E N T R E PR E N EU R I A L
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THE ART AND SCIENCE OF GROWING VENTURES L U I SA A L E M A N Y
AND
J OB J. A N DR EOL I
TABLE OF CONTENTS
PART I. FUNDING SOURCES 1. Introduction to entrepreneurial finance 2. Early sources of funding (1): incubators, accelerators and crowdfunding
2 23
3. Early sources of funding (2): business angels
60
4. Venture capital, private equity and corporate venture capital
97
5. Public sources of funding
129
PART II. FUNDING PROCESS 6. Deal sourcing and screening
148
7. Preparing the financial plan: forecasting
181
8. Valuation of new ventures
214
9. The term sheet and negotiating with investors
249
PART III. GROWING THE VENTURE 10. Monitoring tactics and key metrics
278
11. Corporate governance
310
12. Managing your intellectual property
338
PART IV. ALTERNATIVE ROUTES TO ENTREPRENEURSHIP 13. Entrepreneurship through acquisition (1): MBOs and MBIs
362
14. Entrepreneurship through acquisition (2): ‘Searchers’
408
15. Turnarounds, workouts and other restructuring: reinventing value
449
16. Impact investing: financing social entrepreneurs
485
PART V. HARVESTING AND THE FUTURE OF ENTREPRENEURIAL FINANCE 17. Harvesting: the exit
530
18. The future of entrepreneurial finance
562
Appendix 1. Examples of public support for entrepreneurship in Europe
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Appendix 2. Typical business angel term sheet clauses
587
Appendix 3. General term sheet
588
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EARLY SOURCES OF FUNDING (2): BUSINESS ANGELS
Financial Times articles ground every chapter in a real-world practical application of the theory.
VIEW FROM THE MEDIA
With a little help from our friends, family . . . OCTOBER 4, 2016 BY ANDREW BOUNDS You have a good idea, but how do you go about chairman of Wagamama, who put together a consortium of eight investors in the restaurant raising cash to turn it into a business? Red’s True Barbecue, founded: 2012, sector. Dubbed the ‘Super Eight’, they put in a amount raised: £4.5 m, sources: Founders, combined £2m using the UK’s Enterprise Investment Scheme, which offers tax breaks. angels James Douglas was fortunate when he and Over beef brisket served with their trademark Scott Munro teamed up to open a barbecue sauces, which are now available in supermarrestaurant in Leeds. He had £150,000 from kets, Mr Douglas says they turned down sevselling his first business, an estate agency, eral offers from venture capital funds: ‘We and the local RBS bank manager loved the didn’t want dumb money and we didn’t want food, which has a strong emphasis on grilled pressure money, with people on our case every meat. Started with a £300,000 bank loan and week. We wanted people that could help us around £265,000 of their own money, the with expansion.’ After three funding rounds, the chain has American-style smokehouse restaurant was soon looking to expand. Mr Douglas and Mr eight restaurants from London to Manchester, THE FUTURE OF ENTREPRENEURIAL FINANCE Munro were introduced to Ian Neill, former with a Newcastle branch opening soon. www.ft.com/content/685fc05a-63db-11e6-8310-ecf0bddad227 How a blockchain works 1 A wants to send money to B
2 The transaction is represented online as a ‘block’
LEARNING OBJECTIVES
3 The block is broadcast to every party in the network ? ?
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Engaging graphics enable students to grasp complex concepts quickly.
After reading this chapter you will be able to: A
The book handles relevant contemporary opportunities and methods, from cryptocurrency to crowdfunding.
• Understand where business angels fit into the financing structure ?of entrepreneur? ial ventures. ? • Recognize the profile of business angels. • Appreciate the way in which the operation of the angel market is changing and 4 6 5 understand the implications for entrepreneurs. Those in the network The block then can be added The money moves • Understand their investment process specifically their investment approve the to theand chain, which provides from A to B criteria and transaction valid an indelible and transparent how they make theirisinvestments. record of transactions • Assess the evidence on investment returns. B
Figure 18.3 How a blockchain works. Source: Financial Time (2015)13
just under 14 per cent. Then, in 1989, a political movement caused the market to temporarily collapse.14 The second occurrence was the global financial crisis of 2008, which started after the bankruptcy of Lehman Brothers led to a collapse of
bringing the total so far to more than $100m. Daniel Wiegand, the chief executive who with three others founded Lilium while at the Technical University of Munich, said the investment made Lilium ‘one of the Clear learning objectives give students best funded electric aircraft projects in the defined outcomes and a comprehensive world’. It would enable the company to overview of each chapter. accelerate the commercial development of
transitions to forward propelling flight once in the air. . . . Lilium is hoping to make its first manned flight by 2019 and to have an on-demand service by 2025. Mr Gerber said the aircraft would be capable of travelling 300 kilometres or more in a single charge, with a cost per kilometre that would be competitive against ground travel.
