1 Entrepreneurial Finance Samuele Murtinu Catholic University of Milan – Institute of Economic Policy [email protected]

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Entrepreneurial Finance

Samuele MurtinuCatholic University of Milan – Institute of

Economic [email protected]

2015 – Samuele Murtinu

Introduction

• New Technology-Based Firms (NTBFs) are defined as small businesses whose products or services largely depend on the application of scientific and technological knowledge (Allen, 1992)

• Positive impact on static and dynamic efficiency, and economic growth

Characteristics• Rich endowments of intangible assets• Lack of ‘‘hard’’ assets and collateral• Short track record• Founders with science/technology backgrounds but limited

financial and marketing expertise


Innovation and finance

Schumpeterian competition (Schumpeter Mark I technological regime)

• Entrepreneurial firms play a fundamental role in innovative activities, as they generate novelties which disrupt the quasi-rents

• Creative destruction process (Nelson and Winter 1982; Kamien and Schwartz 1982; Breschi et al. 2000)

Role of finance• Rate and direction of technical change are affected by the

criteria through which financial markets allocate resources (Dosi 1990; Aoki and Dosi 1992).

• Banks and financial markets play the essential role of ‘‘bridges’’ or ‘‘facilitators’’ of the innovative efforts carried out by entrepreneurs (Schumpeter 1911)


Financing gap

FINANCING PROBLEMS• Informational opacity of new firms involved in R&D (patents

vs. secrets)• Highly uncertain returns and costly monitoring• Technology-intensive nature of NTBFs’ activity: complexity• Lack of a consolidated track record• High % of firm-specific and/or intangible assets low

collateral

HIGH DEFAULT PROBABILITY

• Asymmetric information - moral hazard and adverse selection (Akerlof 1970) – and transaction costs (M&M hp are violated)

• Difficult access to financial markets: wedge between the cost of internal and external funds

• Financial constraints


Financial constraints:definition

A firm’s investment is constrained by the availability of finance if and only if• There are investment opportunities (Tobin’s Q)• Such investment opportunities are more profitable (or

strategically profitable) than alternative uses of capital

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Financial constraints:definition

Wedge between internal and external cost of capital• Information asymmetry (Akerlof, 1970)• Asset intangibility• Track record• Investment specificity• Cash flow stability• Market demand• Capital structure (Modigliani and Miller, 1958)

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Varieties of capitalism

Financial systems are classified within different varieties of capitalism:• Germany, Japan and Scandinavian countries are bank-based

systems• UK and US are market-based systems

Countries also differ in terms of• Tax and bankruptcy codes• Ownership dispersion

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The role of banks

R&D funding-gap: internal cash flow as primary source to invest in R&D projects (Hall & Lerner, 2009):• Asymmetric information• Lack of collateral assets/low ratio of tangibility• Credit risk assessed through financial ratios and historical

data (tendency to invest in government bonds)• Banks are not able to separate good projects from 'lemons'

in industries characterized by skewed returns

• High pro-ciclicality of R&D investments• Discontinuity of R&D investments• Banks invest in traditional industries: food, beverage,

healthcare, utilities


The role of banks

• IF: internal finance (=CF)• `lenders are only concerned with the bottom part of the tail

of the distribution of returns' (Stiglitz, 1985: p. 146):– Credit rationing (Stiglitz and Weiss, 1981)– Higher interest rate


(Indirect) Costs of bankruptcy

Loss of customers• Hw/sw no support/upgrade• Airline tickets failure to honor frequent flier schemes• Manufacturers of durable goods warranties/replacement

parts

Loss of suppliers• Inventory

Loss of employees• Lack of job security/Hiring-away• Difficulty to hire new employees• Important for firms whose value largely depends on human

resources


Indirect costs of bankruptcy

Loss of receivables• Difficulty in collecting owed money

Fire sales of assets• Firms forced to sell assets quickly to raise cash (i.e.,

acceptance of a lower price; airlines: -15/40% in the selling price of aircrafts)

• Subsidiaries


Agency costs

NTBFs are usually owner-managedIn any case, managers are hired and retained with the approval of

the owners

LEVERAGE conflict of interest: when the risk of financial distress is high, managers may choose investment decisions that benefit shareholders but harm creditors:

• Over-investment

Agency costs are smaller for short-term debt (less time for moral hazards). The firm is obligated to repay its debt more frequently


Agency costs

OVERINVESTMENTV = 400D = 390E = 10

Timing: close to debt obligations

Investment A PV = 10Investment B PV = 90%(-30)+10%(200) = -7

Baseline situation:V = 400Payoff (debt holders) = 390Payoff (shareholders) = 10


Agency costs

Investment A:V = 400 + 10 = 410Payoff (debt holders) = 390Payoff (shareholders) = 20

Investment B:V = 400 -30 = 370 (prob. 90%) OR V = 400 + 200 = 600 (prob.

