Learning objectives MSc Elective Entrepreneurial Financecressy/Teaching/Msc/EntrepreneurialFinance/... · Entrepreneurial Finance Lecture 1: Context Course leader: Prof. Robert Cressy

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MSc Elective Entrepreneurial Finance

Lecture 1: Context

Course leader:Prof. Robert Cressy

Copyright 2001, Robert Cressy

Learning objectives

n To understand the nature and characteristics ofentrepreneurial businesses

n To understand how these interact with theirfinance structure and requirements

n To understand the financial constraints thatsmall entrepreneurial businesses may face

n To understand the nature of venture capital andthe form of the financial instruments it uses


n To be familiar with the structure of the UKventure capital industry

n To know the returns to UK venture capital inboth absolute and relative terms and by stage,duration and sector


Structure of the lecture

n 1/ What is an entrepreneur?n 2/ Stages of new venture developmentn 3/ The role of equityn 4/ Venture capitaln 5/ The UK venture capital industry


1/ What is an entrepreneur?

n Typical startup entrepreneur (Cressy, 1993)n Objectives

n IndependencenBeing one’s own bossn ‘Making money’nBut NOT

n Fast growthn Innovationn Internationalisationn Ultimate sale of the business


Entrepreneur cont’d

n Background of entrepreneursn Low level of educationn Low skill levelsnWork experience in the area of the startup

n Sector of businessn Services rather than manufacturing

n Retailn Constructionn Property/Professional/Financial servicesn Personal services e.g. hairdressing, car repairs

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Entrepreneur cont’d

n FinancenOwner’s resources (savings)nMoney from friends and relatives (US: ‘love money’)nBanknOutside equity?

n Highly resistant to relinquishing control and/or profits tooutsiders

n Only 1-2% use venture capital

n Business survivalnVery short-livednMost die in the first 2-3 years (See Chart 1)


Chart 1. Failure rates and initialcapitalisation

Figure 2: Initial capitalisation and failure (Source: Cressy,1999)

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x=1500,mu=20,sigma=50


Exercise 1:Rationale of the failure curve

n Why do you think the failure curve aboven Has the shape it doesn Shifts in the way it does as initial capital increases?

nHint: think how startup capital is used by a businessn Why do they have it?n What were Keynes three motives for personal savings?


Failure & initial capital cont’d (Answer to Exercise 1)

n Shape of the curvesn Bell shaped and skewed to the rightn Failure rates

n high initial failure rate followed byn low long run failure rate

n Comparison of pink and blue curvesn Higher initial capital (pink curve) is associated with:

n Longer honeymoon period (zero failure probability)n Lower peak failure ratesn Lower average failure rates

n Median value on Pink curve is to the right of that on the Blue


n The message:n Less well-capitalised startups are more failure-pronen This affects firms in a dynamic way through the

lifecycle


Theory of failure

n Theory of mistakesn When entrepreneurs start in business they make mistakesn These mistakes are costly (e.g. investing in too large a set of

premises by misjudging demand changes)n Mistakes increase risk

n Causing depletion of the initial capital resources

n Growth reduces riskn By adding profits to the business

n The larger the initial resourcesn the longer the time it takes for the firm to fail

n for a given growth rate

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n Effects of credit market behaviour/imperfectionsn Banks are least likely to lend when the business is in trouble

n ‘In order to get a bank loan you have to prove you don’t need it’n Failure is therefore more likely the smaller the capitalisation of the

business

n Theory of learningn Business is a ‘learning experiment’ (Jovanovic, 1982)

n Entrepreneurs have to learn ways of doing things that work and areleast cost or most profitable

n After making mistakes they learn better ways of doing thingsn This means that markets and suppliers for a business take

some time to get established


n During this initial period the business is particularlyvulnerable

n The larger the initial resources the less likely is this to result infailure


The sophisticated Entrepreneur(Bhide, 1999)

n Business ideasn Mainly from work experience (see Chart 2)

n Entrepreneurial objectivesObjective 1: A large enduring enterprise

n Revolutionary idean e.g. Gates’ and the PC: ‘A PC on every desk’n Smith and the FedEx global overnight mail delivery systemn Nokia and the mobile phone

n Mass marketn New processes/manufacturing techniquesn Big money and organisation


n Inspirational leadership stylen Skills required:

n deal-makingn strategic planningn publicityn management of overheads etc.


