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S05: Entrepreneurial Finance

Spring 2012 Antoinette Schoar and Carl Stjernfeldt MIT Sloan School of Management
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Course Overview: The World of Entrepreneurial Finance

The last 20 years present a dramatic increase in the supply and demand for venture capital/private equity.
- The industry has undergone a substantial increase in professionalization over the last decades - In recent years international VC/PE investments accelerated at an unprecedented rate - Large upheavals in the financial markets affect exit options and fundraising - Increased push for new technologies in social media, clean energy, life science etc. - Potential to build businesses significantly more efficiently using cloud technology etc.

Challenging and exiting times for entrepreneurship

What Is Special About Entrepreneurial Finance?

Valuing New Ventures
- Large uncertainties - Massive option values

Financing new ventures:

- Large financing needs - Severe information problems - Severe agency problems

These issues are common to all investments, focus on how investors and entrepreneurs solve them

Course Perspectives and Goals

Understand the broader issues of investing in entrepreneurial ventures Understand the more detailed issues of how to evaluate and finance entrepreneurial investments Apply tools developed in 15.401 and 15.402, and go beyond them:
- Issues here are more complex - Financing structures most important at birth or death of firms

Study interaction of finance and corporate strategy

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Course Perspectives and Goals

Ultimately the goal is to give you the tools you need to:
Start a company and finance it Grow your business successfully Invest in projects with high uncertainty Be a venture capitalist or private equity partner

Course Overview
Module 1: Business Valuation
Venture Capital Method DCF Method Real Options Method

- Framework for qualitative and quantitative evaluation of new business opportunities

Module 2: Structuring Investments/Financing

- Terms of the initial investment/financing
Understanding deal terms Evaluating and negotiating deal terms

Module 3: Term Sheet Negotiations

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- BNI: Understand the dynamics of deal negotiation from the perspective of the entrepreneur and the VC

Guessing Deals
Amazon Apple Biogen-Idec Bloomberg Facebook Groupon Microsoft Priceline Twitter Zipcar

Company Round A investment Month between founding and 1st investment Amount invested in A round. (USD Mil) Valuation in A round(USD Mil) (Post Money) Type of Investor

Firm A 78 1 16.13

Guessing Deals
Firm B Firm C Firm D Firm E Firm F <3 0.25 0.75 < 12 0.275 2.26 < 12 2.5 Individual VC 0.5 20 Individual Angel 1 4.8 13.4 VC Syndicate

Firm G 18 1.3 17.1 VC Syndicate

Firm H <6 5 VC Syndicate

Firm I <3 20.05 80.0 Individual VC

Firm J 18 30 100 Strategic investor

Individual Angel Individual Angel Group of Angels

Type of investment/ Security Type

Common Stock

Common Stock

Convertible Preferred

Convertible Preferred

Convertible Preferred

Convertible Preferred

Convertible Preferred and Loan

Convertible Preferred

Common stock

Round B investment Month between A and B round Amount invested in B round. (USD Mil) Valuation in B round(USD Mil) (Post Money) Type of Investor Subsequent Rounds Years between last VC round and IPO Amount invested (US Mil) Valuation info (USD Mil) (Pre Money) Number of rounds Number of investors across rounds IPO Information Amount of Shares (Mil) Initial Price First Day Close Price Return First Day Proceeds (USD Mil) Market Cap at IPO (USD Mil) Current Mkt Cap (USD Mil) @ Feb 3,2012

No B Round

<6 0.52 VC Syndicate

<9 0.99 4.9 Group of Angels

12 3.7 VC Syndicate

<8 12.7 111 Individual VC

18 30 231 VC Syndicate

22 2 30.8 Individual VC

6 15.0 VC Syndicate

12 35.8 432.84 VC Syndicate

No B Round

4.5 years No subsequent round

3 years 7.9 2 rounds 14

1 year 8,2 2 round 3 1.6 18 23.5 31% 28.8 438 85,390

4 years 37.67 2 rounds 19 3.2 15 18.75 25% 48 29,520

2322.5 9 rounds 12 Still Private

< 1 years 1101.2 3 rounds 16 35 20 26.11 31% 700 12,727 15,580

< 1 year 230 4 rounds 7 9.7 18 28 56% 174.3 778 971

1140.2 6 rounds 16 Still Private

< 0.5 year No subsequent round

No subsequent round

2.8 21 31.25 49% 58.8 778 253,740

4.6 22 28.75 31% 101.2 1,778 428,590

8.3 16 69 331% 132.8 160 27,230

Still Private

Get Private Firms Out of the Way

Company for temp reference Round A investment Month between founding and 1st investment Amount invested in A round. (USD Mil) Valuation in A round(USD Mil) (Post Money) Type of Investor Firm E 0.5 20 Individual Angel Firm H <6 5 VC Syndicate Firm J 18 30 100 Strategic investor