www.ft.com/content/e1f443c8-91a2-11e7-bdfa-eda243196c2c
LEARNING OBJECTIVES After reading this chapter you will be able to: • Understand what we mean when we talk about entrepreneurial finance. • Become familiar with the definitions of ‘entrepreneurship’ and ‘finance’ and the fit of entrepreneurial finance with both fields. • Appreciate the similarities and differences between entrepreneurial finance and corporate finance. • Differentiate between the stages of new venture development and the sources of financing available.
Where Are We Going Next? 11.1.1
1.1
CORPORATE GOVERNANCE
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This chapter begins with a short story about an entrepreneur to illustrate the concept of entrepreneurial finance. It will then answer the question ‘what is Definition entrepreneurial finance?’ by exploring exactly what we mean by entrepreneurship andwith finance. We willCorporate then clarify the differences, and similarities, between corpoIn line the OECD, Governance is defined as:3 rate finance and entrepreneurial finance. The chapter continues with an analysis of Corporate governance set of relationships between a company’s managethe different stagesinvolves of a newaventure from a financial perspective, and by looking at ment, its board, its shareholders and other stakeholders. Corporate governance alsoride! the sources of financing available for each stage. We hope that you enjoy the provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Ancorporate Entrepreneurial Finance Good governance shouldStory provide proper incentives for the board and management to pursue objectives that are in the interests of the company and its We are often asked the question: ‘so what exactly is entrepreneurial finance?’ shareholders and should facilitate effective monitoring
And it is sometimes difficult for us to explain. One answer might simply be ‘well, Corporate governance thus considers the relationships between a company’s management, its board, its shareholders and its other stakeholders. This seemingly straightforward definition allows for an initial assessment of corporate governance, insofar as a particular country’s perspective on the interests a company should serve is concerned, and on the role of corporate governance in society.
11.1.2
Country Perspective
Key terms are thoroughly explained, making the accessible Ventures or companies in general play an important role in book society. This role to students pertains to both their economic value as well as their responsibility to society at and general readers. 4
large. Their economic value relates to the importance of making a profit as a primary goal, while the responsibility to society emphasizes the consequences of their actions within a certain environment. In some instances, these roles reinforce one another, while in others they may come into conflict. The country tradition and perspective indicates the nation’s perspective on this role of companies. Two key perspectives emerge from Academic studies: • Stakeholder (continental European) perspective. • Shareholder (Anglo–Saxon) perspective The stakeholder perspective emphasizes the firm’s societal responsibility role over and above its economic role. Companies are perceived as coalitions of parties working towards a shared goal. The company should protect and strive to satisfy the interests of all contributors, i.e. stakeholders. These stakeholders consist of many parties, such as employees, customers, suppliers, government, interest groups and shareholders. This perspective thus envisages a broad role for
VALUATION OF NEW VENTURES Interviews
with 245leaders of successful start-ups provide practical guidance.