Chart 2. Work experience pays dividends: Sourcesof entrepreneurial ideas (Bhide, 1998)

S w e p t i n t o t h e P C

r e v o l u t i o n

D i s c o v e r e d

s e r e n d i p i d o u s l y

M o d i f i e d i d e a f r o m

p r e v i o u s e m p l o y m e n t

D i s c o v e r e d t h r o u g h

s y s t e m a t i c r e s e a r c h


Sophisticated cont’d

Objective 2: A quick profitnMarket niche

n Relatively small number of customers not served by existingsuppliers

n Differentiated productn rather than a mass market

n No breakthrough technologies requiredn Skills:

n Ingenuity in siphoning off customersn Appropriate pricing policy to cover high (unit) fixed costs

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n Entrepreneurial strategyn Business opportunities

n Screen opportunities quicklyn Analyse ideas parsimoniouslyn Combine research and action

n Financen Search for

n appropriate kinds of financen Cheapest/best sources

n Flexible attitude to controln Prepared to relinquish some equity for growth

n Rational (‘instrumental’) attachment to the businessn Often willing to sell the business after objectives fulfilled



n Finance constraintsnBank financing often unsuitable

n Collateral requiredn Most assets intangiblen e.g patents, copyrights, implicit knowledge

n Most likely to have no or low initial salesn Business therefore often loss-making at outsetn Lack of understanding by banks of high technology

n Only a constraint for 25% of fast growth businesses


Sophisticated cont’dn Risk

n Marketn Overall demand uncertaintyn Competitors

n Technologyn Will the product materialise?

n E.g. a cure for diabetes or aidsn Will it sell if it does?

n Side effects?

n Small scale initiallyn VCs in Europe often shun small early stage projects

n Prefer large scale, low risk investment e.g. UK (see later)n Hence need to rely on Angel involvement

n Track recordn Little or none for startupsn Judgements of financiers therefore based on ‘people factors’


2/ Stages of new venture development

n Figure 1 shows a stylised graph of returns to a new firmtaken from Smith and Smith(2000)n The firm moves through the following stages

n Developmentn Startupn Early growthn Rapid growthn Exit

n Note: This is a stylised picture and one to which many firmswill only partially conform.n E.g. they may fail at startup. Chart 1 demonstrates this point


Time

Dol

lars

RevenueNet IncomeCash Flow

0

0

Development Start-up Early Growth Rapid Growth Exit

Chart 3

Stages of New Venture Development

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 2Copyright 2001, Robert Cressy

Venture development cont’d

n Development stagen Sales (revenues)

nNone at this stagenAt most a prototype product

n Cash flown Funds are initially acquired to develop and test a

prototype product or servicenThese may be used up rapidly and the firm is spending

more than it receivesn Net cash flow is negative

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n Startup stagen Sales

n None initially but sometime into startupn Customers are attractedn Sales start to grow

n Cash-flown Still negative as investments need to be made in:

n Short term assets (NWC)n Trade debtors: often large firms who are slow payersn Trade creditors: suppliers demand early payment

n Wages need to be paid despite these lags in cash payments (see Figure )n Hence overdraft facilities (short term borrowing) taken on boardn When net cash flow becomes positive the overdraft is paid off


Venture development cont’dn Long-term assets (FA)

n Fixed capital is being purchased rather than soldn Long-term loans may be required or equity must be raisedn Factory premises, machinery, computers, laboratories etc. need to

be purchasedn Such investments involve net cash outflowsn Equity investments may be necessary to fund these



n Early & rapid growthn Sales

n The market has been identifiedn Eventually demand takes offn Exponential growth of sales

n Cash-flown Eventually becomes positive as

n Trade credit is managed bettern Trust is built up with

n customers andn suppliers

n Unit operating costs fall with outputn As experience accumulatesn Good suppliers identified



n Exitn Sales

n Growth rate levels outn Firm has an established track record of

n Profitabilityn Growthn Dividends to shareholders

n Entrepreneur is willing to sell shares to the publicn She may personally cash in and allow control to be taken by the

