Week 1 – Lecture 1
Chapter 1: Introduction to Entrepreneurial Finance
Zoom poll
Which of the following is not a fundamental principle of the entrepreneurial process?
o Gathering resources
o Experimentation
Risk Management
The four steps of the FIRE framework are:
o Parallel
Consecutive
o Sometimes parallel and sometimes consecutive, depending on the stage of the investment
What is Entrepreneurial Finance (EF)?
Three fundamental principles:
1. Gathering and recombining resources
Recombination of existing resources to create new sources of value
- Entrepreneurs need to convince resources owners to provide them!
- Financing is a key resource because money allows the entrepreneurs to acquire other resources
2. Uncertainty
The entrepreneurial process is inherently uncertain
- Risk: we know the potential outcomes
- Uncertainty: we ignore what might happen
- You may know the risk distribution of investing in stocks, but you have no idea of whether building a
room-sharing platform will flop or become a great success (e.g., Airbnb)
- So: risk ≠ uncertainty
3. Experimentation
Entrepreneurship consists of experimentation and dynamic flexibility
- ‘Exploration’ by entrepreneurial companies vs ‘exploitation’ by established companies.
- Organizational structure matters for incentives and the ability to ‘pivot’ (adapt dynamically to market
feedback).
Why is EF challenging?
Entrepreneur perspective
Getting funded often considered hard
Bewildering diversity of investors with different characteristics
- difficult to reach out to
Investor perspective
Swamped with proposals – most of them are bad or a poor fit
Long and costly investment process to get their money back
Managing a successful inter-galactic collision is not easy! There is fundamental uncertainty, so it is not
easy for both
Entrepreneurial finance matters also for the economy and society at large. Entrepreneurial companies are
an important driver of economic growth since they advance new technologies, products, and business
models.
Nobel Insights: What drives growth?
Fundamental economic insights are very important for practical business, including entrepreneurial
finance
For growth you need: Innovation, population (you need people), capital, idea’s, education
Bob Solow (1987): what drives economic growth?
- Once labor and capital are fully employed, the key driver is technological progress (you often read
about ‘TFP - total factor productivity’ in the financial press)
- Several economists have been investigating the links of innovation (also corporate) and
entrepreneurship with TFP
Examples of findings from such studies:
, -Start-ups that have received VC funding have significantly higher TFP than a control group of startups
without it.
- Venture capital generates more innovative outputs than corporate R&D spending.
- Increases in local venture capital funding increase the local start-up rate, employment, and
aggregate income.
Conclusion: entrepreneurial finance does contribute to economic growth! -> due to innovation
Two Frameworks
FIRE framework (Fit Invest Ride Exit)
FIT: matching process between entrepreneurs and investor
INVEST: process of closing a deal - money for ownership
RIDE: the path forward, with all the surprises and pivots that
are endemic to the entrepreneurial process.
EXIT: the process by which the investors sells some or all of
their shares to obtain a return on their investment.
FIT - Pitching an idea (entrepreneur) and screening opportunities (investor), all in
the hope to find a match
INVEST - Forging a deal where the investor makes an investment in return for a
financial claim. Trust is an important element of the deal
RIDE - Allows the two parties to journey through space toward their destination.
The dashboard includes various indicators representing the investor’s need to
monitor the company’s progress. The steering sticks indicate the importance of
making joint decisions and adjust directions in mid-flight
EXIT – It’s the destination that investors are steering toward throughout the entire
FIRE process. Achieving a good exit is an investor’s main goal. It can be a successful
one (the sun) or a unsuccessful one (the black hole)
STAGED FINANCING - You don’t get fuel to get direct to the exit. You get fuel
during multiple stages. The financing round allows the company to go forward an
hit an important milestone. At this point it needs another financing round to
proceed. With enough stages the venture finds a lucrative exit
The FUEL framework
Reflects the investor’s nature and approach to the deal
- Investors are not fungible, money is not green
- focuses on the investor’s defining traits
Fundamental structure: who is the investor?
Underlying motivation: what does he want?
Expertise and networks: what does he contribute?
Logic and style: how does he operate?