VOICE OF THE EXPERT: Frank Maene (Belgium)
Frank Maene has been working with software startups for the past twenty-five years, both as investor, coach and executive. Frank currently sits on the board of Awingu, BitSensor, Flavr, VAMP, Sentiance and SweepBright. Prior to Volta Ventures, he was a managing partner at Hummingbird Ventures and Big Bang Ventures. Notable transactions include exits to Western Digital (Amplidata), Clarabridge (Engagor), SUN (Qlayer) and Symantec (DCT). Currently focusing on startups with HQs in the Benelux, he has operational experience in Silicon Valley and Turkey. Frank holds Master’s degrees in Applied Economics and Accountancy from the University of GentVlerick, Belgium. How do you agree upon the percentage in the venture as return for your investment? Through negotiation. Advanced valuation methods such as discounted cash flows are useless to value a pre-revenue startup since there simply aren’t any cash flows to apply a discount rate on. As a seed and early stage venture capital fund we don’t seek a majority stake in the company. We believe that the founders should remain in control of their company to make sure that they are fully engaged and motivated. On the other hand, an equity stake of less than 15% has become insignificant for a VC and not worthwhile the time and effort. Based on the equity stake (15–30%) and the amount that is being raised you can quickly determine the valuation of the company. The exact equity stake will depend upon elements such as quality of the team, value of the product/solution, size of the market, competitors and the associated terms such as liquidation preference and other preferred terms.
KEY TAKEAWAYS • New ventures are difficult to value due to the lack of historical information, the anticipated high growth and the uncertainty of the markets in which they operate. • A valuation can be carried out, but rather than looking at the present value, investors prefer to estimate the value of the venture at the time of their exit. • The Venture Capital (VC) method is the preferred method when dealing with high-growth startups. It is based on the way that venture capitalists think about new investments. • Investing time in researching the market, its dynamics and the way value will be created will pay off. Very few numbers are needed for the VC method. • Pre-money and post-money valuations represent the present value, which is calculated from the VC method and the value at exit. • Convertible notes are a good tool for early financing rounds. • Price is not the same than value and it is affected by many factors.
Key takeaways at the end of each chapter neatly consolidate the information learned.
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LUISA ALEMANY
Questions at the end of each chapter reinforce learning and strongly engage students with the material.
END OF CHAPTER QUESTIONS 1. Why is it difficult to value new ventures? 2. What are the main valuation methodologies? Why are these not useful when valuing startups? 3. What is the key question that investors in new ventures ask themselves when thinking about investing? 4. What information do we need to have in order to estimate the future value of the money invested by the venture capitalist or the business angel? 5. What is the meaning of IRR? 6. What is the typical IRR demanded by early-stage investors? 7. If an investor is looking to get 50 per cent IRR from investing in a company for four years, what is the money multiplier that he needs to get? 8. A venture capitalist invests €1.5 million in a new startup that she estimates will be worth €100 million in five years. If her expected IRR is 60 per cent, what percentage of the company would she be asking for? 9. In the previous example, what would be the post-money valuation? And the pre-money? 10. The company BravoTech issued 200,000 shares for its Series A round. The price per share was €3. If the company was incorporated a year before and 600,000 shares of €0.05/share were issued: (a) what was the money raised in Series A?; (b) what was the pre-money valuation?; and (c) what was the percentage left for the founders after the Series A round?
FURTHER READING Damodaran, A. (2006). Damodaran on Valuation: Security Analysis for Investment and Corporate Finance. 2nd edition. John Wiley & Sons. Gompers, P. and J. Lerner, J. (2001). The Money of Invention: How Venture Capital Creates New Wealth. Harvard Business School Press. IPEV (2010). International Private Equity and Venture Capital Valuation Guidelines. Edition August 2010, IPEV Board. The European Venture Capital Association, formerly EVCA and now called ‘Invest in Europe’, is a founding member of the IPEV Board together with AFIC (the French VC Association) and BVCA (the UK VC Association). Lerner, J. (2000). Venture Capital and Private Equity: A Casebook. Wiley. Timmons, J. A. (2008). New Venture Creation: Entrepreneurship for the 21st Century. 8th edition. McGraw Hill.
Comprehensive reading is recommended for students to Brealey, R. A., Myers, S. C. and Allen, F. (2013): Principles of Corporate Finance. 11th expand their knowledge further. Global edition. McGraw Hill. REFERENCES
Brennan, M. J. and Schwartz, E. S. (1988). The case for convertibles. Journal of Applied Corporate Finance, 1, 55–64.