Board appointed by the shareholdersn Form of exit

n IPOn Trade sale


Exercise 2:Cash flow and profits

n Describe the situation in the next Figuren Where is the breakeven point?n In profit termsn In cash flow terms

n Over what period will the firm have to borrowto fund its operations?


Figure 1:Cashflow & profits

after startupSales(t)

Purchases(t)

CashinflowfromSales(t)

Cash outflowfromPurchases (t)

Time(t)0

Wages(t)

Net Cashflow(t)Startup

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Cash-flow breakeven(Answer to exercise)

n The firm’s sales and purchases occur immediately itstarts upn E.g. a pure arbitrage business such as used cars

n The period of trade credit is the same for sales andpurchases and is t* (see next figure)

n Cash needs to be paid in wages from the outsetn Only after the period of trade credit (t*=90 days) is net

cash flow positiven The profits breakeven point is at t=0n The cash flow breakeven point is t=t*


Figure 2:Cash-flow breakeven

(Answer to Exercise 2)

CashinflowfromSales(t)

Cash outflowfromPurchases (t)

Time(t)0

Wages(t)

Net Cashflow(t)

Startup

-w

k-w

t*


n The firm would have to borrow e.g. onoverdraft, until t* is reached

n Then it could start to pay off its debts


3/ The role of equity

n Finance problems affect the early stages of thebusiness:n Survival (see chart 1)n Growth

n NB. Problems may have their origins in causesother than finance e.g. management deficiencies


Equity cont’d

n Broad types of funding availablen Debt

nAdvantagesn No loss of controln Larger share of profits to owner

nDisadvantagesn increases financial riskn requires collateral


Equity cont’d

n Private equitynDefinition:

n long term financen provided by outsidersn for a share in the ownership of the firm

nAdvantagesn Long-term fundsn Reduction in financial risk

n D/E ratio declines: Allows more debt to be taken on boardif required

n No commitment to fixed payments (as with debt): dividendsnot compulsory

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Case study:Equity rationing?

n There is a growing body of evidence suggestingthat small firms may not get enough fundsaccording to NPV criterian This applies to equity as well as debtn Small firms are considered by some as having

n lower return andn higher risk


Rationing cont’d

n Carpenter and Petersen (2001)n Sample of some 2,500 US firms that went public in the

period 1981-98nMeasures of size and financing recorded

n At time of IPOn After IPO

n Findingsn At time of IPO

n Average (median) firm makes little use of long-term debt (5-8% total assets)

n Larger firms make more use of it (40-50% total assets)


Rationing cont’dn New equity (from IPO) is extremely important in financing

assetsn Median ratio of new equity to TA is 1.3-2.1n 90th percentile ratio is 7.9-12.4

n Hence IPO permits big increase in firm assetsn But little equity is raised subsequent to IPO (see Fig. )

n Despite significant employment growth

n Interpretationn The authors argue that this is evidence of financing constraintsn What interpretation would you place on the findings?


Post-IPO use of equityUse of equity by hi tec firms post IPO, US, 1981-98

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4/ Venture capital

n Definition:n Venture capital is the purchase by outsiders of shares in an

unquoted companyn The objective is primarily for the purpose of capital gain


Cumulative convertiblepreference shares (CCP)

n VCs typically initially supply funds in the form not ofcommon stock (ordinary equity) but in Preferencesharesn Cumulative

n Dividends can be delayed until IPO (or 6-8 years, whichever is thesooner)

n Cumulated unpaid dividends can then be paid in one sumn Convertible

n They can be converted into equity at the behest of the shareholdern This is more likely if the firm is perceived to be doing well

