Entrepreneurial Finance: Strategy, Valuation, and Deal Structure - Hardcover

Smith, Janet Kiholm; Smith, Richard L.; Bliss, Richard T.

Hardcover

ISBN 10: 0804770913 ISBN 13: 9780804770910

Publisher: Stanford Economics and Finance, 2011

Synopsis

Entrepreneurial Finance: Strategy, Valuation, and Deal Structure applies the theory and methods of finance and economics to the rapidly evolving field of entrepreneurial finance. This approach reveals how entrepreneurs, venture capitalists, and outside investors can rely on academic foundations as a framework to guide decision making.Unlike other texts, this book prepares readers for a wide variety of situations and problems that stakeholders might confront in an entrepreneurial venture. Readers will find a unique and direct focus on value creation as the objective of each strategic and financial choice that an entrepreneur or investor makes. The authors specifically address the influences of risk and uncertainty on new venture success, devoting substantial attention to methods of financial modeling and contract design. Finally, the authors provide a comprehensive survey of approaches to new venture valuation, with an emphasis on applications.The book appeals to a wide range of teaching and learning preferences. To help bring the book to life, simulation exercises appear throughout the text. For those who favor the case method, the authors provide a series of interactive cases that correspond with the book chapters, as well as suggestions for published cases. Finally, the book is organized to complement the development of a business plan for those who wish to create one as they read along.Entrepreneurial Finance is most effectively used in conjunction with a companion website, http://www.sup.org/entrepreneurialfinance. On this site, Venture.Sim simulation software, spreadsheets, templates, simulation applications, interactive cases, and tutorials are available for download. For those teaching from the book, the authors also provide an invaluable suite of instructor's resources.

About this title

About the Author

Janet Kiholm Smith is the Von Tobel Professor of Economics at Claremont McKenna College.

Richard L. Smith is Philip L. Boyd Chair and Professor of Finance and Management Science and Chairman of the Department of Finance and Management Science at the University of California, Riverside.

Richard T. Bliss, is an Associate Professor of Finance and was most recently the Division Chair and Barefoot Family Endowed Chair for Finance at Babson College.

Excerpt. © Reprinted by permission. All rights reserved.

Entrepreneurial Finance

Strategy, Valuation, and Deal StructureBy Janet Kiholm Smith Richard L. Smith Richard T. Bliss

Stanford University Press

Copyright © 2011 Board of Trustees of the Leland Stanford Junior University
All right reserved.
ISBN: 978-0-8047-7091-0

Contents

List of Illustrations.........................................................................xviiAbbreviations.................................................................................xxiiiPreface.......................................................................................xxviiAcknowledgments...............................................................................xxxixAbout the Authors.............................................................................xliChapter 1 Introduction........................................................................3Chapter 2 new Venture Financing: Considerations and Choices...................................37Chapter 3 Venture Capital.....................................................................79Chapter 4 new Venture Strategy and Real options...............................................125Chapter 5 Developing Business Strategy Using Simulation.......................................162Chapter 6 Methods of Financial Forecasting: Revenue...........................................205Chapter 7 Methods of Financial Forecasting: Integrated Financial Modeling.....................243Chapter 8 Assessing Financial needs...........................................................297Chapter 9 Foundations of new Venture Valuation................................................341Chapter 10 Valuation in Practice..............................................................386Chapter 11 the entrepreneur's Perspective on Value............................................432Chapter 12 Deal Structure: Addressing Information and Incentive Problems......................477Chapter 13 Value Creation and Contract Design.................................................529Chapter 14 Choice of Financing................................................................571Chapter 15 Harvesting.........................................................................611Chapter 16 the Future of entrepreneurial Finance: A Global Perspective........................658Index.........................................................................................695

Chapter One

Introduction

What distinguishes the successful entrepreneur and promoter from other people is precisely the fact that he does not let himself be guided by what was and is, but arranges his affairs on the ground of his opinion about the future. He sees the past and present as other people do; but he judges the future in a different way. Ludwig von Mises, Human Action

Thousands of business ventures are started every year. Most fail within a short period. Of those that survive, most achieve only meager success, some achieve rates of return high enough to justify the initial investment, and a few achieve phenomenal success. What distinguishes the successes from the failures? There is not just one answer. A new venture based on a good idea can fail because of poor implementation or bad luck. One that is based on a bad idea can fail despite excellent implementation. Many that survive but do not thrive should never have been undertaken. Sometimes, even when a venture is hugely successful, early financing mistakes limit the entrepreneur's ability to share in the rewards.