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Copeland, T., Koller, T. and Murrin, J. (2010). Valuation: Measuring and Managing the Value of Companies. 5th edition. Wiley. Jensen, M. C. (1986). Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review, 76(2), 323–329. Jensen, M. C. and Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), Case studies allow students 305–360. Lewis, C. M., Rogalski, R. J. and Seward, J. K. (1998). Understanding the designtheory of to understand through convertible debt. Journal of Applied Corporate Finance,, 11(1), 45–53. practical examples. European Miller, M. H. and Modigliani, F. (1961). Dividend policy, growth and the valuation of cases show a breadth of shares. Journal of Business, 34(4), 411–433. Scherlis, D. and Sahlman, W. (1987). A Method for Valuing High-Risk, Long-Term opportunity beyond Silicon Valley. Investments. Harvard Business School Note 9–288–006. 006.
Let’s Practise: Case Study Fibra Optica Express Maria Garcia, founding partner of leading venture capital firm Garcia & Martinez Venture Partners (G&M), was pretty happy that Friday. The weekend was looking good, sun was forecast for both days and, on top of that, she had just received a very interesting business plan recommended to her by a well-known professor. The entrepreneurial team was composed of three ESADE MBA students and two engineers from Barcelona Polytechnic University (UPC). A quick read-through of the executive summary was enough for her to realize that Fibra Optica Express (FOE) was a promising venture. Additionally, it fitted well with G&M’s investment criteria and was within its area of expertise. She thought that maybe by working a little bit over the weekend, she could present a preliminary report on the company for the Monday morning Investment Committee.
The Opportunity
The accessible, sometimes
After reviewing in detail FOE’ss Business Plan, and being impressed by the CVs of comic, writing the founders, Maria decided to start with the valuation of the business. It wasstyle the prevents readers feeling overwhelmed type of venture she liked to analyse: early stage, with a prototype ready and some initial sales. Best of all, FOE’ss technology was protectedwith by atechnical national information and and international patent. retains their interest. An early-stage company brings with it a high risk to investors; however, it was M were looking for. In fact, high risk means high the type of investment G&M return. For this type of company, the target IRR was 40 per cent and the investment would last for around four years. The IRR was high, but it needed to compensate for the risk involved and the probability of the startup not surviving at all.
Academics and practitioners from a range of institutions across Europe provide a cutting‑edge, practical, and comprehensive review on the financing of entrepreneurial ventures. From sourcing and obtaining funds, to financial tools for growing and managing the financial challenges and opportunities of the startup, Entrepreneurial Finance: The Art and Science of Growing Ventures is an engaging text that equips entrepreneurs, students and early-stage investors to make sound financial decisions at every stage of a business’ life. Largely reflecting European businesses and with a European perspective, the text is grounded in sound theoretical foundations. Case studies and success stories as well as perspectives from the media and from experts provide real-world applications, while a wealth of activities give students abundant opportunities to apply what they have learned. A must-have text for both graduate and undergraduate students in entrepreneurship, finance and management programs, as well as aspiring entrepreneurs in any field.
L u i s a A l e m a n y is an associate professor in entrepreneurial finance at ESADE Business School. She holds an M.B.A. from Stanford University, California, and a Ph.D. from the Universidad Complutense, Madrid. Her research focuses on business angels, venture capital, impact investing, and entrepreneurship education for children. From 2009 to 2017, Dr Alemany was the director of the ESADE Entrepreneurship Institute. She is currently the academic sponsor of ESADE Business Angels Network (BAN) and is active at the European level, where she has been a director of the board of the European Business Angels Network (EBAN). She also holds seats in different investment committees, both in venture capital and impact investing. She is part of the first European women-only business angels network, Rising Tide I and II. Dr Alemany has held positions at Procter & Gamble, McKinsey & Co., and Goldman Sachs. She also has experience in venture capital and private equity, having worked for the funds Europ@Web and The Carlyle Group. J o b A n d r e o l i is a senior lecturer and Ph.D. candidate at the Center for Finance of the Nyenrode Business Universiteit and the Nyenrode New Business School in the Netherlands. In addition, he leads the Nyenrode Incubator in Amsterdam and is on the advisory board of a venture capital firm. Prior to joining Nyenrode, Mr Andreoli has worked as a strategy consultant for Ernst & Young (EY) and Capgemini and was responsible for setting up the Strategy and Innovation practice of Atos Consulting. He has also been involved in startups and working with small and medium-sized enterprises that tend towards financial distress. Mr Andreoli holds an M.Sc. degree in Strategic Management from Rotterdam School of Management, Erasmus Universiteit and an M.Sc. in Education from VU Amsterdam.
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