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CCP cont’dn Preference shares

n These are shares without voting rights but which have more seniorclaims if the firm isn Liquidatedn Sold to another party


Why the preference for Preference?(Taken from Gompers and Sahlman, 2001)

n Consider the following business situation:n An entrepreneur Joe Flash sells 50% of his startup

business Surfit, for £1.5 to Rex VC, a venturecapitalistn a 50.05/49/95 split to be exactn leaving Joe with a majority stake and control over decisions

n This values the business at £3mnRex paid £1.5m for half of Surfit


Why? Cont’d

n Surfit’s Assets:nTangible: £1.5m cashn Intangible: Joe’s Powerpoint slides and business plan

n Another businessman John Terrific offers Joe£2m for Surfit

n Joe accepts givingn £1m to Rex (his 50%)n £1m to Joe (his 50%)


Why? Cont’d

n Note what has happened to Rex’s investment:n It has instantly fallen in value by £500k or 33%!

n Note that John Terrific has been able to recruitJoe and his business idea for a mere £500k!n He has acquired a business for £2m with cash assets

of £1.5mn Hence his net price for the deal is only £500k


Why? Cont’d

n How does Rex VC avoid this problem?n By use of one of the following:

n Preferred stocknVesting of founder, management and key employee sharesnCovenants and supermajority provisions

n We examine only the first: preference sharesn Preferred stock has liquidation preference over common

stock (=ordinary shares)


Why? Cont’dn It gets paid before common stock does in the event of

n liquidationn sale of the business to another party

nHence in our example, if Rex VC had invested £1.5m inpreference shares under the sale to John Terrificn Rex would have had this sum returned to him on sale

n before any payment to ordinary shareholders

nWhat about the remaining £2m-£1.5m=£500k from thesale?n It depends on the type of preferred stock used:

n Redeemable preferredn Convertible preferred

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Why? Cont’d

n Redeemable preferred (RP)nCannot be converted into equitynCarries a negotiated term specifying when it must be

redeemed by the company, typically smaller of:n IPO daten 5-8 years

nAgreement might have been:n Rex pays £1.5m for RP with face value £1.5mn And Rex gets 49.95% of common equity = £250k

n Joe gets 50.05% of common equity =£250k


Why? Cont’d

n Convertible preferred (CP)nCan be converted to common equity at the shareholder’s

optionn Forces the shareholder to decide whether to take her

returns throughn Liquidation option (e.g. at IPO)n Conversion option (before IPO)

nWhat are the choice criteria?n Looking back, we can see that Rex VC would not have

converted his preference shares in to common stock:n In so doing his wealth would have fallen


Why? Cont’dnThus the criterion is rather simple:

n if the current value of the firm exceeds the initial value (I.e. the valueimmediately after the initial investment) then convert

n else, do not convert

n For example, if the offer Joe had received was £4m andRex VC converted his preference shares into equity hewould receive 50% of £4m or £2mnThis is >£1.5m Rex had initially invested.


Trester’s dataFinancial structure of venture capital deals, USA, 1998Table 1 All deals, Early stage, # venture firms =8, percentages

Mean(95%) Confidence interval (n=800) Min MaxPreferred 96.4 1.3 90 100Common 2 1 0 10Debt 2.1 1 0 10

Table 2 All deals, Later stage, # venture firms=8, percentagesMean(95%) Confidence interval (n=800) Min Max

Preferred 87.8 2.3 50 100Common 3.9 1.3 0 10Debt 10.1 2.1 0 50

Table 3 Preferred deals where preferred is convertible (%), # venture firms=8Mean(95%) Confidence interval (n=800) Min Max

88.8 2.2 30 100

Source: Trester(1998)


n The inference from Trester’s data is:n Most venture capital deals involve a majority of

preferred stock rather than ordinary equityn It is more common in Early stage deals than Later stage

ones

n The vast majority (almost 90%) of preferred isconvertible


5/ Context:UK formal venture capital industry

n Our definition of venture capital includesn Informal venture capital: Business Angels

n Investments: Small sums of money (<£1m)n Investors:

n high net worth individuals (e.g. successful entrepreneurs)n with a hands-on approach to investment

n play a role in managing firmn usually live and invest locally

n Formal or Institutional venture capitaln Investors: Large financial institutionsn Investments: Large sums of money