10%)Expected V = 370*0.9 + 600*0.1 = 393

Payoff (debt holders) = 370 (prob. 90%) OR 390 (prob. 10%)Expected payoff (debt holders) = 370*0.9 + 390*0.1 = 372

Payoff (shareholders) = 0 (prob. 90%) OR 210 (prob. 10%)Expected payoff (shareholders) = 210*0.1 = 21


Agency costs

Investment A is the best one for the firm because:- It allows to pay debt-holders- It increases shareholders’ wealth (10 20)

Investment B INSTEAD:- With a very high likelihood (90%) leads the firm to bankruptcy- With a very high likelihood (90%) the firm does not pay the

debt

HOWEVER…

Shareholders will choose the investment B (their payoff is higher)


The role of business environment

Obstacles to growth are a function of• Development of financial and credit markets• Efficiency of legal systems• Shareholder and creditor rights• Regulatory burdens• Corporate taxes• Bankruptcy processes• Perception of corruption• IPR protection• Provision of infrastructures• Crime• Political stability


The role of firm-specific characteristics

Obstacles to growth are a function of• Size: power of banks decreases with borrower size

(Petersen & Rajan, 1995)• Age• Ownership• Networks


Pecking-order theory

Entrepreneurs prefer (in order):• Internal finance• Debt• Equity (does not require collateral, and does not increase the

likelihood of financial distress)

Sometimes, firms are not able to grasp business opportunities because of a lack of external finance



Reasons:• max(π) is ONE of the GOALS• Financial markets are not EFFICIENT (Modigliani and Miller,

1958), as assumed by traditional neoclassical models- No full information (entrepreneur vs. investor)- Information are costly

Adverse selection (Akerlof, 1970) second-hand carsVG = value of a “good quality” car

VB = value of a “bad quality” car

Customers cannot evaluate which are the good carsDealers are not able to signal the quality of their cars



If we assume that in the market:• 50% good cars• 50% bad cars

Customers’ willigness to pay = (VG + VB)/2

Result: dealers “put on the market” BAD CARS ONLY!

In the long run: customers expect that there are only bad cars in the market and will pay VB

Conclusion:GOOD FIRMS SELF-SELECT OUT from the financial market

MARKET FAILURE!



Why DEBT before EQUITY?First possible reason: DILUTION

Example:n = 500 millionp = $16Equity market value = n*p = $8 billion

Necessity to invest $1 billion through new equity issuancennew = $1 billion/p = $1 billion / $16 = 62.5 million

p before = $16p after = $9 billion/562.5 million = $16



Second possible reason: firm is underpriced

The use of DEBT varies greatly among industries

Firms in high-growth industries (e.g., biotech) use little debt, while airlines, automakers, utilities and financial firms have high leverage ratios

Firms in high-growth industries do not have any taxable income. Their value comes from their potential to produce high profits in the future (e.g., drugs with tremendous potential).



When the marginal cost of debt financing becomes sufficiently high, new equity financing becomes the least-cost marginal source of finance


The role of private venture capital (VC)• Positive impact of VC on NTBFs’ performance: innovation,

growth, TFP, and likelihood of going public• Context-specific screening• Monitoring and value-added (financial, marketing, human

resources, and operations management)

HOWEVER

• Focus on a limited set of industries• Backing of a very small fraction of ‘potentially investable’

NTBFs:– Kaplan & Lerner (2014): 1,200 firms out of 600,000 firms (with

employees) in the period 2009-2013 (0.2%)

FINANCING GAP MARKET FAILURE

2015 – Samuele Murtinu25

The role of private venture capital (VC)

The GP is typically a

limited liability company,

participated only by the

fund promoters, and is an unlimited shareholder of the fund. For

sake of credibility, it

also provides a (small) fraction of the VC fund

Investors are limited shareholders of the fund, with priority in case of liquidation


Statistics on VC fundraising

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Screening

What VCs consider:• Quality of the business plan and coherence with investment

policies• Founders’ human capital• Expected growth of the business• Innovation (and means to protect it)• Synergies with other portfolio investments• Way-out perspectives (4-7 years)

• Market conditions and timing are important

• Specialization vs. diversification

RATE OF

RETURN


The deal structuring

The main issues to be discussed between the VC and the entrepreneur are related to:• Price to be paid for the shares, in excess of the par value; if the

price is ‘low’ the entrepreneur is selling his project at a discount, while if the price is ‘high’ the VC profitability will be lower (target IRR)

• Stage financing, according to the achievement of the business plan milestones

• Composition of the board• Options held by the VC (e.g. ‘tag-along’ or ‘drag-along’

clauses, super-majority, take-over clauses, pre-emption and veto rights)

• Way-out perspectives


VC investments as % of GDP (country of portfolio companies)


VC investments as % of GDP (country of VC funds)


Europe vs. US

VC investments• USA (19.1 billion € in

2011; 0.13% of GDP)• EU (3.9 billion € in

2011; 0.03% of GDP)

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Exit

The exit may occur in one of the following ways:• IPO: the company is taken public with an Initial Public Offering,

and access the Stock Exchange; the VC stake is part of the IPO• Trade sale: the VC stake is sold with a private offer, to a

bidding company, or to another fund, or the entrepreneur buys back the shares

• Write-off: in case of failure and poor performance, the venture is left to its own destiny and the investment is written-off

Documents

1 Entrepreneurial Finance Samuele Murtinu Catholic University of Milan – Institute of Economic Policy [email protected]