from income instatement.
You can estimate from a similar public company comparable to yours what your earnings or revenues will be.
Relative Value (RV) Method
It uses data from public companies and public and private market transactions to estimate value.
Main idea: gathering information on value drivers of comparable firms (multiples).
o E.g., profitability, expected growth, and risk.
Useful for estimating terminal value (TV).
Most multiples are based on revenue or earnings from Income Statement.
o But there are also multiples based on assets on the balance sheet.
Accounting-based Multiples
They relate the value of venture equity or total capital to reported accounting information.
Most common is the Price-Earnings (P/E) ratio:
o Gives the (market) value of equity on the basis of reported NI (less dividends). This is based on
financial statements of another company. So you can recognize the stage and based on this you
make an estimate. In this method youre not interested in alternative scenarios. You only want
to see the value in one point of time. So its an estimate that is not really waterproof. It is a
very simple method. You dont talk about risk but expected income.
Others (based on capitalization):
o Price to cash income, price to levered cash flow, price to revenue, etc.
Based on enterprise value: EV = E + D cash: if your company has not the similar proportion of equity
and debt as the company that is compared it is better to use this approach.
o EV to EBITDA (Earnings before interest, taxes, and depreciation and amortization), EV to
sales, EV to book value of debt and equity. It is important to realize that if you choose a ratio,
other ratios should give you somewhat similar results. If this is not the case then you are not
dealing with a similar company.
Non-accounting-based multiples Here you can use the multiple regression approach. Very straightforward
approach. No balance sheet or financial statements.
Industry-specific nonfinancial metrics.
Examples of proxies for ventures value:
o Magazine: projected number of subscribers, pages of advertising.
o Biotech co: number of patents.
o Internet co: number of website visits, average time spent on the site.
They can be used to estimate (regression) either equity or EV.
o Depends how comparable and new venture are financed in the same way.
Public firms may not be too similar you dont know this exactly
We cant observe prices of similar private deals between different companies.
Current financial measures are linked to assets in place, with little relationship to future performance.
You dont know it all. In other words, it is too simple.
Multiples in practice
Constitute a group of comparable companies
o Similar products, geographical spread, similar markets, financial structure (leverage)
o Exclude clear outliers in order to keep your average more robust.
Use recent average (a few years) of value
Use more than one multiple
Calculate mean and medians for each multiple because the medians dont have problems with outliers.
For large variations in the sample, understand these differences.
For multiples of equity, use data from:
o Listed companies
o Recent acquisitions
Multiples are used to check consistency
Multiples are used as an intermediate step to conduct the method hereunder:
Venture Capital (VC) Method
Often used by venture capitalists there is no theory or statistic behind this method. It is more about
feeling. It is how the investors feel about that project. They are interested in one thing: the terminal
value. Why? Because this is what they will get when they make their investment liquid. There is only
one scenario, and that is the successful one.
o But not as transparent and consistent as other methods
Value is estimated on the basis of projected harvest-date cash flows
o Under the assumption that the venture meets its objectives (success scenario)
It generates less valuable information:
o It doesnt provide milestones to track performance. Because we only look at terminal value.
o It doesnt allow investors and entrepreneurs to identify key drivers of value.
VC Steps
1. Forecast sales or earnings/cash flow for a period of years. When they start getting positive.
2. Estimate the time at which the VC will exit the investment, harvesting by acquisition or IPO.
3. Value the exit price (TV) based on an assumed multiple (P/E, sales, etc.)
a. Multiple reflects the capitalization of earnings for a company as successful as in the scenario.
4. Discount interim CF and TV at rates ranging between 25-80% per year. There is no theory on how to
calculate a discount rate. Investors always use a discount rate between 25% and 80%. Very high! All
the uncertainty of the project goes to the discount rate. It is important as entrepreneur to calculate your
own discount rate. To see if they are fair.
a. This yields the PV.
5. Compute the minimum fraction of ownership an investor would require (VCs stake).
VC Method
Its based on optimistic forecast(no alternative scenario), so the hurdle rate is intended to compensate
for risks.
o Rates well above cost of capital
o VCs dont believe entrepreneurs projections anyway.
Rates are higher also because:
o Shares purchased are illiquid.
o VCs provide services that need to be compensated for (adding value).
Reputation capital, access to skilled managers, industry contacts, network, etc. they
sell you network and put this cost on the discount rate.
VC method is based on intuition and experience
o No real guidance for young entrepreneurs and first-time investors. By trying different discount
rates with different entrepreneurs they estimate discount rates. So based on the history of the
VC.
