The Fundamentals of Entrepreneurial Finance
Marco da Rin & Thomas Hellmann, 2020.
Chapter 1 – Introduction to Entrepreneurial Finance
What is Entrepreneurial Finance?
Entrepreneurial Finance is a combination of entrepreneurship (right-brain thinking, messy, unknown) and
finance (left-brain thinking, structured, logical).
Definition: provision of funding to young, innovative, growth-oriented companies.
Entrepreneurial companies: innovative products & business models.
- Young: less than 10 years old.
- Start-ups: less than 5 years old.
The difference with small businesses or small and medium-sized enterprises (SMEs): entrepreneurial businesses
are growth-oriented. Small businesses are meant to stay small.
Different sorts of funding:
- Business angels: individuals who invest in start-ups.
- Venture Capital (VC): investment funds managed by professional investors on behalf of institutional
investors.
- Established companies (mostly strategic).
- Crowdfunding: funding by the public.
There’s an exchange between an entrepreneur and an investor: funding contract. Entrepreneur receives money
and investor receives claim on company’s future returns.
Entrepreneurial process: turning ideas into businesses.
1. Decide to become an entrepreneur;
2. Founders perceive an opportunity to suggest a solution to an unmet need;
3. They structure their vision into a business plan and implement the steps;
4. Convincing stakeholders and getting resources;
5. Often the course is adjusted to changing circumstances;
6. Hire employees, build prototypes, gain customers etc;
7. End of entrepreneurial process: company fails, gets acquired, or grows into an established corporation.
3 fundamental principles:
1. Resource gathering: recombination of existing resources to create new sources of value (J.
Schumpeter). Financing is the most important one: allows them to acquire other resources.
2. Uncertainty: lack of reliable information about the likelihood of outcomes. F. Knight: the difference
between risk and uncertainty is that with risks outcome is unknown but probability distribution is. With
uncertainty, we ignore what might happen. Both are not equal!
3. Experimentation: entrepreneurship consists of experimentation and dynamic flexibility. J. March: the
difference between exploitation and exploration. Exploitation means leveraging the market position of
established companies. Exploration means the path is unknown. Organizational structure matters for
incentives and the ability to ‘pivot’ (adapting dynamically to market feedback).
Why is EF challenging?
Entrepreneurial perspective:
- Getting funded is often considered hard. Finding and managing investors. They are hard to convince
and also want something in return.
- Bewildering diversity of investors with different characteristics: it’s difficult to reach out.
Investor’s perspective:
- They are overloaded with proposals: most of them are bad or a poor fit. What companies are worth
investing in? All of them need screening and others also investigation.
- It is a long and costly investment process to get their money back.
Why is entrepreneurial finance important?
- Entrepreneurs: financing (and the choice of investor(s)) determines the success of their business.
- Investors: by funding the right ventures they can earn high returns. However, established companies
invest mostly as part of innovation strategies (to engage in the future).
- Economy & society: the ventures are a driver of economic growth.
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,Nobel Insights
“What causes long-term economic growth?”
Robert Solow 1987: once labour and capital are fully employed, the main determinant of long-term growth is
‘technological progress’. TFP = Total Factor Productivity: the amount of output divided by all factor inputs.
Economic growth comes from increases in the efficiency of how an economy converts inputs into outputs.
Paul Romer 2018: growth is endogenous. R&D investments are different from standard capital investments: they
generate innovations that benefit society. Innovation does not come from established companies, it comes from
entrepreneurs who challenge them.
Entrepreneurship is important for society because it creates new jobs In their first initial year they have an
average annual net job creation in the U.S. of 1.4 million. However, we need to take into account the ‘up-or-out’
dynamics of young firms. 17% of all created jobs get lost at the end of the first year, by the end of the second
year another 14% gets lost etc. Employment is easier created during expansions of the economy.
Conclusion: young firms contribute to the net job creation, small firms do not, however.
Several studies show that:
- Start-ups that have received VC funding have significantly higher TFP than a control group of start-ups
without it.
- VC generates more and better patents than corporate R&D spending
- Increases in local VC funding lead to more creation of local start-ups, more employment, and higher
aggregate income
- Angel financing is associated with company growth.
A measure of the importance of entrepreneurial finance is size, which is hard to measure. Most of the data
focuses on the VC industry.
Not all start-up stories are success stories. A study finds that one out of four founders makes no financial return.
Other studies find lower failure rates.
It is also found that VC-backed companies account for a large fraction of new jobs created by start-ups, as these
have around 160 employees after 10 years, in comparison to 16 for non-VC-backed companies. Furthermore,
79% of non-VC-backed start-ups fail, in comparison to 40% of VC-backed start-ups. Also, VC funding protects
start-ups in the beginning phase, it protects them against failure.
The Entrepreneurial Financing Process
FIRE framework: the entrepreneur’s journey.
Consecutive steps of the entrepreneurial finance process.
1. Fit: matching process between entrepreneurs and investors.
The process by which entrepreneurs and investors find each other and determine their mutual interest in
investing. It is a difficult process: the entrepreneur decides what type of investors they want and they need to be
able to reach out to them. The same way investors choose the kind of deals they look at.
Attracting Business Angel’s attention and gaining their interest is still a matter of people. The way entrepreneurs
pitch their ideas, their experience, and their way of (overly) positive talking. It’s a fine line.