This is a book on financial decision making for new ventures. In it, we provide the fundamentals for thinking analytically about whether an opportunity is worth pursuing and about how to apply the tools of financial economic theory to enhance the expected value of the undertaking. Corporate ventures and social ventures face similar challenges to those faced by stand-alone, for-profit ventures. Where there are important differences, we discuss the application of these tools to corporate venturing and social venturing.

1.1 Entrepreneurship and the Entrepreneur

The term "entrepreneur" is of French origin. Its literal translation is simply "undertaker," in the sense of one who undertakes to do something. In the early 1700s, the English banker Richard Cantillon coined the use of the word in a managerial context. He emphasized the notion of the entrepreneur as a bearer of risk, particularly with respect to provision of capital. This early usage, however, does not adequately characterize our current understanding of what it means to be an entrepreneur. Clearly, risk bearing is an aspect of entrepreneurship, but risk is also borne by capital providers who may have no involvement in managing the venture and by employees who may have no financial capital invested.

In the early 1800s, the French economist J. B. Say described the entrepreneur as a person who seeks to shift economic resources from areas of low to areas of high productivity. Although Say's notion points us in a useful direction, it is too general. Most purposeful human activity can be described as shifting economic resources to higher-valued uses (or at least attempting to do so).

The contributions of Cantillon and Say gained renewed attention in the early 1900s through the writings of two other economists. Joseph Schumpeter (1912) viewed the entrepreneur as actively seeking opportunities to innovate. In his view, the entrepreneur is the driver of economic progress, continually seeking to disturb the status quo in a quest for profits from deliberate and risky efforts to combine society's resources in new and valuable ways. In contrast, Frank Knight (1921) conceived of the entrepreneur as a manager of uncertainty and the entrepreneurial function as one of directing resources in the presence of uncertainty (and realizing a reward for performing successfully). Uncertainty, in Knight's view, is an unavoidable aspect of the ordering of economic activity.

Current use of the term "entrepreneurship" derives from these views and from more recent thinking by management scholars such as Peter Drucker. Drucker, who was a personal friend of Schumpeter, describes entrepreneurs as individuals who "create something new, something different; they change or transmute values" (Drucker [1985], p. 20). Today, entrepreneurship is most often described as the pursuit of opportunities to combine and redeploy resources, without regard to current ownership or control of the resources. This notion clearly draws on the definition offered by Schumpeter but adds structure by recognizing that the entrepreneur is not constrained by current control of resources.

Thinking of entrepreneurship in this way suggests a multidimensional process. The entrepreneur must do the following:

1. Perceive an opportunity to create value by redeploying society's resources

2. Devise a strategy for marshaling control of the necessary resources

3. Implement a plan of action to bring about the change

4. Harvest the rewards that accrue from the innovation

This definition is broad enough to encompass entrepreneurship that arises in the for-profit sector, including extant corporations, as well as in the not-for-profit sector, including in universities and charitable foundations.

Survival and Failure Rates of New Businesses

The sequence of actions just outlined seems to suggest that successful innovation necessarily yields a reward. This, of course, is far from true. To be successful, an entrepreneur needs to maintain a clear focus on how strategic choices and implementation decisions are likely to affect rewards.

Figure 1.1 shows the survival rates of new ventures from a US Census Bureau longitudinal study of business ventures that were launched in 1992 and tracked through 2002, as well as a subsequent study of ventures that were launched in 1997. Based on the data, 50 percent of ventures survive for at least 4 years and about 30 percent survive for at least 10. There is almost no difference in survival rates between the 1992 and 1997 samples. The figure also shows survival rates of "high-growth" ventures, where high growth is defined as at least a 50 percent increase in employees from 1992 to 1993 and a starting number of employees of at least five. The 4-year survival rates are higher for high-growth firms—about 72 percent over the 4 years following classification as high-growth.

Survival cannot be equated to success. In fact, in a Small Business Administration (SBA) study based on data compiled by the Census Bureau, one-third of the entrepreneurs of businesses that did not survive reported that they considered the venture a success. Among other possibilities of successful closure, nonsurviving businesses may have been established to take advantage of transitory opportunities, may have been closed in one location and reopened in another, or may have been acquired. The dashed line in Figure 1.1 shows an adjustment of the failure rate based on the one-third estimate.