All based on VCs bargaining power
o More VCs firms in the market, entrepreneurs experience, track record, and capital inflows
increase valuations. Once you increase competition in VC, there will be a decrease in discount
rate. Entrepreneurs dont only move like places like Silicon Valley to meet with other
entrepreneurs, it is also to be in a more competitive environment when it comes to VCs.
Conclusions he finds this course too intense for 8 weeks. The cases are meant to practice.
DCF methods are the most logical
o Based on solid and theoretical approach
o But often difficult for new ventures
o CEQ is simpler and less biased.
DCF may work as benchmark for other methods. If you accept the deal or not. To have an idea how
projects can change in comparison to others.
Valuation by Multiples: you should make strong assumptions. Then you can see that these methods are
consistent or not over time. Then you can adjust your assumptions.
o Great variability in the common measures
o Myopic measures (based on past book values).
o But useful to verify robustness of DCF assumptions.
Appendix RADR
The difficulty of using RADR:
Assuming a discount rate of 5%, what is the maximum that Metals Inc. should bid?
In the stock market, a call option is the right to buy a share at a future date for a price established today
(strike price). So if the price goes up you can actually profit from it.
o The payout increases with the actual stock price.
A put option is the right to sell an asset in the future at a pre-established price. Buy this option at high
market price and sell the asset when the price is low.
o The payout increases if the asset depreciates.
One sided exposure to risk
There is one sided exposure to risk because you only sell or buy when it is actually profitable to do so. If the
price is too high or low then you just dont use the option. Then the NPV is zero. So if the price is increasing or
decreasing in your advantage then your NPV is higher than zero.
Financial Option vs. Real Option
Like financial options, the value of real options increases with risk and time to expiration.
o The higher the variance, the higher the value of the option. What is related to the variance?
The time to sell or buy the asset. What has more value, 5 or 10 years? From the stock market,
we can fairly estimate what happens in 5 years, and the belonging variance. But as time
increases the standard error or the variance will increase as well because of uncertainty
But real option markets are not complete. Opposite to financial markets.
o The Law of One Price (LOP) doesnt apply.
With financial options -> if NPV Investment > 0, everybody will want that option,
and that options will return to NPV Investment = 0. The idea of arbitrage. If two
different assets have the same cash flow, then they must have the same price. Example
of selling German beer in the Netherlands. You can sell it in NL until supply and
demand will establish to the same price in NL as in Germany.
No necessary relationship between real option premium and real option value.
You cannot trade a real option. One exception. The insurance market is one option for
trading real options. Why? Because you can insure yourself against a bad economy.
Real options are often interdependent. In the case of financial option portfolios. And the calculate the
value by the weighted average. This is not the case with real options. This is because the decision on
the option influences the other one.
o The value of a portfolio cannot be determined by adding up individual values.
o The decision to exercise a real option has implications for the values of others.
Decision Tree
Useful way to conceptualize alternatives that involve real options.
o It helps to identify relevant options and critical decisions. In your project.
2 Important techniques
o Backward induction: start with the last decision points and eliminate alternatives recursively.
You start from the end and then you will go back, eliminating the least profitable alternatives
o Prune the tree: By eliminating irrelevant options recursively, we focus on the important
choices.
Decision Tree
Invest in large or small, or not go at all. You have three choices, after that the nature takes over. If you know the
demand, you will go high. If its low, you go small. But you dont know. So you calculate the probabilities.
Calculate for each possibility the expected value. This is a very simple example. In this example its only about
the variable cost.
This example is about whether to expand or not. The decision of expanding comes usually after the state of
nature. When Im comparing expected values and select something, what does that tell about my risk aversion?
Nothing, Im risk neutral. When risk aversion starts to play a role, then you put heavier weight on the bad
outcomes.
Valuing Real Options
What discount rate should we use? The point is that real option doesnt use this type of discount rate. The only
discount rate we use is the risk free rate. You dont have the same expected cashflow with real options.
What is the systematic risk (Beta) of the option- embedded project?
Difficult to determine because of non-linearities in the expected cash flow.
We can follow the risk-neutral valuation approach. You recalculate the probability of a cash flow accounting
for a risk adjustment.
Tracking Portfolios: Replicate cash flows of call option with common stock and debt
Tracking Portfolio
If I want to calculate the market value of a real option, I replicate the cash flows of this real option with
common stock plus debt. E.g. in the good state and bad state cash flow. In the good state I have the same return
as with bonds, same debt. But the returns will change.
Amounts:
Remember law of one price. Worst explanation ever given in academic history.
G= good state
B = bad state
Risk-Neutral Valuation
Assume that investors are risk neutral and earn the risk free rate of return on all investments.
