Venture Capital and the Finance of Innovation, 2nd Edition

"This useful guide walks venture capitalists through the principles of finance and the financial models that underlie venture capital decisions. It presents a new unified treatment of investment decision making and mark-to-market valuation. The discussions of risk-return and cost-of-capital calculations have been updated with the latest information. The most current industry data is included to demonstrate large changes in venture capital investments since 1999. The coverage of the real-options methodology has also been streamlined and includes new connections to venture capital valuation. In addition, venture capitalists will find revised information on the reality-check valuation model to allow for greater flexibility in growth assumptions."-- Provided by publisher Cover......Page 1 Title Page......Page 5 Copyright......Page 6 PREFACE TO 2ND EDITION—A READER’S GUIDE......Page 9 ACKNOWLEDGMENTS......Page 15 CONTENTS......Page 19 PART I: VC BASICS......Page 27 1.1 What Is Venture Capital?......Page 29 1.2 What Do Venture Capitalists Do?......Page 35 1.3 The History of Venture Capital......Page 36 1.4 Patterns of VC Investment in the United States......Page 40 Summary......Page 45 References......Page 46 2.1 Firms and Funds......Page 47 2.2 The Limited Partners......Page 53 2.3 VC Partnership Agreements......Page 56 Summary......Page 67 Exercises......Page 68 Appendices: Key Terms and Conditions for Three VC Funds......Page 69 3.1 Industry Returns......Page 72 3.2 Fund Returns......Page 79 Summary......Page 88 Exercises......Page 89 4.1 The Capital Asset Pricing Model......Page 91 4.2 Beta and the Banana Birds......Page 95 4.3 Estimating the Cost of Capital for VC......Page 100 Summary......Page 105 Exercises......Page 106 5.1 The Economics of VC......Page 109 5.2 The Best VCs: A Subjective List......Page 112 5.3 VC Value Added and the Monitoring of Portfolio Firms......Page 121 References......Page 124 6.1 The Global Distribution of VC Investing......Page 125 6.2 The Cost of Capital for International VC......Page 137 References......Page 145 Exercises......Page 146 PART II: TOTAL VALUATION......Page 147 7.1 VC Investments: The Historical Evidence......Page 149 7.2 The Investment Process......Page 161 Summary......Page 170 References......Page 171 CHAPTER 8 TERM SHEETS......Page 172 8.1 The Basics......Page 173 8.2 The Charter......Page 177 8.3 Investor Rights Agreement......Page 181 8.4 Other Items......Page 185 Key Terms......Page 187 Exercises......Page 188 9.1 Types of Preferred Stock......Page 189 9.2 Antidilution Provisions......Page 199 Summary......Page 202 Exercises......Page 203 10.1 The VC Method: Introduction......Page 204 10.2 The Standard VC Method......Page 210 10.3 The Modified VC Method......Page 211 Exercises......Page 218 CHAPTER 11 DCF ANALYSIS OF GROWTH COMPANIES......Page 221 11.1 DCF Analysis: Concepts......Page 222 11.2 DCF Analysis: Mechanics......Page 224 11.3 Graduation Value......Page 230 11.4 DCF Analysis: The Reality-Check Model......Page 233 Key Terms......Page 238 Exercises......Page 239 CHAPTER 12 COMPARABLES ANALYSIS......Page 240 12.1 Introduction to Comparables Analysis......Page 241 12.2 Choosing Comparable Companies......Page 245 12.3 Using Comparable Companies to Estimate the Cost of Capital......Page 250 Summary......Page 252 Exercises......Page 253 Appendix 12.A: Potential Comparables for Semico......Page 254 PART III: PARTIAL VALUATION......Page 255 CHAPTER 13 OPTION PRICING......Page 257 13.1 European Options......Page 258 13.2 Pricing Options Using a Replicating Portfolio......Page 260 13.3 The Black-Scholes Solution......Page 264 13.4 American Options......Page 268 13.5 Random-Expiration Options......Page 269 13.6 Reading Exit Diagrams......Page 271 13.7 Carried Interest as an Option......Page 273 Summary......Page 274 Exercises......Page 275 Appendix 13.A RE Options: Technical Details......Page 276 CHAPTER 14 THE VALUATION OF PREFERRED STOCK......Page 278 14.1 Base-Case Option-Pricing Assumptions......Page 279 14.2 RP Valuation......Page 280 14.3 Excess Liquidation Preferences......Page 283 14.4 Dividends......Page 285 14.5 CP