Entrepreneurial Finance Richard L. Smith and Janet Kiholm Smith John Wiley & Sons Publishings, 2000 Book website

TABLE OF CONTENTS
PART 1: GETTING STARTED
Chapter 1: Introduction		1
1.1	The Entrepreneur	2
1.2	Financing and the Entrepreneur	4
1.3	The Finance Paradigm	5
1.4	What Makes Entrepreneurial Finance Different Corporate Finance? Interdependence between Investment and Financing Decisions Diversifiable Risk and Investment Value Managerial Involvement of Outside Investors Information Problems and Contract Design Incentive Alignment and Contract Design The Importance of Real Options Harvesting the Investment Value to the Entrepreneur	5 6 8 8 9 9 10 11 11
1.5	Why Study Entrepreneurial Finance?	12
1.6	The Objective: Maximum Value for the Entrepreneur	13
1.7	The Process of New Venture Formation	13
1.8	Organization of the Book	15
1.9	Summary	17
Chapter 2: An Overview of New Venture Financing		22
2.1	The Rocket Analogy	23
2.2	Choosing the Organizational Form	24
2.3	Information Problems Facing the Entrepreneur and Investors	27
2.4	Measuring Progress with Milestones	28
2.5	Stages of New Venture Development	30
2.6	Sequence of New Venture Financing	32
2.7	Sources of New Venture Financing Self, Friends, and Family Angel Financing Venture Capital Investors Small Business Investment Companies Ex-Im Bank Trade Credit Factoring Asset-based Lenders Mezzanine Capital Private Placements IPOs Public Debt Later-Stage Financing Alternatives	34 34 37 37 41 41 41 42 42 43 43 44 45 45
2.8	The Deal	46
2.9	Summary	49
PART 2: FINANCIAL ASPECTS OF STRATEGIC AND BUSINESS PLANNING
Chapter 3: The Business Plan		55
3.1	Why Business Plans of New Ventures are Different	56
3.2	Make the Plan Fit the Purpose	59
3.3	Is Too Much Attention Devoted to the Business Plan?	59
3.4	Plan First—Write Second	60
3.5	Strategic Planning and the Business Plan What to Include Evidence of Credible Commitments Evidence of Reputation and Certification	61 63 66
3.6	Confidentiality	68
3.7	Financial Aspects of the Business Plan	69
3.8	Targeting the Investors	72
3.9	Due Diligence	72
3.10	Updating the Business Plan	73
3.11	Summary	73
Appendix 3A: Outline of a Business Plan		78
Chapter 4: New Venture Strategy		80
4.1	Henry Ford and the Model T	81
4.2	What Makes a Plan or Decision Strategic?	83
4.3	Financial Strategy	84
4.4	Product-Market, Financial, and Organizational Strategy	84
4.5	Deciding on the Objective	87
4.6	Identifying the Alternatives	88
4.7	Recognizing Real Options Describing Rights to Make Decisions as Options Comparisons Between Real Options and Financial Options	89 90 91
4.8	Strategic Decision Analysis and Decision Trees The Option to Wait to Invest The Option to Add to the Initial Investment The Option to Abandon the Venture	93 95 95 98
4.9	Rival Reactions and Game Trees Nash Equilibrium Prisoners’ Dilemma Tensions Between Maintaining Flexibility and Commitment	99 102 102 103
4.10	Summary	103
Appendix 4A: An Introduction to Options		109
Chapter 5 Developing Business Strategy Using Simulation		114
5.1	Simulation—An Illustration	117
5.2	Simulating the Value of an Option	118
5.3	Using Simulation to Evaluate a Strategy Identifying Strategic Alternatives Choosing Evaluation Criteria Modeling the Problem Specifying the Assumptions and Describing the Uncertainties Running the Simulation Analyzing the Results	120 120 121 121 122 125 128
5.4	Comparing Strategic Choices with Simulation The Option to Abandon The Option to Wait The Option to Invest More	128 130 133 135
5.5	Summary	139
PART 3: FINANCIAL FORECASTING
Chapter 6: Methods of Financial Forecasting		144
6.1	The Cash Flow Cycle	145
6.2	Critical Determinants of Financial Needs Minimum Efficient Scale Profitability Cash Flow Sales Growth	147 147 149 149 149
6.3	Working Capital, Growth, and Financial Needs Working Capital Financing Working Capital Policy	150 151 152