Under this assumption:
This is not the actual probability, but the one that takes into account risk-aversion.
Current value of option:
Lets use the tracking portfolio to calculate the value of the real option again.
I have the financial option of buying future copper. I buy at 0.6 and sell at 0.9 or 0.5, plus the returns of my
bonds. Another bad explanation, unbelievable. He just fills in the formula, so you must know what each letter
stands for.
The present value of operating in the future market should be equal to the present value of operating in the
current market. Why? -> discount rate. Because of arbitrage. They should both be zero.
Moral of the story is that both methods yield the same result. Both give the same answer.
Sometimes you dont have different scenarios for cash flows (good, bad, moderate), but a continuum of cash
flows. So cash flows with variance, meaning that they have a normal distribution. Then you use:
Black-Scholes Formula
What if CFs are not binomial (High vs. Low)? There is no probability of success or no success. Its a
continuum now.
Suppose assets returns are normally distributed. Then:
Strike price: is the cost of producing the product. The pre-established price of cost of that transaction.
But in a continuous case there are no scenarios. You have a continuum of scenarios. From this continuum of
cash flows you have a standard deviation.
Another way of calculating the sigma is by calculating the volatiltity of a similar company in the market. You
know the volatility of those cash flows by analyzing them over time and then you can calculate the sigma using
data from others.
From Decision Trees to Game Trees
Decision trees do not incorporate other agents reaction (competitors, investors, etc.).
o its like a decision tree, but its not nature that does something but other agents (competitors)
act to my decisions. You dont play random. Your strategy changes as the strategy of your
competitors or investors change their strategy.
o Playing strategic game
Strategic games commonly played:
o Business plan: An entrepreneur must decide how much optimism to put into the
projections.
Overoptimistic projections might imply deals of investors with tighter returns.
o Strategic partnering: A potential partner might become a competitor. E.g. vertical integration
with a partner, now the partner knows a part of the company and can become a competitor
o Control: How much control to forsake in exchange for funding. Discussed last week with
venture capitalists and business angels. Your losing control but youre getting more funding.
o Information disclosure: Deciding whether to patent an idea now (and risk copycat entry of
rivals) or maintain it as a secret.
Three options: large bar, small bar, and waiting to what the competitor does. If i go for a large bar. My
competitor stays out. When I do small bar, competitor will go in.
Now if I wait, my competitor can choose to enter or wait. They will enter the market even though they know I go
large. from this tree you will see that Kellys bar will go large right away.
Sometimes its difficult because sometimes the same cash flow are generated with options. Then you will put
probabilities on what the decisions of the competitor.
The idea of trees is to make the most simple model but include all the options.
For the entrepreneur, the higher her investment, the lower the amount remaining for diversification.
o Therefore, the higher her discount rate. (so reverse: the lower the investment made by the
entrepreneur, the higher the amount she could use for diversification)
Example
Assume constant return to scale, so that each $ invested generates $5.37 in CF after 6 years.
The entrepreneur has a non-negative NPV up to $1.631 million (NPV is maximized at $636K).
If size (investment needed) is given (?), an outside investor must be found. (why does the entrepreneur
needs outside investment? You need to have a certain an amount of cash to keep operating. If you make
very low investments, you wont have enough cash to keep the company operating) (sometimes taking
high growth strategy in the beginning is really risky. It is better to stage your projects)
Sharing Ownership Proportionally
From previous example, the investor should enter with $1.364 million
o To maximize entrepreneurs NPV.
With proportional sharing, the investor, with 68.2% of the total investment, receives 68.2% of equity.
Thus the entrepreneur maximizes her NPV by choosing the ownership share.
In practice, this is not a likely contract structure. (this because the entrepreneur wants to remain
control. In reality, there is a game in which the investor puts in probably less than 68%. Why is that the
case? See next slide)
Example: a venture need $2M to start and requires $1.5M from outside investment and has a market
value of $6M.
(investors will
have a lower but still a positive NPV)
From a zero-NPV investment of $1.5M, $500K (25% of $2M) is the proportional investment of the
investor. (that is proportional to the equity they receive from the company. This will cover the cost of
capital. This is proportional to equity the investor receives)
o And the remaining $1M is the side payment (=the entrepreneurs free leverage) to the
entrepreneur
(In the extreme case that the entrepreneur puts nothing in the company, he does get money and equity. Since
entrepreneurs cant mitigate risks, why dont they sell all their equity and work there as employee? Why does this
not happen. Even if they know their NPV? There are several reasons. Entrepreneurs are subjective about their
venture. They are more optimistic, they believe that their value will be more. Another reason is that market are
not so competitive. What the investors offer is often below the market value. From the point of view of investors,
they need the entrepreneur to have an incentive to work hard.