Type of investment/ Security Type Round B investment Month between A and B round Amount invested in B round. (USD Mil) Valuation in B round(USD Mil) (Post Money) Type of Investor Subsequent Rounds Years between last VC round and IPO Amount invested (US Mil) Valuation info (USD Mil) (Pre Money) Number of rounds Number of investors across rounds

Convertible Preferred

Common stock

<8 12.7 111 Individual VC

6 15.0 VC Syndicate

No B Round

2322.5 9 rounds 12

1140.2 6 rounds 16

No subsequent round

Company Round A investment Month between founding and 1st investment Amount invested in A round. (USD Mil) Valuation in A round(USD Mil) (Post Money) Type of Investor

Now it gets tougher

Firm A Firm B Firm C Firm D Firm F 78 1 16.13 Individual Angel <3 0.25 0.75 Individual Angel < 12 0.275 2.26 Group of Angels < 12 2.5 Individual VC 1 4.8 13.4 VC Syndicate

Firm G 18 1.3 17.1 VC Syndicate

Firm I <3 20.05 80.0 Individual VC

Type of investment/ Security Type Round B investment Month between A and B round Amount invested in B round. (USD Mil) Valuation in B round(USD Mil) (Post Money) Type of Investor Subsequent Rounds Years between last VC round and IPO Amount invested (US Mil) Valuation info (USD Mil) (Pre Money) Number of rounds Number of investors across rounds IPO Information Amount of Shares (Mil) Initial Price First Day Close Price Return First Day Proceeds (USD Mil) Market Cap (USD Mil) Current Mkt Cap (USD Mil) @ Feb 3,2012

Common Stock

Common Stock

Convertible Preferred

Convertible Preferred

Convertible Preferred

Convertible Preferred and Loan

Convertible Preferred

No B round

<6 0.52 VC Syndicate

<9 0.99 4.9 Group of Angels 1 year 8,2 2 round 3 1.6 18 23.5 31% 28.8 438 85,390

12 3.7 VC Syndicate

18 30 231 VC Syndicate

22 2 30.8 Individual VC

12 35.8 432.84 VC Syndicate

4.5 years No subsequent round

3 years 7.9 2 rounds 14 4.6 22 28.75 31% 101.2 1,778 428,590

4 years 37.67 2 rounds 19 3.2 15 18.75 25% 48 29,520

< 1 years 1101.2 3 rounds 16 35 20 26.11 31% 700 12,727 15,580

< 1 year 230 4 rounds 7 9.7 18 28 56% 174.3 778 971

< 0.5 year No subsequent round

2.8 21 31.25 49% 58.8 778 253,740

8.3 16 69 331% 132.8 160 27,230

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Fundraising Strategy
What determines the amount of capital raised?
- Capital intensity of industry - Competitive strategy, network externality - Capital market conditions (valuation)

Frequency of rounds?
- Reflection of how much control investors want - Can investment be structured as milestones? - Ability of firm to reach performance goals

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Company Round A investment Month between founding and 1st investment Amount invested in A round. (USD Mil) Valuation in A round(USD Mil) (Post Money) Type of Investor

Capital intensive deals

Firm B <3 0.25 0.75 Individual Angel Firm C < 12 0.275 2.26 Group of Angels Firm D < 12 2.5 Individual VC

Firm G 18 1.3 17.1 VC Syndicate

Type of investment/ Security Type Round B investment Month between A and B round Amount invested in B round. (USD Mil) Valuation in B round(USD Mil) (Post Money) Type of Investor Subsequent Rounds Years between last VC round and IPO Amount invested (US Mil) Valuation info (USD Mil) (Pre Money) Number of rounds Number of investors across rounds IPO Information Amount of Shares (Mil) Initial Price First Day Close Price Return First Day Proceeds (USD Mil) Market Cap (USD Mil) Current Mkt Cap (USD Mil) @ Feb 3,2012

Common Stock

Convertible Preferred

Convertible Preferred

Convertible Preferred and Loans

<6 0.52 VC Syndicate 3 year 7.9 2 rounds 14 4.6 22 28.75 31% 101.2 1,778 428,590

<9 0.99 4.9 Group of Angels 1 year 8,2 2 round 3 1.6 18 23.5 31% 28.8 438 85,390

12 3.7 VC Syndicate 4 year 37.67 2 rounds 19 3.2 15 18.75 25% 48 29,520

22 2 30.8 Individual VC < 1 year 230 4 rounds 7 9.7 18 28 56% 174.3 778 971

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Company Round A investment Month between founding and 1st investment Amount invested in A round. (USD Mil) Valuation in A round(USD Mil) (Post Money) Type of Investor