6.4	Pro-Forma Analysis	155
6.5	Forecasting Sales Forecasting Sales of an Established Business Forecasting Sales of a New Venture	158 159 163
6.6	Estimating Uncertainty Assessing Risk on the Basis of Experience Developing Alternative Scenarios	167 168 168
6.7	Forecasting Income Statement and Balance Sheet Information	169
6.8	Information Sources	172
6.9	Building a Financial Model: An Illustration	173
6.10	Summary	180
Appendix 6A: Using the Pro-Forma Spreadsheet		186
Appendix 6B: Sources of Information for Forecasting		189
Chapter 7:Assessing Financial Needs		191
7.1	Sustainable Growth	194>
7.2	Assessing Financial Needs When Growth is not Sustainable	198
7.3	Planning for Product-Market Uncertainty Providing for Product-Market Success Planning for Unexpected Failure High-Tech, High-Growth Innovation	199 200 201 201
7.4	Cash Flow Breakdown Analysis An Illustration Using Breakeven Analysis to Project Financial Needs Present-Value Breakeven Analysis	201 203 207 207
7.5	Assessing Financial Needs with Scenario Analysis	207
7.6	Simulation of Financing Requirements: An Illustration Uncertainty About Development Timing Uncertainty About the Rate of Sales Growth Uncertainty About Cost and Profitability Gauging Uncertainty and Avoiding Undue Complexity Results of the Simulation Interpreting the Simulation Results	210 210 211 212 212 214
7.7	How Much Money Do You Need? Using Simulation to Examine Alternative Financing Arrangements	215 216
7.8	Assessing Financial Needs with Staged Investment	220
7.9	Summary	221
PART 4: VALUATION
Chapter 8 The Framework of New Venture Valuation		227
8.1	Perspectives on Valuation of New Ventures	228
8.2	Myths About New Venture Valuation Myth 1: Beauty is in the Eye of the Beholder. Myth 2: The Future is Anybody’s Guess. Myth 3: Investors Demand Very High Rates of Return to Compensate for the Risks They are Taking. Myth 4: The Outside Investor Determines the Value of a Venture.	230 230 230 231
8.3	An Overview of Valuation Methods	234
8.4	Valuation by the Risk-Adjusted Discount Rate Method Identifying Relevant Cash Flows Determining the Outside Investor’s Cost of Capital	235 236 237
8.5	Valuation by the Certainty Equivalent Method Difficulties of Using the RADR Method How the CEQ Method Addresses the Problem	246 246 248
8.6	Limitations of the Capital Asset Pricing Model	249
8.7	Reconciliation with the Pricing of Options	250
8.8	Required Rates of return for Investing in New Ventures	251
8.9	Summary	252
Appendix 8A: Mathematics of Time Value		260
Appendix 8B: Statistical Review		265
Chapter 9: Valuation in Practice: The Investor’s Perspective		271
9.1	Criteria for Selecting a New Venture Valuation Model	272
9.2	Using the Continuing Value Concept Estimating Cash Flows During the Explicit Value Period Estimating Continuing Value The Effects of Market Timing on Continuing Value	273 274 275 278
9.3	New Venture Valuation Method Using Venture Capital Method Using the First Chicago Method Using the RADR Form of the CAPM Using the CEQ Form of the CAPM	281 281 284 285 292
9.4	Valuing the Investment An Illustration Valuation by the CEQ Method Valuation by the RADR Method Valuation by the First Chicago Method Valuation by the Venture Capital Method	298 298 299 302 304 305
9.5	Summary	306
Chapter 10: Valuation: The Entrepreneur’s Perspective		314
10.1	The Entrepreneur as an Underdiversified Investor An Example of Competition Between Entrepreneurs and Diversified Investors Defining the Entrepreneur’s Commitment to a Venture	316 317 318
10.2	Required Rates of Return for Full-Commitment Investments The Entrepreneur’s Opportunity Cost of Capital Leveraging an Investment in the Market Portfolio to Determine Cost of Capital How Ability to Diversify Affects Cost of Capital Factors that Offset the Entrepreneur’s Cost of Capital Disadvantage	318 319 320 320 322