.
Allocation of Expected Returns
The side payment reduces the entrepreneurs capital contribution for the 75% remaining.
o From $1.5M to $500K.
o It enables the entrepreneur to invest more in the market, increasing her NPV (How?).
The side payment works as a free leverage for the entrepreneur.
o Or a payment for human capital.
In Practice
If venture CFs are more valuable to investors than to entrepreneurs, why entrepreneurs dont sell all
their equity?
o Trading all risky claims for cash.
Because:
o Entrepreneurs place subjective value on the venture
o Entrepreneurs are often more optimistic, so investors may not offer enough.
o Capital market is not so competitive, so offers will be often below market value.
o Entrepreneurs effort is important to success, so entrepreneurial ownership is a way of aligning
incentives and interests.
Passive Investors vs. Active Investors
Weve just talked about passive, well-diversified investors so far.
Other two cases:
o Subsidized, passive investors:
EXAMPLE
In which one of the cases there is more room for negotiating? The first one.
From the bottom we can see that the NPV with the active investor is the highest. The problem of the active
investor here is that they have room for negotiating, but they are adding services so they want compensation for
that. They will say that they pay that 2 million to human resources (for the services) and state that there NPV is
very low because of this.
Information Asymmetry
Before the agreement: each party is unsure about what the other knows
o Is the venture a cherry or a lemon? (entrepreneurs and investors take advantage of their
own information to catch as much value of the agreement. And what if the company isnt
doing so good? Can you blame the entrepreneur? And what if the investors dont provide the
services they have promised?
After the agreement: how much effort is applied to the project? How to evaluate performance?
Incomplete information vs. Asymmetric information: (the difference is that if they have asymmetric
beliefs, they want to profit from that information)
o If both parts are ignorant regarding an outcome but share the same beliefs, the contract can be
simple.
o The problem is when they have asymmetric belief and private information.
They have the incentive to distort their true information and beliefs to extract more
from the other.
Adverse Selection (is before the agreement) & moral hazard (is after the agreement)
Entrepreneurs compete for funds by presenting optimistic projections and omitting negative
information. ( suppose two projects, one is good and one is bad)
o Investors react by offering high hurdle rates. (for both the projects)
o Problem: Good ventures tend to be undervalued and not pursued.
The existence of lemons drive cherries out of the market. (this is because the
good projects think the hurdle rate is too high and wont continue with investor. And
lemon will take the rate. And because of this, investor has a lemon and rates go up
even more.) ( he provides example of used cars. Can you ever believe the seller? He
will always say that the car is really good even though its shit)
Why an investor is interested in the venture?
o Investors may only seek for competitive threats.
o Well-intentioned investors are beaten by too good to be true offers. (even though there is
well intentioned investor that has low rates you also think this is too good to be true)
Example
An investment opportunity of $600K that can be funded by a VC.
Assumptions:
o There are 2 equally likely states of returns: State1 and State2. One is good and 2 is oke.
o Entrepreneur learns the true state at time 0. (he already knows the state and the return of this
investment)
o VC investor learns the true state at time1. (so after the investments made)
o VC market is competitive (VC pays for shares that are worth $600K).
Asset Values:
Entrepreneur states at time zero that he will undertake the expansion no matter
which state occurs. (so he will do the investment no matter what)
Value of the venture at time 0 for entrepreneur (he takes average):
V =
($300 + $100)/2 + ($80 + $20)/2 = $250
Total value, V = V+E =250+600 = $850
EXAMPLE
In State 1:
In State 2:
Revelation mechanism; the idea that as investor you know that there are two types
of projects, so what you can do is provide two different deals and contracts in
such a way that bad projects will choice one type of project and good projects will
choice another type of contract. They dont choice the same project.
For example: you offer contract in which entrepreneur lose part of the shares if
hes not successful and a contract in which regardless the state, you always get
X% of the equity. So what happens in the end if the project fails, the entrepreneur
has to quit the project and you as investor receives alpha times the assets (minus
liabilities!) of the company. So alpha is what is going to the investor. So in the
second contract, if it fails, all the assets will go to the investor. In summary, if the
entrepreneur is sure about the project to be successful, he will choice the second
contract and if the entrepreneur is not sure about the contract, he will choice
contract 1 (NOT SURE, A LITTLE VAGUE)
Example Adverse selection
If both are ok, then the entrepreneur will invest! If something flips, he wont
invest!
