An invaluable resource for current and aspiring technology investors, Venture Capital and the Finance of Innovation provides an in-depth understanding of the tools and models needed to succeed in this competitive and highly fluid business environment. Building on a comprehensive introduction to fundamental financial and investment principles, the text guides the reader toward a robust skill set using enterprise valuation and preferred stock valuation models, risk and reward, strategic finance, and other concepts central to any venture capital and growth equity investment.
Two features of the book stand out from other sources on the subject. First, it pays special attention to the enterprise valuation methodology for high-growth companies. What drives the value of a company that has little physical assets, losing money now but has a small chance of achieving great success in several years? How do you create estimates for sales, profit and return on capital when little data is available? The book answers these questions using a discounted cash flow model that is tailor-made for technology companies (DCF.xlsx downloadable from the instructor website), and the comparables model. Second, it highlights the most valuation-relevant feature of VC term sheets, namely the use of convertible preferred stock.
Accessible, comprehensive, and assuming only basic knowledge of venture capital, this text offers essential guidance for successful VC and growth equity investing in any market.
Table of Contents
About The Book ii
About The Authors vii
Acknowledgments xi
Preface xiii
About The Instructor Website xvii
Part I VC Basics
1 The VC Industry 1
1.1 What is Venture Capital? 1
1.2 What Do Venture Capitalists Do? 6
1.3 The History of Venture Capital 6
1.4 Patterns of VC Investment in The United States 11
1.4.1 Investments by Stage 11
1.4.2 Investments by Industry 12
1.4.3 Investments by U.S. Region 14
Summary 15
Key Terms 15
References 15
Appendix: Note on Authors’ Calculations Made for Exhibits 1-4 and 1-5 16
2 VC Players 17
2.1 Firms and Funds 17
2.2 The Limited Partners 23
2.3 VC Partnership Agreements 25
2.3.1 Management Fees 25
2.3.2 Carried Interest 27
2.3.3 Restrictive Covenants 32
Summary 35
Key Terms 35
References 36
Exercises 36
Appendices: Key Terms and Conditions for Three VC Funds 36
Appendix 2.A: EarlyBird Ventures I 37
Appendix 2.B: Talltree Ventures IV 37
Appendix 2.C: Owl Ventures IX 38
3 VC Returns 40
3.1 Industry Returns 40
3.1.1 Definitions 40
3.1.2 A Gross-Return Index 42
3.1.3 A Net-Return Index 42
3.2 Fund Returns 45
3.2.1 Definitions 45
3.2.2 Evidence 51
Summary 53
Key Terms 53
References 54
Exercises 54
Appendix: Note on the Three VC Return Indices Shown in Exhibits 3-3 and 3-4 55
4 The Cost of Capital For VC 57
4.1 The Capital Asset Pricing Model 57
4.2 Beta and The Banana Birds 61
4.3 Estimating the Cost of Capital for VC 64
Summary 69
Key Terms 69
References 69
Exercises 70
5 The Best VCs 72
5.1 The Economics of VC 72
5.2 The Best VCs: A Subjective List 75
5.3 VC Value Added and the Monitoring of Portfolio Firms 83
Summary 85
Key Terms 85
References 86
6 VC Around The World 87
6.1 The Global Distribution of VC Investing 87
6.2 The Cost of Capital for International VC 98
6.2.1 Baseline Model: The Global CAPM 98
6.2.2 Discussions of Country Betas and Extensions to the Global CAPM 100
6.2.3 A Global Multifactor Model for Venture Capital 103
Summary 105
Key Terms 105
References 105
Exercises 106
Part II Total Valuation
7 The Analysis of VC Investments 107
7.1 VC Investments: The Historical Evidence 107
7.2 The Investment Process 117
Summary 124
Key Terms 124
References 124
8 Term Sheets 125
8.1 The Basics 126
8.1.1 Investors 126
8.1.2 Price Per Share 127
8.1.3 Pre-Money and Post-Money Valuation 127
8.1.4 Capitalization 128
8.2 The Charter 129
8.2.1 Dividends 130
8.2.2 Liquidation Preference 131
8.2.3 Voting Rights and Other Protective Provisions 132
8.2.4 Mandatory Conversion 132
8.2.5 IPO Ratchet Provision 132
8.2.6 Redemption Rights 132
8.3 Investor Rights Agreement 133
8.3.1 Registration Rights 135
8.3.2 Matters Requiring Investor-Director Approval 136
8.3.3 Employee Stock Options 136