Investor types:
Founders, family & friends
, Fintech: crowdfunding & ICOs
Government support
Angel investors
Corporate investors
Venture capital
Venture debt
Week 1 – Lecture 2
Chapter 12: Venture Capital
Zoom poll
What makes it difficult to build a portfolio of VC funds?
o The lack of information about GP’s past returns
The limited number of funds one can invest in
o The amount of money to be invested
What is an important advantage of capital calls?
o Simplicity
o They allow LP’s to refuse funding when the investment is not attractive
They allow to maximize the financial returns of the VC fund
Venture Capital Model (=baseline)
Two phases:
1. Investment phase: where money moves form the investors
to the companies
2. Return phase: where the company generates a return that
is passed back up to the investors and the VC firm
There is money from others, long term commitment
Institutional investor (limited partner), which manages investment funds and provides the money to VC
firms
VC firm (General Partner), and its fund vehicle. The fund is the legal vehicle that receives the money from
the investors and channels it to the companies.
Entrepreneurial company, that receives funding to invest and grow with the hope of achieving a
successful exit
= > The relationship between an institutional investor and a VC firm is governed by a Limited Partnership
Agreement = contract that sets out the rules concerning the creation of the fund vehicle, the financial flows,
and the duties and rights of both parties.
= > The relationship between the VC firm and the entrepreneurial company is governed by the stock purchase
agreements and other related legal documents that provide final legal form to the term sheets agreements.
VC is a form of financial intermediation:
It raises funds from third parties (LPs)
It invests the fund on their behalf
It gives back any profits to LPs, retaining part of them
Limited partners (LPs) => Institutional investors: manage large amount of financial assets
(pension funds, insurance companies, banks, sovereign wealth funds, endowments)
They choose their asset portfolio based on their expectations about the risk and return of different assets
and about the degree of their correlation
Portfolio allocation choice consist of three decisions: allocating money across asset classes, allocating
money to VC within the alternative assets class, and building a VC portfolio by selecting which GPs to
invest in
, Money is allocated across four ‘assets classes:’ stocks, bonds, commodities, alternative assets.
- VC is in the category of ‘alternative assets’ (VC < 5%)
How do LPs build their GP portfolio?
- VC markets are illiquid and segmented, so it is difficult to invest in a given GP at a given time:
o they only raise funds every few years, so there are few funds investable at any time, and
secondary markets are tiny
o use of gatekeepers or funds-of-funds to gain access in funds raised by established GPs
Nobel insights
Eugene Fama (Nobel, 2013) developed a widely used model of asset pricing (with Kenneth French), the
three factor model that extends the CAPM (ch. 5):
- market, book-to-market, size
Robert Shiller (Nobel, 2013) argued that the Fama-French model under-predicts the amount of stock
market volatility we observe: this is due to investor sentiment.
Robert Merton (Nobel, 1997) and Myron Scholes (Nobel, 1997) provided a framework for pricing options
(also with Fisher Black. Compensation of VC funds has an option-like structure
General partners (VC)
The choice of GPs matters because of return persistence
Three approaches:
- Top down: buying shares of funds being raised
- Bottom up: invest in target GPs when they raise a new fund
- Fund-of-Funds: additional intermediation
GP selection criteria to select:
- First fund: new to the operations (first team)
- Seasoned: already operating GP new to LP
- Re-invest: GP already invested in
GP has better knowledge of the state and prospects of their portfolio companies. Also has investment
expertise that LPs lack. -> LPA (limited partnership agreements) to address this issues -> it regulates rights
and duties of both parties
LPA
Money is transferred to the fund gradually:
- Through periodic ‘capital calls’ : GPs give them to their LPs about how much money they need for
the period.
A typical VC fund has a 10-year horizon. LPs have the right to receive back their investment with its capital
gain within 10 years. First 5 years is the “investment period”, when companies are selected and receive
funding. The remaining years are the “harvesting period”, when companies are exited. GPs can allocate
their initial investments over several years without being rushed to make lower quality investments. And
it give enough time to grow and achieve successful exit outcomes
Fund rules
1. Investment restrictions
A fund promises its LPs to invest according to an investment strategy that is defined in terms of size,
stage, industry, geography, and other characteristics
2. Fund management rules
3. Restrictions on partner activities
It may specify the circumstances under which a partner can or cannot make personal investments in
the funds’ companies
GP compensation
- Management fee = 2% of ‘capital
- Carried interest = 20% of ‘profits’
o To cover operating costs and provide incentives to maximize final fund value
Incentives
- Fees give an incentive to raise larger funds: is such growth ‘sustainable’?
- Result: ‘strategy drift’ with larger funds investing at later stages, where more money is put into a
single company.