2. Incentive Compatibility: Entrepreneur isnt encourage to lie about the state. This incentive
compatibility is the whole problem of information symmetry; what is the condition to make
entrepreneur not lying?
- This is the whole problem of information asymmetry. How to let the entrepreneur
say the true state of the company?
- State 1: S1*V1 _> S2*V1 (so if he lies he get S2*V1 and if he doesnt lie he will
get S1*V1)
o What the entrepreneur receives (S1*V1) must me greater than what he
receives when he lies about the state (S2*V1)
o Lying = instead of saying to the investor that the company is in state 1,
they say that they are in state 2
- State 2: S2*V2 _> S1*V2
- So if this two conditions are satisfied, you know the entrepreneur will not lie
about the real state.
Example Adverse selection
- Suppose investors share = 600 (this is what de company needs)/850(expected value of the company,
this is not true value, investor doesnt know!) = 71% (so s=29% this goes to entrepreneur, 1-s = 71%
goes to the investor)
o What investors can do, is they can say we invest 600 in the company and we get 71% of the
shares, so the S% of the entrepreneur is 29% and alpha is 71%
o And now the question is: will the entrepreneur invest in both states or not? The answer is:
no! Why, because if an entrepreneur keeps only 29% of the shares of 980 (this is the real
value, 850 is estimated value of the investor, so as entrepreneur you use this amount), which
will be less than 300 (=284), which means that the entrepreneur will not invest (see below)
- State 1: Ve(invest) = $284 (29% of 980 < Ve(not invest) = $300
o Investment isnt rational
- So above contract between entrepreneur & investor is not real. So lets move to another contract
(suppose entrepreneur agrees to reveal the true state)
o Investors share = 600/980 = 61% in State 1 (so s=39% entrepreneur receives of the share)
o
o
-
But another question is: will entrepreneur lie over in which state he is?
o
o
He will always say state 1 will happen to get a larger share (so condition of state 2 (S2*V2 _>
S1*V2) is not satisfied)
So the investor will receive a NPV=0 in state 1 and NPV<0 (negative NPV) in state 2 , so the
investor dont want to do the investment anymore because the entrepreneur has the incentive to
lie
The entrepreneur will keep more shares in state 1, so in state 2 he will lie about it and say that
he is in state 1. So he will lie, because even though when youre in state 2, they will say no, we
are in state 1.
(someone in class wrote down the example with t and debt and equity?)
Example Adverse selection
- Solution?
- Debt financing
o The investment is riskless
Why? No matter of the state, there is always a positive growth. No matter of youre
getting more or less cash flow, you know that in the end the cashflow is positive so
they can pay back the 600, so there is no risk. The cash flow in the end will always be
positive, so you can always pay back the $600.
However, is this always the case for (new) entrepreneur/companys? Can they always
pay back? (lecture 5, they generated cash flows, but not enough) Answer: so the
investments are not riskless, some companys wont have enough cash flow to pay the
loans back, so you cannot solve the problem of asymmetric information, because
investments are risk investments.
- Is it the case of new ventures?
o Small, riskless ventures
o High-risk, high-return ventures
Notes: so some entrepreneurs prefer debt financing over equity financing, because debt financing avoid the
problem of asymmetric information, because in the end the entrepreneur wants to maximize the value of the
company, because the entrepreneur wants to pay back those loans no matter what. If they lie about the state of
company, this has a negative consequence for paying back the loans or not.
Moral Hazard (second problem, hidden information after the investment is made)
- Once a sunk investment is made, parties may act in ways that are not consistent with their original
intentions
o Agency problems
Somebody is not working according to the contract/agreements (so the investor or the
entrepreneur)
- For example:
o An entrepreneur may not always act in the best interest of other shareholders
o Entrepreneurs may take on more risk than creditors would like
o Investors may expropriate the wealth of common stockholders
Tunnel = you have the same shareholder holding shares from two different companies
and they reducing the cash flow of company one and at the same time increase the
cash flow of the other company, so if you have shares in two companies, you are
happy with this transaction because the value of both companies are increasing at the
same time and if you only have share in one company, you are unhappy)
Financial tunnelling: equity dilution
Operational tunnelling: transferring cash flows/assets to related parties
- Well-designed contracts anticipate moral hazard, reducing its costs. So regulations and contracts
overcome the problems of moral hazard and can reduce the agency costs and the problem of tunnelling.
Example Moral hazard (how to calculate agency costs)
- Entrepreneur choose how to allocate time (and effort): 24/7 in company or 10 hours per week, etc.
o All his time can be dedicated to the venture, which increases firm value (V)
o Or to other activities (F)
o D = (V*, F*) is the allocation of time/effort that maximizes her utility.
o V* is the value of the firm.