2. Invest: process of closing a deal the entrepreneur obtains money from the investor in exchange for a
financial claim. Conditions specified in a contract
Process of structuring the investment. Both parties need to be satisfied, which is the main challenge. The
contract contains 2 elements: (1) the amount of money, and (2) the security (how many shares does the investor
get in return?). The most used financing techniques are equity and debt financing. The term sheet (contract)
determines the cash flow rights and the control rights.
Investments are driven by expectations about future returns.
3. Ride: the path forward, with all the surprises and pivots that are usual in the entrepreneurial process.
The interaction between entrepreneur and investor after the deal. They learn how to communicate and what their
market looks like. Investors often take place on the company’s board.
Financing often takes place in stages (financing rounds), because investors don’t provide further funding until the
next milestone is achieved.
4. Exit: the process by which the investors sells some, or all of their shares to obtain a return on their
investment.
In the liquidity event, investors obtain a return on their investment. It is the destination of the investors: a good
exit. A successful exit can be an IPO (company goes public) or when the company gets acquired at a high
valuation (by an established company). Unsuccessful exits have more forms: ceasing operations, liquidating
assets, bankruptcy, or getting acquired at low valuation.
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,Staged financing: Investors want to give ventures enough money to go from one milestone to another. They do
not give more, in case the project fails. Therefore, financing comes in stages = financing rounds.
Each financing round requires a new financial contract, new negotiations new valuation and term sheet.
Terminology:
- Pre-seed investment: investing with the intent of preparing the company for a seed round.
- Seed round: investments by business angels and other investors before VC-funding.
- Series A, B, C: all VC financing rounds.
- Seed stage: pre-revenue companies;
- Early stage: companies beginning to generate revenues, but still developing business model;
- Expansion stage: companies that have consolidated their business model and are generating revenues;
- Late-stage: companies that have been growing for a few years.
Seed & Early = start-ups. Expansion & Late = scale-ups.
Who are the investors?
- Venture capitalists (VCs): professional investors who raise their own funding from institutional
investors. These funds are invested in entrepreneurial companies. They often restrict themselves to
certain industries or areas.
- Founders: use their own savings or personal credit. This is also called internal funding.
- Three F’s (Family, Friends and Fools): they invest based on personal relationships.
- Angel investors: private individuals who invest their own money without knowing the founders
beforehand. They can invest individually or as a group.
- Corporations: invest with a strategic motive. Sometimes they fund from within: ‘intrapreneurship’.
- FinTech:
o Crowdfunding: ventures obtain funding through an online platform. Three types: raising
money in return for some rewards, peer-to-peer (loans), and equity.
o Initial Coin Offerings: based on Blockchain.
- Government: supportive through direct and indirect funding programs. Sometimes the programs
support entrepreneurs with grants, tax credits, credit guarantees, etc.
Investor Type Seed stage Early stage Late stage
Founders, family & friends
Fintech: Crowdfunding & ICOs
Government support
Angel investors
Corporate investors
Venture capital
Venture debt
Venture capital structure. The entrepreneurial company receives funding
from a VC fund, which is a legal vehicle supervised by a limited liability
company (General Partner) and is run by a group of individuals (VCs).
The general partner enters an agreement with some institutional investors
(Limited Partners) that provide funding for the VC fund.
Institutional investors are pension funds, insurance companies, university
endowments, sovereign wealth funds, investment banks, wealthy families,
etc.
FUEL framework: reflects the investor’s nature and approach to the deal.
Investors are not replaceable and money is not green. The framework focuses on the investor’s defining traits.
There is 1 fundamental question that sets up the core issue. The other 2 elaborate.
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, 1. Fundamental structure: who is the investor? What is their fundamental identity?
a. What are their organizational structure and financial resources? who is the owner and how
much money do they have?
Angels invest modest amounts, they are limited by their wealth and risk. VCs have access to larger amounts of
money.
b. What is the governance structure and decision-making process? what are the rules and how
are decisions made?
Angels make their own decisions. VCs take decisions by investment committees governed by partnership rules
(and oversight by LPs).
2. Underlying motivation: what does the investor want?
a. How important are financial and nonfinancial returns to them?
The structure of VC firms provides strong incentives for financial returns. Angel investors can have more varied
goals. Maybe the social contribution or the thrill of staying involved.
b. How risk-tolerant and patient is the investor?
3. Expertise and networks: what does the investor offer to the entrepreneur?
a. What expertise do they bring to the table?
This is needed to screen out the right companies and to add value. Knowledge and skills of investors.
b. What networks can they draw on?
These are needed to help the entrepreneur gain access to key resources. Knowledge and skills investors gain
access to.
4. Logic and style: how does the investor operate?
a. What logical criteria do they use to select companies?
This links back to the Fit and Invest steps of the FIRE Framework. What types of deals make sense and how are
these structured?
b. What is their style of interacting with the companies?
The style considers how the investor and entrepreneur interact during the Ride and Exit steps of the framework.
Chapter 2 – Evaluating Venture Opportunities
Assessing Opportunities
Starting point of any investment is evaluating the proposed business opportunity.
- Will the opportunity be profitable enough (for a given risk)?
o Can the entrepreneur appropriate a fair share?
o Can resource providers to this also?
- Importance of conceptual strength: method versus ‘gut feeling’.
- Absolute and relative evaluation.
Business model: it articulates the logic, the data and other evidence that support a value proposition for the
customer, and a viable structure of revenues and costs for the enterprise delivering that value.
- Structuring a value-creating process.
Business plan: a description of the logic of the business model.
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