Bubble Deals?
Firm F 1 4.8 13.4 VC Syndicate

Firm I <3 20.05 80.0 Individual VC

Type of investment/ Security Type Round B investment Month between A and B round Amount invested in B round. (USD Mil) Valuation in B round(USD Mil) (Post Money) Type of Investor Subsequent Rounds Years between last VC round and IPO Amount invested (US Mil) Valuation info (USD Mil) (Pre Money) Number of rounds Number of investors across rounds IPO Information Amount of Shares (Mil) Initial Price First Day Close Price Return First Day Proceeds (USD Mil) Market Cap (USD Mil) Current Mkt Cap (USD Mil) @ Feb 3,2012

Convertible Preferred Convertible Preferred

18 30 231 VC Syndicate < 1 years 1101.2 3 rounds 16 35 20 26.11 31% 700 12,727 15,580

12 35.8 432.84 VC Syndicate No subsequent round

8.3 16 69 331% 132.8 160 27,230

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What is left?
Company Round A investment Month between founding and 1st investment Amount invested in A round. (USD Mil) Valuation in A round(USD Mil) (Post Money) Type of Investor Firm A 78 1 16.13 Individual Angel

Type of investment/ Security Type Round B investment Month between A and B round Amount invested in B round. (USD Mil) Valuation in B round(USD Mil) (Post Money) Type of Investor Subsequent Rounds Years between last VC round and IPO Amount invested (US Mil) Valuation info (USD Mil) (Pre Money) Number of rounds Number of investors across rounds IPO Information Amount of Shares (Mil) Initial Price First Day Close Price Return First Day Proceeds (USD Mil) Market Cap (USD Mil) Current Mkt Cap (USD Mil) @ Feb 3,2012

Common Stock

No B round

4.5 years No subsequent round

2.8 21 31.25 49% 58.8 778 253,740

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IPO market is very cyclical

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First day under-pricing

On average the stock price jumps on the first day of trading
- From 1990 to 2010 companies left over $35 billion on the table - The median firm has modest first day return, but a few firms have several hundred percent

This pattern is found in most developed capital markets

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Money left on the table

Company Priceline.com Ivillage Inc Pacific Internet MarketWatch.com United Pan-Europe Communications Covad Communications Group Delphi Automotive Systems Corporations ZDNet Group OneMain.com Autobytel.com Lead Underwriter Morgan Stanley Dean Witter Goldman Sachs Lehman Brothers BT Alex Brown Goldman Sachs Bear Stearns Morgan Stanley Dean Witter Goldman Sachs BT Alex Brown BT Alex Brown Offer Price $16 $24 $17 $17 $32.78 $18 $17 $19 $22 $23 Pricing Valuation (mil.) $160 $88 $51 $47 $577 $140 $1,700 $190 $187 $104 First Trade Price $81 $95.88 $88 $90 $43 $40.50 $18.75 $35.75 $38 $52.75 First Trade Valuation (mil.) $810 $350 $264 $248 $757 $316 $1,875 $358 $323 $238 Money on the Table (mil.) $650 $262 $213 $201 $180 $176 $175 $168 $136 $134

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Course Mechanics
Cases (5), Lectures (5), Guests (1)
- Guest: John Chory (Partner, Latham & Watkins)

Guideline questions for each case available on Stellar

- Work in study groups of no more than 4 students - Expect to be challenged by the cases
Not meant to be easy, but you'll learn more Do not use outside sources (library, web) to find out what happened

Spreadsheets for cases will be on Stellar

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Memos
Memos are 25% of grade

- Hand in memos for cases before class - Write to major decision-maker - Up to two pages of text - Be ready to discuss cases even if youre not handing in memo - Prepare presentation for negotiation exercise - Groups of up to 4 people, cannot be changed
Attach exhibits / calculations

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Class Participation
25% of final grade
Individual Based on quality and quantity Good chance to practice in low-risk environment Isn't class participation grade subjective?
Not after 10 classes TA will be taking notes in class

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Class Participation Process

You know the basic rules
- Listen to others and build
Try not to change the subject

- Ask questions
Sometimes whole class is lost

- I will cold call

The best way to preempt being cold called is to be prepared and participate

Please don't come late!

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Final Exam
50% of your grade
- Case based - Take home exam - Last day of class

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This Course Is Not For Everyone

Requires Tolerance for Ambiguity
- Entrepreneurial ventures involve massive uncertainty - Not always a formula or right answer - Please do not take the course if you are looking for cookbook answers

Be prepared to work independently

- Homework and negotiation exercise are important preparation for class discussion
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Availability
In person: Office Hours in E62-638
- Tuesday: 4:30pm - 6:00pm - Email us to make an appointment:
aschoar@mit.edu, carlstj@mit.edu

- We will not discuss any aspects of a case until we have done the case in class

TA: Felipe Severino: fseverin@mit.edu

- Recitations: we will send out 3 dates to vote on
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