Notes: you can dedicate full time to the company, then you get V or you dedicate no time to company and reduce
the value of the company to zero, but increase the other things that youre doing in your life. There is only one
perfect balance and if you find this, you can find the perfect value of the venture where youre working for.
Now lets include shareholder (see below).
Example Moral Hazard (now includes investor in the model)
- Suppose the entrepreneur sells (1 ) of the firm.
- The outside investor may value the firm at V* and then pays (1 )xV* for the shares.
- Now entrepreneurs marginal effort pays only units of F,rather than 1.
o It changes the trade-off between V and F
- With less effort, firm value is now V0.
Alpha = 1 (1 unit F -> 1 until V)
Alpha <1 (1 unit F -> alpha units V)
Notes: now include shareholder. You keep alpha and 1-alpha goes to the investor. If the investor sees the value
of the company as V* (V-star), the investor will give me V*(1-alpha) of funds and he wants to receive back in
the end (1-alpha)V*. However, if the investor give the entrepreneur cash (1-alpha)V*, what happens is that
youre only keeping alpha percentage of the shares and you dont have the one-to-one relationship anymore with
the company and the value of other things in life. In other words: for one unit of F that you give up in your life,
you get 1 unit or dollar in your company. But now, if youre only holding an alpha percentage of the value of the
company, if you give up 1 unit of your life, you only receive alpha units of V that is less than 1. So basically,
youre changing the trade off selling shares by changing the trade off of my life times that youre dedicated to
the company and the dedication to other things in your life. Since your changing the trade off, what happens in
the end is that the investor know that you are dedicating less time to the company and the value will not be V*
but V0. So youre reducing the value of the company by changing trade of and working less!
Now, if the investor anticipates debt instead of providing (1-alpha)V*, which is a lot of money, he will provide a
little bit less -> (1 )xV. Why? Because he knows that (1 )xV the entrepreneur will maximizes his utility
as well so the entrepreneurs shifts down the time constrain providing less cash and rather the company having
value V0, the company has the value V. However, the problem is: this new value of the company is lower than
V* so lower than the original one. So this means that by not providing full information how much effort you put
in the company and the investor cant monitor this, the agency costs will move from V* to V (see below)
Example Moral Hazard
- Anticipating that entrepreneur will dedicate less time to the venture, investor will value the firm at V
and pays (1 )xV for the shares.
- Agency cost = V* V
How to lower the agency cost? So how can you get the V closer to V*? In other words: how can keep the
investor encourage the entrepreneur to keep working for the firm and put much effort in it? Answer: relational
contract!
Solutions
- Relational Contracting:
o You dont give all the cash right away, just give a part of it. Then you wait if the company will
meet the benchmark or targets. When the company does, you give the next part of the
investment and vice versa
o Rule 1: investor/VC provides continued funding as long as doing so is in its interests.
o Rule 2: rule of monitor: Deal terms enable investor to monitor the entrepreneur, so the investor
is an active investor, hes following all the management decisions, he is like working in the
company
Restrict entrepreneurs ability to take own decision
o Problem with this? Problem of tunneling; the investor or VC gets too much to say in the
company, giving too much power to VC. How to avoid this?
- It exposes entrepreneurs to the risk of opportunism
o Mitigated by VC/investors reputation.
- Type of contract (solution?) -> signaling/screening:
o A credible demonstration that waives the need to convey private information (signaling)
The entrepreneur can not provide all information, your information is too value for the
company itself, other will steal it -> you will sent signals (Im expecting very high
cash flow in the future, but its a little risky, etc. -> you give some idea if your
product is good or not)
o Investor offers a menu of alternative terms (screening)
Difference between signaling and screening is who proposes the deal? In the case of
signaling, the entrepreneurs proposing a deal in which he knows he can actually
differentiate itself from the other projects. In screening, the investor proposes exactly
the same project.
o For instance, contract that ties entrepreneurs return to performance targets.
Example for screening/signaling
- I need $6.0m to start my company
-
-
-
If the benchmarks are met after 12 months, the VC invest additional $2.0m
VC may not invest if a benchmark isnt met.
o I have to either find a new investor or force liquidation
If a benchmark isnt met but VCs still invest, VC gains managerial control
If the entrepreneur accepts this deal of above, what do these terms reveal/signal about me?
o By structuring the deal around my projections, I signal confidence about the project
o By giving up control if benchmarks arent met, I signal confidence in my managerial skills.
o Finally, I have to devote full effort to maintain control
If you as entrepreneur lied about your positive forecast, you wont accept this
contract. If you think your project is way too risky, you dont want to accept this deal
because there is an opportunity of really loosing your company to the investor. Then
you go back to the standard contract 1-S to the investor and keep S no matter what
happens, you go back to the type of VCs who would give this bad type of contracts,
projects with lower but riskier cash flow.