Moreover, from 2000 through 2007 an average of 904,900 new businesses were created per year. The average number of business terminations during the same period was 744,100 per year, resulting in 160,800 average annual net new business formations, about 17 percent of the number of starts. As these statistics suggest, over 83 percent of new ventures eventually are terminated. The number terminated with financial loss to creditors via bankruptcy, however, is quite small—only 4.5 percent of all terminations. The remainder, "voluntary terminations," involve cases where the business was closed for inadequate profitability or where the owner simply decided to exit.

Economic Downturns and Entrepreneurship

Starting a new venture or maintaining an existing small business is challenging even when product and financial markets are vibrant. The challenges can multiply when markets are stagnant. Financing can be scarce because the supply of capital to the markets is low. Moreover, providers of financing may be concerned that some prospective entrepreneurs are motivated more by necessity than by opportunity and may be concerned that the ventures they fund during recessions, if driven by necessity, will be slow to pay off. More concretely, financing can be difficult when venture capital money is not readily available, banks are not lending, and friends and family are strapped for cash.

There can, however, be positive features of starting a venture in a downturn. For an entrepreneur, the opportunity cost of starting a venture is lower when there are fewer traditional job market opportunities; competition may be less intense; it may be easier to hire qualified employees; and costs may be lower. Microsoft, Genentech, FedEx, Southwest Airlines, Gap, and The Limited were all founded during economic downturns. Hewlett-Packard, Polaroid, and Revlon were started during the Great Depression. Of the 30 companies that currently comprise the Dow Jones Industrial Average, 18 were founded during recessions or bear markets. Following the 1997 Asian financial crisis, which led to massive layoffs from South Korea's large industrial conglomerates (chaebol), that country saw a significant increase in entrepreneurship.

Globalization of Entrepreneurship

Entrepreneurship now comes from almost everywhere, including once-closed command economies like China. Several developments have contributed to globalization. The personal computer, the wireless phone, and the Internet allow investors to reach markets that were inaccessible a few years ago. The importance of entrepreneurship in creating jobs and dynamic economies is now recognized by leading international entities like the European Union, the United Nations, and the World Bank, all of which encourage initiatives and provide financial support for entrepreneurship. Governments worldwide are enacting policies and providing financial subsidies that they hope will encourage entrepreneurs. Competition for ideas and for financing has increased dramatically in recent decades. Globalization of competition raises the stakes for everyone, particularly in the wealthier countries.

The World Bank ranks countries according to the supportiveness of their environments for starting and doing business. These rankings provide a clearer picture of international competitiveness. Figure 1.2 shows the most recent rankings of large-population countries. Ease of doing business (plotted in the figure) is based on 10 factors, including availability of financing, legal environment, and availability of employees. Ease of starting business is another of the 10 factors; we plot it separately in Figure 1.2 because it is the factor most closely related to stand-alone entrepreneurial activity. Countries that rank high on both dimensions, such as the first four in the figure, tend to be those that can support high-growth start-ups. Those that are high for ease of doing business but low for ease of starting business, such as Japan, Korea, and Mexico, tend to be countries where high-growth entrepreneurial activity is conducted mainly through established corporations and business groups. Those where ease of starting business is high but ease of doing business is low, like Cameroon, Ukraine, Indonesia, and India, tend to be relatively unregulated environments with weak infrastructures. Those where both are low, such as Iran, Iraq, Afghanistan, and Venezuela, tend to be turbulent environments with political unrest and dictatorships or militaristic factions.

Types of Entrepreneurship

Replicative versus innovative. There is a useful distinction between "replicative" and "innovative" entrepreneurship. Schumpeter wrote extensively about innovative entrepreneurs, who "act as destabilizing influences triggering 'creative destruction'—the simultaneous creation of new industries through innovation and elimination of sectors of prior economies." Innovative entrepreneurship has the potential to add huge value to economies—the type of entrepreneurship that goes on in Silicon Valley, for example. Google, Intel, Intuit, and e-Bay were all founded by innovative entrepreneurs who challenged prevailing business models. They are what William Baumol, a leading researcher in the area, describes as "bold and imaginative deviators from established business patterns and practices" (Baumol [2002], pp. 56–57).