10.3	Limitations of the Opportunity Cost Framework CAPM Valuation Bias Against High-Risk Investments Limitations of Ability to Leverage Investment in the Market Index Dealing with the Limitations	323 324 324 325
10.4	Valuing Full-Commitment Investments Using the CEQ Method to Estimate Value Using the Maximum-Achievable-Leverage RADR to Estimate Value	328 238 329
10.5	Implementation—Full Commitment Using the RADR for a First Look at Value Valuing a Venture as a Full Commitment	329 332 332
10.6	Required Rates of Return for Partial Commitment Investments Using the RADR Method to Estimate Value Using the CEQ Method to Estimate Value Using the Maximum-Achievable-Leverage RADR to Estimate Value The Relation between the Entrepreneur’s Wealth and New Venture Value	335 335 338 339 339
10.7	Implementation—Partial Commitment Valuing the Venture as a Partial Commitment Comparing Full and Partial Commitment Values Wealth, Diversification, and Venture Value Valuing Ventures that have Cash Flows in Multiple Periods	340 340 342 342 343
10.8	Estimating the Entrepreneur’s Wealth and Investment Estimating the Present Value of Compensation in Alternative Employment The Entrepreneur’s Total Wealth An Illustration Human Capital as a Third Asset in the Entrepreneur’s Portfolio	346 346 347 347 347
10.9	How Undiversified are Entrepreneurs? Scenario 1 Scenario 2 Generalizations	348 349 349 350
10.10	Benefits of Diversification Alternatives to Investing in the Market Index Achieving the Right Balance Qualitative Considerations	350 352 353 353
10.11	A Sanity Check—The Art and Science of Good Investment Decisions Assessing Sensitivity to Assumptions Using Simulation to Deal with Uncertainty About Assumptions	353 353 354
10.12	Using and Misusing Simulation in Valuation	356
10.13	Treatment of Sunk Costs in the Valuation	356
10.14	Summary	357
PART 5: ORGANIZATION DESIGN AND FINANCIAL CONTRACTING
Chapter 11 Financial Contracting With Symmetric Information		365
11.1	Some Preliminaries	366
11.2	Proportional Sharing of Risk and Return Choosing the Scale of the Venture Outside Investment with Proportional Sharing	367 367 370
11.3	Non-proportional Sharing of Risk and Return How Shifting Risk Affects the Entrepreneur The Outside Investor’s Perspective Risk-Allocation Contracting in Practice	370 371 373 374
11.4	Contract Choices that Allocate Expected Returns The Entrepreneur’s Gain from Contracting with a Well-Diversified Investor How Much of the Entrepreneur’s Wealth Should be Invested in the Venture? Who Should Own the Venture? Reconciling Theory with Practice What if the CAPM is the Wrong Asset-Pricing Model? Determining the Scale of the Venture	375 380 380 381 382 383
11.5	Contract Choices that Alter Venture Returns Evaluating Investment by Subsidized Investors Evaluating Investment by Active Investors	383 383 385
11.6	Implementation and Negotiation Evaluating Alternative Financing Proposals Developing and Evaluating Counterproposals	387 387 388
11.7	Summary	390
Chapter 12: Dealing with Information and Incentive Problems		396
12.1	Information Problems, Incentive Problems, and Financial Contracting Financial Contracting with Known Symmetrical Beliefs Precontractual Information Costs Example: Adverse Selection in Capital Raising Postcontractual Incentive Problems Example: Moral Hazard in Organizations	397 398 398 400 405 408
12.2	Contract Design Discrete Contracting Relational Contracting and Flexibility Incomplete Contracts and Mechanisms for Resolving Information and Incentive Problems	412 412 413 414
12.3	Organizational Choice An Economic Perspective on Organizational Structure A Contracting Framework of Organizational Choice A Recap	423 424 426 429
12.4	Summary	429