Valuation......Page 287 14.6 CP with Excess Liquidation Preferences or Dividends......Page 289 14.7 Combining RP and CP......Page 292 14.8 Comparing RP and CP......Page 294 Summary......Page 295 Exercises......Page 296 15.1 Series B......Page 298 15.2 A Conversion Shortcut......Page 303 15.3 Series C......Page 304 15.4 Dividends in Later Rounds......Page 308 15.5 Beyond Series C......Page 311 Exercises......Page 314 CHAPTER 16 PARTICIPATING CONVERTIBLE PREFERRED STOCK......Page 316 16.1 Binary Options......Page 317 16.2 The Valuation of PCP......Page 318 16.3 The Valuation of PCPC......Page 320 16.4 Series B and Beyond......Page 322 Exercises......Page 329 CHAPTER 17 IMPLIED VALUATION......Page 331 17.1 Post-Money Valuation Revisited......Page 332 17.2 Measurement of Portfolio Value......Page 336 17.3 Down Rounds?......Page 340 17.4 How to Avoid Valuation Confusion......Page 343 Key Terms......Page 344 Exercises......Page 345 18.1 Management Carve-outs......Page 346 18.2 Dealing with Partners......Page 353 18.3 A Complex Example......Page 355 Exercises......Page 360 PART IV: THE FINANCE OF INNOVATION......Page 363 19.1 R&D Around the World......Page 365 19.2 Two Touchstones......Page 371 19.3 How Is R&D Financed?......Page 375 19.4 Where Do We Go from Here?......Page 380 Summary......Page 381 References......Page 382 20.1 Event Trees......Page 383 20.2 Simulation with Continuous Probability Distributions......Page 388 20.3 Simulation with Multiple Sources of Uncertainty......Page 399 Exercises......Page 402 CHAPTER 21 REAL OPTIONS......Page 404 21.1 Decision Trees......Page 405 21.2 Real Options in R&D......Page 407 21.3 The Valuation of Real Options......Page 408 21.4 Risk-Neutral Probabilities......Page 414 21.5 Drugco, Revisited......Page 421 Exercises......Page 424 22.1 The Black-Scholes Equation, Revisited......Page 426 22.2 Multiple Strike Prices and Early Exercise......Page 435 22.3 Dividends......Page 437 Summary......Page 443 Exercises......Page 444 23.1 What Is Game Theory?......Page 445 23.2 Simultaneous Games......Page 449 23.3 Sequential Games......Page 459 23.4 Game Theory and Real Options......Page 464 Key Terms......Page 469 Exercises......Page 470 24.1 Drug Development......Page 471 24.2 Energy......Page 481 Summary......Page 490 Exercises......Page 491 APPENDIX A: SAMPLE TERM SHEET......Page 492 APPENDIX B: THE VCFI SPREADSHEETS......Page 510 APPENDIX C: GUIDE TO CRYSTAL BALL®......Page 513 GLOSSARY......Page 538 INDEX......Page 561 Machine generated contents note: Part I: VC Basics. Chapter 1: The VC Industry. Chapter 2: VC Players. Chapter 3: VC Returns. Chapter 4: The Cost of Venture Capital. Chapter 5: The Best VCs. Chapter 6: VC Around the World. Part II: Total Valuation. Chapter 7: The Analysis of VC Investments. Chapter 8: Term Sheets. Chapter 9: Preferred Stock. Chapter 10: The VC Method. Chapter 11: Discounted-Cash-Flow Analysis of Growth Companies. Chapter 12: Comparables Analysis. Part III: Partial Valuation. Chapter 13: Option Pricing. Chapter 14: The Valuation of Preferred Stock. Chapter 15: Later-Round Investments. Chapter 16: Participating Convertible Preferred Stock. Chapter 17: Implied Valuation. Chapter 18: Complex Structures. Part IV: The Finance of Innovation. Chapter 19: R&D Finance. Chapter 20: Monte Carlo Simulation. Chapter 21: Real Options. Chapter 22 Binomial Trees. Chapter 23 Game Theory. Chapter 24 R&D Valuation. Appendix A Information Sources for Venture Capital. Appendix B Sample Term Sheet. Appendix C The VCFI Spreadsheets. Appendix D Guide to Crystal Ball. Glossary. Index. The Financial Principles Every Venture Capitalist Needs To Master In Venture Capital and the Finance of Innovation, future and current venture capitalists will find a useful guide to the principles of finance and the financial models that underlie venture capital decisions. Assuming no knowledge beyond concepts covered in firstyear MBA course, the text serves as an innovative model for the valuation of start ups, and will familiarise you with the relationship between risk and return in venture capital, historical statistics on the performance of venture capital investments, total and partial valuation—and more.