Replicative entrepreneurs, on the other hand, function as efficient coordinators of resources. They start and maintain businesses that mimic predecessors. As population grows, the economy must provide more goods and services. Economies need more grocery stores, home improvement stores, dry cleaners, and donut shops. Many of these needs are filled by replicative entrepreneurs. Replicative businesses often stay small and don't export their products or services outside the boundaries of the area they serve. Many communities and local economies try to encourage this type of entrepreneurship and do quite well, as indicated by the numbers of new businesses started and people employed by them.

In this book, we include examples of both types of entrepreneurship, but we focus primarily on innovative entrepreneurship. New ventures that involve innovations with uncertain potential pose significant challenges for strategy, forecasting, valuation, contracting, and financing choices—greater challenges than those faced by ventures that build on established business models and ventures that can be financed with small investments, traditional borrowing, and operating cash flows. By focusing on innovative entrepreneurship and high growth, we tackle the most challenging issues that entrepreneurs and investors may confront. The differences, however, are of degree rather than substance. All entrepreneurs and investors can benefit from better understanding of concepts like milestones, staging, and real options.

Opportunity-based versus necessity-based. A related distinction is between "opportunity-based" and "necessity-based" entrepreneurship, terms coined by the Global Entrepreneurship Monitor (GEM) consortium. Innovative entrepreneurship is virtually all opportunity based, whereas replicative entrepreneurship is divided between opportunity and necessity. Necessity-based entrepreneurship represents people driven to entrepreneurship by lack of alternatives. Necessity-based ventures may be simple businesses, including microbusinesses that require negligible capital, have no employees other than the entrepreneur, and produce near-subsistence-level earnings.

Figure 1.3 shows results of the 2006 GEM survey, ordered by the percentage of the adult workforce that is involved in opportunity-based entrepreneurship. Because opportunities vary depending on economic circumstances, perceptions of what constitutes opportunity-based entrepreneurship vary across countries. Emerging economies such as Peru, Colombia, and China show high overall entrepreneurial activity but also high percentages of necessity-based entrepreneurship. Developed countries with low barriers to business formation, such as the United States, Australia, and Malaysia, exhibit high percentages of opportunity-based but low percentages of necessity-based entrepreneurship. Countries with high barriers to new venture formation, including several Western European countries and Japan, show low percentages of both kinds of entrepreneurship. As noted above, these are countries where existing enterprises tend to carry out high-growth entrepreneurial activity.

Corporate Venturing

International evidence highlights the point that much entrepreneurial activity occurs within established businesses or in strategic partnerships among established businesses. Corporate venturing is particularly common for ventures that require large and complex research teams and use of generic testing equipment and where development times are long. For example, large pharmaceutical firms almost exclusively pursue pharmaceutical innovation. Similarly, introductions of new large commercial aircraft are normally pursued as strategic partnerships involving airframe manufacturers, engine manufacturers, and avionics manufacturers.

Corporate venturing, while easier in some respects, is more challenging in others. One obvious difficulty is that of designing appropriate incentives to motivate entrepreneurial effort in large organizations without creating perceived equity imbalances among employees. Sometimes the venturing activities are so central to the core business that they are pursued as part of the company's overall research and development (R&D) effort. Other times, corporations create separate entities that are wholly owned subsidiaries and operate much like independent venture capital firms.

Social Venturing

Social venturing involves entrepreneurial efforts where financial returns are traded off against social objectives. The distinguishing characteristic of a social venture versus a commercial one is the primacy of the objective to address social issues. Social venturing encompasses activities ranging from the pure research efforts of university faculty to any number of not-for-profit activities supported by funding sources that operate much like venture capital funds. University research is predominantly grant supported. Some universities have sought to act as incubators for research projects with the potential for commercialization, using technology transfer arrangements and ownership of intellectual property to realize returns on their support of faculty research.

(Continues...)

Excerpted from Entrepreneurial Financeby Janet Kiholm Smith Richard L. Smith Richard T. Bliss Copyright © 2011 by Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Stanford University Press. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Edition details

• Publisher: Stanford Economics and Finance
• Publication date: 2011
• Language: English
• ISBN 10: 0804770913
• ISBN 13: 9780804770910
• Binding: Hardcover
• Number of pages: 744