Chapter 13: Financial Contracting		439
13.1	Staging of Investment: The Venture Capital Method Single-Stage Investment Multi-stage Investment Why Does Staging Reduce the Outside Ownership Share? Determining Required Ownership Percentage When Follow-on Investment is Expected How the Capitalization of a Venture Relates to the Stage of Financing	440 442 442 444 445 445
13.2	Single-Stage Investment—CAPM Valuation with Discrete Scenarios Proportional Allocation of Risk and Return Allocating More of the Equity to the Entrepreneur Reducing the Entrepreneur’s Investment	446 448 448 449
13.3	Staging of Investment Staging with Irrevocable Commitment to Invest Staging with Conditional Investment Evaluating the Option to Invest in the Second Stage Valuing Conditional Multi-stage Investment Valuing the Interest of the Entrepreneur Negotiation and Additional Considerations	452 452 454 456 460 464 464
13.4	Using Contracts to Signal Beliefs and Align Incentives	465
13.5	Using Simulation to Design Financial Contracts Developing the Financial Model of the Venture and Specifying the Assumptions Using Simulation to Estimate Expected Cash Flows and Risk Evaluating the Financial Claims Evaluating Alternative Financial Contracts	466 469 471 472 477
13.6	Information, Incentives, and Contract Choice Valuing Different Types of Financial Claims Increasing the Number of Contracting Parties Contracting to Resolve Information and Incentive Problems	477 477 481 482
13.7	Summary	484
Appendix 13A: Evaluating Alternative Financial Contracts		489
PART 6: FINANCING SOURCES AND HARVESTING
Chapter 14: Venture Capital		495
14.1	An Overview of the Venture Capital Market	496
14.2	The Organization of Venture Capital Firms Organizational Structure The Investment Process Why Limited Partnership Funds?	499 500 503 506
14.3	How Venture Capitalists Add Value Adding Value by Selecting Investments and Negotiating Deals Adding Value by Allocating Effort Efficiently Adding Value by Monitoring and Advising Portfolio Companies	507 507 509 510
14.4	Investment Selection and Venture Capitalist Compensation	513
14.5	Venture Capital Contracts with Portfolio Companies	513
14.6	Venture Capital Contracts with Investors	516
14.7	The Role of Reputation in the Venture Capital Market	518
14.8	Summary	519
Chapter 15: Choice of Financing		529
15.1	Financing Alternatives 530
15.2	Start with the Objective and Basic Principles of the Financing Decision Basic Considerations that Affect Financing Choices Other Considerations that Affect Financing Choices	531 531 531
15.3	First Step: Assess the Nature of the Venture’s Financial Needs Four Questions the Entrepreneur Must Ask When Choosing Financing The Influence of Immediate Financing Needs The Influence of Near-term Financing Needs The Influence of Cumulative Financing Needs	532 533 533 535 541
15.4	Second Step: Assess the Current Condition of the Venture The Influence of Stage of Development The Influence of the Value of Active Outside Involvement The Influence of the Asset Base	542 542 542 544
15.5	Third Step: Assess the Relation Between Financing Choices and Organizational Structure The Relation Between Financing and Strategic Planning The relation Between Financing and Franchising	546 546 548
15.6	How Financial Distress Affects Financing Choices Why Turnaround Financing is Different Influence of Financial-Distress Costs on Choice of Financing	548 549 552
15.7	How Reputations and Relationships Affect Financing Choices	552
15.8	Total Availability of Financing for Small Businesses and New Ventures	553
15.9	Avoiding Missteps The Investor’s Perspective on Timing	556 556
15.10	Summary	557
Chapter 16: Harvesting		566
16.1	Going Public The Initial Public Offering Process Harvesting in the IPO Harvesting After the IPO	567 568 576 577