Harvesting
-
-
Exit routes
- For debt financing:
o Repayment of principal
- For equity financing:
o Trade sale / acquisition: sale of the venture to a corporate group
Management and investors both sell their shares
The acquiring firm usually wants to buy all the shares
o Initial Public Offering (IPO)
Changing firms legal status
It allows investors to sell their own shares
After a lock-up period
o Management Buy-Out (MBO): the management buys back the shares of investors
It allows management to regain control of the company
o Refinancing by another institutional investor
Investor 1 wants his investment back right now, but as entrepreneur you cant pay him
back, you look for other investor so you can pay back investor 1. So you shift the
equity
Another Exit Route
- Bankruptcy of the venture: (example of case where this happened: Netflix)
o Not enough liquidity/cashflow to operate
o Venture is not able to find outside finance anymore
o High risk of failure if the leverage ratio (Debt/Equity) is too high given current earnings
- Advantage of equity:
o No bankruptcy if dividends are not paid
Notes: when investment is too risky, thats a problem of debt financing: if you increase the debt or liabilities too
much, as some point you cannot pay back those loans anymore and there is a risk f closing the company. But this
doesnt happen if all your company is financed by issuing equity. Why not? Answer: you have no liabilities,
even if you have negative cashflows, you can keep operating because investors dont want their principal back,
they hope a proportion % of the shares and they know that the price of the shares is going down over time. But
even though the price is going down to zero, the firm is still operating. The firm has no value anymore, but can
still operate. But once the firm has no value anymore, but can still operate in the form of debt, they dont have to
pay this debt, then you go for bankruptcy, because there is no money to pay back the loan. So the point of equity
financing is to avoid this type of situation.
Selecting an underwriter
- An investment bank or a group of investors or banks who will raise capital on behalf of the firm.
o Responsible for: advising the entrepreneur in terms of value, how much equity they should
issue, who will receive the shares, they negotiate the size of the shares, etc. (see below)
o Advising the issuer
o Distributing the shares
o Determining the offering size
o Preparing the marketing material
o Preparing regulatory filings
o Underwriting the risk of market fluctuations during the offer
- Criteria (how to choice an underwriter?):
o Valuation!
o Reputation of the analyst covering the firm
Performance of past IPOs
o Not a criteria: fees! Fees = the rates that you pay to the underwriter, always between 5% and
7% of capital raised. So this is not a criteria, underwriters dont compete on the fees, but they
compete by changing the valuation by giving to your firm (see first criteria)
o After market trading support, trading history
The offering
- The underwriter buys the shares from the company at a fixed price and immediately sells it to investors
at the IPO price
o Process is: company sells the shares to the investment bank, banks goes to institutional
investors and institutional investors goes to the public. So institutional investors make the
profit (425% for example, see below). Why not the banks? They want the institutional
investors as their clients so they give it to the institutional investors, like a kind of gift.
o So the underwriters are taking advantage of the whole underpricing process of the first days of
the IPO of your firm (buy at low price shares of your firm, sell at high price to investors)
- Flipping: investors that are allocated shares in the IPO sell these at the first day of trading at a
significant profit
o Spinning: underwriters offer shares in hot IPOs to executives in companies, whose business
the bank is looking to attract
- First-day underpricing
o On average, the stock price jumps on the first day of trading
o Example from the internet bubble: priceline.com (internet auction for unsold airline tickets) did
an IPO in march 1999: stock price from $16 -> $65
Underpricing: $65 - $16 (+425%)
Cheap airline tickets: priceline, had this problem, so high opportunity costs and their
initial price could be much higher). Question: Why do a company accepts this
underpricing? Answer: they accept this, because they believe in the investment
bankers and the investment bank does a lot for me and is responsible (see above)
- It represents a substantial cost for the issuing firm
o A lot of money left on the table
Reasons for IPO Underpricing
- Herding effects
o Demand by institutional investors induces less informed investors to rush in
- Market power
o Underwriter has control over the order book
- Why dont issuers get upset?
o They believe the reasons investment bankers present to them
o Issuers are very risk averse and want to make sure that IPO succeeds
o Since they get rich themselves in the IPO, they do not mind the underpricing
Some of them do!
o Homework: whats Open IPO? = Alternative for reducing this underpricing
-
1.