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Context cont’d

n VC Fund types1. Captive funds

n Source of moneyn Own-moneyn Big organisations

n Clearing banksn Big VC firms e.g. 3is

n Investmentn Stage: MBO/MBIn Size: Largen Horizon: Short 2-4 yearsn Exit route: Flotation, London Stock Exchange

n Management stylen Hands-offn Transaction-based


Context cont’dn Practitioner profile

n Agen Young: 20s-30s

n Qualificationsn Profession: accountantn Education: graduate, highly numerate, computer-literate, finance-

related

2. Non-captive (‘Active’) fundsn Source of money

n Other people’sn Wholesale: Institutions (pensions, insurance)n Retail: Dedicated funds (Investment trusts, limited partnerships,

VCTs, EIS)


Context cont’dn VC Investment

n Stagen Various: Seed, startup, expansion, MBO/MBI

n Sizen Smaller than those of captive funds

n Horizonn Longer: 5-7 years

n Managementn Hands-on

n Exit routen Private: Trade sale (% )n Public: flotation on 2 nd ary market (% ): AIM, TechMark


Chart 4:Numbers of investments by stage

Source: BVCA, 1999, Table 4

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Refinancing bankdebt

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Chart 5:UK investment value by stage


Value of investments by stage

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Context cont’d

n Charts 4 and 5 show that in term of numbersn Business expansion

n accounts for almost half of venture capital investmentsn Management Buyouts & Early stage

nEach accounts for about a quarter of investments

n However, in terms of total share of fundsn Management buyouts take the lion’s share (75%)n Early stage take a very small proportion (5%)

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Context cont’d

n Chart 6 shows that this is accounted for by sizeof investmentn the average size of VC investment is

n largest in MBOs at around £16mn smallest in Startup and Expansion at around £1m and

£2m respectively


Chart 6:Average size of investment by stage


Average formal VC investment size by stage, UK 1999

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Startup Other early stage Expansion Secondarypurchase


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(£0

00)


Exercise 3:Job matching in venture capital

n Which of the above two fund types (if any)would you most likely fit into, jobwise?

n Why?


Context cont’d

n VC Industry structuren Market segments

n Seed, Startupn Expansionn Secondary purchasen MBO/MBIn Rescue/turnaroundn Technology

n VC firmsn Focus

n Generalistn Range of market segments e.g. 3i, Apax , HSBC

n Specialistn Specific market segments e.g. Early Stage or Biotechnology


Chart 7:VC fund distribution by Stage

Source: Denny(2000)

Chart: Number of VC funds by Stage of investment, 1998

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Early stage Development Mid size MBOs Large MBOs Generalist All funds

Stage

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er o

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Fund focus

n The chart shows thatn Numbers of funds are evenly distributed by Stage,

butn Early Stage has lower representation than the restn Generalist are about as common as specialist funds

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Exercise 4:DIY industry analysis

n Go to the BVCA website and check outn How many VC firms there are in the membershipn How many are in the following sectors

n High techn Biotechnologyn Telecommunicationsn Computersn Electronics

n Conventionaln E.g. consumer goods

n Calculate the average size of company (assets under control) in eachbroad sector

n Compare the two sectors and explain


Fund performance

n VC industry performance (see Chart 8)n Stage returns in the UK

nRate of return rises steadily with scalen from Early Stage to MBO

n It is highestn in the early years of the investment, orn in shorter-lived investments (Data doesn’t tell us which)

nGeneralist funds come out about average over all stages


Chart 8:Returns by Stage and Duration

Source: Denny, 2000

Returns to VC investment by Stage, 1997

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Early stage Development Mid size MBOs Large MBOs Generalist All funds

Stage of investment

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e IR

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er a

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um

3 years

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10 years


Exercise 5:High tech returns

n What is commonly meant by a high tech firm?n Would you say that high tech returns are likely

to be higher/lower/the same as conventionalinvestments?