8.4 Other Items 136
8.4.1 Rights and Restrictions 137
8.4.2 Founders’ Stock 137
Summary 138
Key Terms 138
References 138
Exercises 138
9 Preferred Stock 139
9.1 Types of Preferred Stock 139
9.2 Antidilution Provisions 147
9.3 IPO Ratchet Provisions 150
Summary 151
Key Terms 151
References 151
Exercises 152
10 The VC Method 153
10.1 The VC Method: Introduction 153
10.1.1 Exit Valuation 154
10.1.2 Target Returns 155
10.1.3 Expected Retention 156
10.1.4 The Investment Recommendation 157
10.2 The Standard VC Method 157
10.3 The Modified VC Method 159
Summary 164
Key Terms 165
Reference 165
Exercises 165
11 DCF Analysis of Growth Companies 167
11.1 DCF Analysis: Concepts 167
11.2 DCF Analysis: Mechanics 169
11.3 Graduation Value 174
11.4 DCF Analysis: The Reality-Check Model 177
11.4.1 Baseline Assumptions for the Reality-Check DCF 177
Summary 181
Key Terms 181
References 182
Exercises 182
Appendix 11.A: Cost of Capital: Technical Details 182
12 Comparables Analysis 183
12.1 Introduction to Comparables Analysis 184
12.2 Choosing Comparable Companies 187
12.3 Using Comparable Companies to Estimate the Cost of Capital 192
Summary 194
Key Terms 194
Reference 194
Exercises 194
Appendix 12.A: Potential Comparables for Healthco 195
PART III Partial Valuation
13 Option Pricing 196
13.1 European Options 196
13.2 Pricing Options Using a Replicating Portfolio 198
13.3 The Black-Scholes Solution 202
13.4 American Options 205
13.5 Random-Expiration Options 206
13.6 Reading Exit Diagrams 207
13.7 Carried Interest as an Option 209
Summary 211
Key Terms 211
References 211
Exercises 211
Appendix 13.A: RE Options: Technical Details 212
14 The Valuation of Preferred Stock 213
14.1 Base-Case Option-Pricing Assumptions 213
14.2 RP Valuation 214
14.3 Excess Liquidation Preferences 217
14.4 Dividends 219
14.5 CP Valuation 221
14.6 CP with Excess Liquidation Preferences or Dividends 223
14.7 Combining RP and CP 225
14.8 Comparing RP and CP 227
Summary 228
Key Terms 228
Reference 228
Exercises 229
15 Later-Round Investments 230
15.1 Series B 230
15.2 A Conversion Shortcut 234
15.3 Series C 235
15.4 Dividends in Later Rounds 239
15.5 Beyond Series C 241
Summary 243
Key Terms 243
Exercises 243
16 Participating Convertible Preferred Stock 245
16.1 Binary Options 246
16.2 The Valuation of PCP 247
16.3 The Valuation of PCPC 248
16.4 Series B and Beyond 250
Summary 257
Key Terms 257
References 257
Exercises 257
17 Implied Valuation 258
17.1 Post-Money Valuation Revisited 258
17.2 Measurement of Portfolio Value 262
17.3 Down Rounds? 266
17.4 How to Avoid Valuation Confusion 268
Summary 269
Key Terms 269
References 270
Exercises 270
18 Complex Structures 271
18.1 Management Carve-Outs 271
18.2 Dealing with Partners 277
18.3 A Complex Example 279
Summary 283
Key Term 283
Exercises 284
Part IV The Finance of Innovation
19 R&D Finance 285
19.1 R&D Around the World 285
19.2 Two Touchstones 290
19.2.1 Drug Development 290
19.2.2 Energy Innovation 293
19.3 How is R&D Financed? 293
19.4 Where Do We Go from Here? 298
Summary 299
Key Terms 299
References 299
20 Monte Carlo Simulation 300
20.1 Event Trees 300
20.2 Simulation with Continuous Probability Distributions 304
20.3 Simulation with Multiple Sources of Uncertainty 313
Summary 315
Key Terms 316
Exercises 316
21 Real Options 317
21.1 Decision Trees 317
21.2 Real Options in R&D 319
21.3 The Valuation of Real Options 320
21.4 Risk-Neutral Probabilities 325
21.5 Drugco Revisited 331
Summary 333
Key Terms 333
Exercises 334
22 Binomial Trees 335
22.1 The Black-Scholes Equation, Revisited 335
22.2 Multiple Strike Prices and Early Exercise 342
22.3 Dividends 345
Summary 350
Key Terms 350
References 350
Exercises 350
23 Game Theory 351
23.1 What is Game Theory? 351
23.2 Simultaneous Games 354
23.3 Sequential Games 362
23.4 Game Theory and Real Options 366
Summary 370
Key Terms 370
Exercises 371
24 R&D Valuation 372
24.1 Drug Development 372
24.2 Energy 381
24.3 The Forest and the Trees 388
Summary 389
Reference 389
Exercises 389
Appendix A Sample Term Sheet A-1
Appendix B The VCFI Spreadsheets A-14
Appendix C Guide To Oracle Crystal Ball A-16
Glossary G-1
Index I-1