2.
But critical during financial crisis and economic downturns (Mazzucato, 2013)
o Reducing barriers for the creation of start-up firms by:
Modernizing and simplifying corporate laws (most are focused on large corporations, so government
adjust it for creation of start-ups)
- Adapted to SMEs (small medium enterprises)
- E.g., Jumpstart Our Business Start-ups Act (JOBS Act), USA
- ENTERNEXT, the new pan-European Entrepreneurial Exchange
o Relaxed rules and regulations governing the IPO of SMEs
Providing registration exemptions and tax benefits
-
E.g., Auto-Entrepreneur program in France
o It reduces red tape in business registration and tax payments.
Role of government
- Direct funding to innovative companies
o Particularly in the areas of biotechnology and clean technology (Dittmer et al., 2013).
This industries need long-term investments, government finances some of these
projects that are important (wind-energy, etc.)
o More inclined to make highly risky and long-term investments
In early stage proof of concept
- Introducing incubator and accelerator programs
E.g., Start-Up Chile, intended to attract foreign entrepreneurs by offering cash,
working visa, and local support
100 start-ups (from 28 countries) out of 1,570 in 2013.
The funding gap (most in seed and start-up stage)
- Over the last decade, VC companies have delivered uninspiring returns (Mulcahy, 2013) (= returns
of VC is going down -> decrease in VC funds -> so VCs shift towards to late stage of investment in
new venture, because they dont want risky investments anymore, looking for safe investments with
high returns. Companys need track record for example to show that they have positive cashflows in
future. This also counts for Angels (VC is not only VCs but also Angels!)
o Leading to a decrease in VC funds
o Shifting investment to companies in later stages
o Or to companies founded by serial entrepreneurs
-
-
Question: why is government increasing participating in investing in funds? Why dont they
invest in start-ups, why not direct investment? Answer: they want to create a strategy, an
environment in which in some point the government can leave and let all the private investors
work in the VC-cycle (investor -> invest in VC fund -> VC fund invest in start-ups -> start-ups
go for exit strategy -> from exit strategy the investors get returns). Problem in the 90s: returns
is going down, so investor goes to another company to invest, investors moves out, so you
have less and less investors for start-ups. The role of the government is thus to provide not
direct fund to start-ups, but to support the cycle doing downturns to encourage the investors to
get in the cycle so finally government leaves and let only the private investors in the system)
How to establish a venture capital ecosystem?
o What policymakers can do to unleash private sector investments?
Gap might be filled by new types of Angels:
o Super-Angels
o Crowd-investing
2.
Strategic Exit: Large companies seeking to acquire ventures with distinctive skills and capabilities
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E.g., Google, Facebook (Facebook buys Whatsapp for intellectual property, skills)
Less interested in fully developed, profitable business models
o Different from a Financial Sale Exit
It offers competitive advantages and new profitability for the buyer.
It is happening earlier and resulting in high exit values:
o Instagram sold for $1 billion at 2 years
o
Investors, identifying a potential strategic exit, may favor getting the venture to a break-even
position as quickly as possible
o To minimize the capital needed
o Building value rapidly to become an attractive target.
3.
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Super Angels
Becoming more established in the European VC industry
Often managed by former entrepreneurs.
o Well connected in their former line of business
4.
Crowdfunding: many investors investing small amounts through internet-based platforms -> 4
types
- Donation-based (most often a website, no financial return if you invest)
o
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o
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Reward-based
The crowd receives the finished product or recognition in the credits.
Credit-based
o
Equity-based
o Crowd directly or indirectly becomes shareholder.
Directly: Buy direct share, but problem if a lot of people do this?
Answer: you have too many investors in your company, so too hard to
take decisions in situations
Indirectly: Crowd choice a project and for each project there is a fund
and the fund buys the equity, so fund is only shareholder to discuss with
about decisions
o Another solution to avoid problem of too many shareholders: Equity-linked
notes, with no voting rights.
Crowdfunding
- It allows entrepreneurs expose their ideas, projects, and schemes to the widest audience
- Both entrepreneurs and investors can identify opportunities beyond the traditional channels and
personal networks.
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Benefits include
o
Proving a concept
Challenges of crowdfunding
- It requires experience in making a pitch to smaller investors
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Slower growth
5.
Free-rider investors
It allows investors to follow companies and track their growth and development
Now accredited investors can pour at least $1,000 alongside other investors.
SecondMarket, a broker-dealer (second market), manages the fund that pools the
contributed crowdfunding investments.
The fund is the shareholder
Another example: Angels Den (UK)
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o