n List your reasons


Returns to specific sectors:High-tech(Answer to Exercise 5)

n UK high tech investments at early stagen Differ from the typical early stage investmentn They provide

n higher returns than other stages in that sectorn 28% versus 23%

n Higher returns thann Expansion (15%) andn MBO/I (20%)

n See Chart 9n These returns were measured from inception to 1998n Thus they avoid the distortion of the technology stocks

bubble of the year 2000


High-tech cont’d

n Highest returns were in fact inn Communications (38%)n IT (23%)n Biotech and Healthcare (21%)

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Chart 9:High tech sector returns

High tech Venture Capital investment returns, from inception to 1998( Source: Bank of England, The financing of technology-based small firms, 2001)

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10

15

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Total high tech Early stage high tech Expansion MBO/I

IRR

(% p

.a.)


VC benchmark comparisons

n Comparison with alternative investments(benchmarks )n See Chart 10n The return to VC investment is higher over a shorter period:

n VC delivered a 30% p.a. IRR to investors over 3-5 yearsn After that (10 years) returns halve to 15% pa.

n The FTSE100 is the best alternative use of funds over theperiod at 23% IRR pa.

n The FTSE Small Cap. showed the lowest return of thealternatives considered.n At an IRR of 15% it returned about half that from VC investment


Chart 10:VC and benchmark comparisons

Comparison returns to Venture Capital, 1997(Source: Denny, 2000)

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30

35

UK pension funds FTSE All share FTSE100 FTSE Small Cap. Average venture capitalreturn

Comparison investment

IRR

(% p

.a.) 3 years

5 years

10 years


VC cross-country comparisons

n How do returns in different countries compare?n See chart 11n The relative returns to Stages across countries differ

significantly:n 3-year returns to VC investment were

n Higher for MBOs in the UK than in the EU and USAn Higher for Early stage in the USA and EU than in the UK


Chart 11:Cross-country VC returns

3 year returns to VC investment by stage in the UK, EU and USA, from inception to 1998

(Source: Bank of Engand, 2001)

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5

10

15

20

25

30

35

40

Early stage/seed MBO Total

IRR

(% p

.a.) UK

USA

Europe


VC returns by stage and duration

n How do venture capital returns vary with stage andduration of investment?

n See chart 12n Survey covers 134 Venture Capital funds

n But no standard errors are reported by duration of investmentn Therefore numbers in individual cells may be small and unreliable

n However, they suggest (subject to the above) thatn In the short run (the first year particularly), returns on larger

investments are greater than smalln This holds for investments of longer duration e.g. 10 years

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Chart 12.VC returns by stage & duration

VC returns by stage and duration of investment(Source: Bank of England, 2001)

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-20

0

20

40

60

80

Early stage Development Mid MBO Large MBO Generalist

IRR

(%, p

.a.)

10 years

9 years

8 years

7 years

6 years

5 years

4 years

3 years

2 years

1 year


Summary and conclusions

n Entrepreneurial enterprises are risky, opaqueactivities

n The traditional financial markets therefore seemto supply inadequate funding to them

n Outside equity is more appropriate than debt forthese enterprises

n Venture capital supplies outside equity tounquoted potentially fast growth companies


n This is most commonly supplied by cumulativeconvertible preference shares

n The UK venture capital industry is the biggest inEurope and second in the world (first being theUS)

n The most common VC investment is forexpansion of established firms

n However, more money overall goes intoManagement Buyouts/Buy-ins


n Returns to UK venture capital in the last 3-5years have outperformed the relevantbenchmarks

n Returns to high tech investments have exceededthe rest

n However, these returns partly reflect the recentbubble in the tech sector


Further reading

n See Notes below

Documents

Learning objectives MSc Elective Entrepreneurial Financecressy/Teaching/Msc/EntrepreneurialFinance/... · Entrepreneurial Finance Lecture 1: Context Course leader: Prof. Robert Cressy