16.2	Acquisition Equity of the Venture Purchased for Cash Assets of the Venture Purchased for Cash Equity or Assets of the Venture Exchanged for Equity of the Acquirer After the Acquisition Agreeing to Disagree Valuing Private Transactions	578 578 579 580 580 581 581
16.3	Management Buy-Out Valuing MBO Transactions	583 584
16.4	Employee Stock Ownership Plans of Private and Family Businesses The ESOP Process Valuation Considerations	584 585 587
16.5	Roll-Up IPO Valuation Considerations	587 588
16.6	The Harvesting Decision Company Size The Value of a Public Market for the Shares Synergies Track Record and Ease of Valuation Timing Ownership and Control Taxes Transactions Costs	589 589 589 590 590 590 591 591 591
16.7	Summary	591
PART 7: CONCLUSION		566
Chapter 17: The Future of Entrepreneurial Finance: A Global Perspective		601
17.1	Completing the Circle Entrepreneurial Investment and Financing Decisions Are Interdependent Investment Value Depends on the Entrepreneur’s Ability to Diversify Some Outside Investors are Actively Involved in Their New Venture Investments Financial Contracts and Other Devices Can Be Used to Address Information Problems New Venture Financial Contracts Can Align Incentives Real Options Are an Important Source of Value for New Venture Stakeholders Harvesting Is Critical to the Investment Decision New Venture Organizational and Financing Choices Can Be Compared Based on Their Effects on Value to an Entrepreneur or to an Investor	602 602 602 604 604 605 605 606 607
17.2	Breaking New Ground How can Portfolio Theory Best Be Adapted to Evaluate High-Risk Opportunities with Significant Probabilities of Failure? What is the Opportunity Cost of Capital for High-Risk, Long-Term Investments? What is the Best Way to Value Investment Opportunities Involving Portfolios of Complex and Interdependent Real Options? What is the Best Way to Estimate the Uncertain Cash Flows of a New Venture and the Correlation of Those Cash Flows with the Market? What is the Best Approach for Valuing Multiple-Period Cash Flows for an Under-Diversified Investor? What Kinds of Investment Opportunities Are Most Effectively Pursued by Individual Entrepreneurs and What Kinds Are Most Effectively Pursued by Corporations? How Do Financial Wealth and the Opportunity Cost of Human Capital Affect an Individual’s Decision to Undertake a High-Risk Entrepreneurial Venture? How Can Organizations that Engage in Research and Development Promote Entrepreneurial Activity While Preserving the Right to Realize Some of the Rewards of the Activity? How Will a Decrease in the Rate of Innovation Affect the Allocation of ResourcesDevoted to Entrepreneurial Activity?	607 607 607 608 608 608 609 609 609 609 610
17.3	An International Comparison of Entrepreneurial Activity The Role of Financial Structure in Simulating Entrepreneurial Activity The Financial Structure Facilitates Assessment of Risks and Rewards The Financial Structure Limits Exposure to Risk and Increases Expected Rewards The Financial Structure Both Facilitates and Limits Risk-Taking by the Entrepreneur The Financial Structure Includes Patient Investors with Minimal Needs for Liquidity The Tax Structure Favors Capital Investment The Financial Structure Facilitates Diversification and Pooling of Risk The Financial Structure Provides Easy Access to Well-Functioning Public Capital Markets Investment Decisions are Predominantly Market-Driven	610 612 612 613 613 614 617 619 620 622
17.4	The Future of Entrepreneurial Finance Methods of Selecting New Venture Investment Opportunities Will Improve Changes in the Set of Entrepreneurial Investment Opportunities Will Threaten Existing Institutions Changes in the Competitive Climate Are a Threat to Existing Institutions What will be the Drivers of Success?	623 623 624 626 628
INDEX		632