Venture Capital and the Finance of Innovation (3^rd Ed.)

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. The book shows the reader how to use a user-friendly and automated valuation model of VC preferred stock (available at www.vcvtools.com) to value various types of preferred stock and to visualize how term sheets split the values of the firm between entrepreneurs and VCs.

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.

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