A complete summary, including all chapters (slides, lectures and book) needed to know for the exam for Entrepreneurial Finance. Lecture notes will be automatically added to the document, after completing the lectures.
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Full Summary of The Fundamentals of Entrepreneurial Finance!! (M. Da Rin & T. Hellman, 2020) - 323062-M-6
FULL SUMMARY ENTREPRENEURIAL FINANCE (323062-M-6) - The Fundamentals of Entrepreneurial Finance (Da Rin & Hellman)
Entrepreneurial Finance: Complete summary of the slides, lecture notes & material from the book "The Fundamentals of Entrepreneurial Finance"
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Entrepreneurial Finance Notes
Preparations lecture 1
Chapter 1
Entrepreneurial Finance is about the combination between entrepreneurship and finance. It’s
defined as the provision of funding to young (<10 years old), innovative, growth-oriented companies.
Companies younger than 5 years are called start-ups. Start-ups, entrepreneurial companies and
ventures will be used interchangeable. The word ‘firm’ refers to the investor.
There are three fundamental principles of the entrepreneurial process: resource-gathering,
uncertainty and experimentation. The first principle implies that the money offered by investors will
play a vital role in the development of the venture. The second principle says that investors will have
to live with uncertainty at every step of the process. Uncertainty is different than risk in the sense
that for risk we know the potential outcomes, whereas for uncertainty we ignore what might
happen. The third principle suggests that investors, too, need to be flexible when working with
entrepreneurs. Exploration is for entrepreneurial companies, where exploitation is done by
established companies.
Entrepreneurial Finance is challenging. Entrepreneurs do not yet have a banker, since they’re young,
which makes it hard to find and reach out to relevant investors. So, getting funding is hard. On the
other hand, investors get so many business pitches that, for them, it’s too difficult to know what to
invest in. Moreover, there’s a long and costly investment process to get their money back. To some
extent, both entrepreneurs and investors worry about the same challenges: finding a good match,
striking a good deal, surviving the ride, and finding their way to a successful exit. Though, investors
are experienced in the process, whereas entrepreneurs are not.
Entrepreneurial Finance is important. From the entrepreneur’s perspective, obtaining financing is
vital for the success of her business. A good investor supports the venture by mentoring and
providing strategic advice, by making introductions to business partners and future investors, by
helping to hire talented managers, or by attracting a knowledgeable board of directors. From the
investor’s perspective, funding the right ventures is crucial for generating high returns, as start- ups
are risky and sometimes opaque.
This delicate choice is sometimes delegated to professional VC firms, whose core business is funding
start- ups. Institutional investors allocate some money to VC firms as a way of diversifying their
portfolio and seeking out high returns. Established corporations also fund entrepreneurial ventures,
as part of their innovation strategies. It gives them a window on new technology and a chance to
engage with promising ventures in their industries. Finally, for private investors, financing
entrepreneurs is not only a personal passion, it can also be an efficient way of applying their skills
and expertise to make money.
Entrepreneurial finance matters also for the economy and society at large. Entrepreneurial
companies are an important driver of economic growth since they advance new technologies,
products, and business models. Put simply, economic growth comes from increases in the efficiency
of how an economy converts inputs into outputs. Broadly speaking, there are two main lines of
argument that may lead to endogenous growth. The first line looks at innovation from established
companies. The second line of argument looks at entrepreneurship. Each new generation of
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,entrepreneurs challenges incumbents by introducing better, faster and cheaper products or services.
So entrepreneurship is at the heart of long-term economic growth, creating a lot of new jobs.
VC is growing as an industry. Failure is very common in start-ups, but VC-backed startups experience
failure much less often. VC funding allows start-ups to go through the initial experimentation phase.
The FIRE framework following the relationship between an
entrepreneur and investor. Fire stands for Fit, Invest, ride and
Exit.
Fit concerns the matching process of how entrepreneurs and
investors find each other and assess their mutual fit. The
essential components of the Fit step, illustrated with the notion
of the entrepreneur pitching an idea and the investor screening
opportunities, all in the hope of finding a match. Angel
investors are wealthy private individuals who sometimes invest in entrepreneurial ventures.
Apparently, what they look most for in entrepreneurs is passion and the people-side.
Invest concerns the process of closing a deal, where the entrepreneur obtains money from the
investor in exchange for a financial claim, with conditions specified in a contract. They need to agree
on amount and the security (number of shares that the investor gets in return for making the
investment).
Ride concerns the path forward, where entrepreneurs and investors navigate through the
entrepreneurial process and encounter numerous challenges. Along the ride the entrepreneur and
investor learn about the market and the scale of their business opportunity. In addition, they learn
about each other. Investors want to give the company enough money to go from one milestone to
another and reserve the right not to provide further funding in case the project falters. As a
consequence, financing typically comes in stages. Each new funding event is called a financing round.
Each new round requires a new financial contract and therefore involves a new set of negotiations,
resulting in a new valuation and a new term sheet. Funding can come from a combination of old and
new investors.
Exit is a destination, the end of the journey, when the investors obtain a return on their investments
by selling their shares. One way of exit is IPO, when a company goes public on the stock market. The
other successful type is when a company gets acquired at a high valuation. Unsuccessful exits take
several forms. They may consist of ceasing operations, liquidating assets, declaring bankruptcy, or
getting acquired at a low valuation. Another type of exit is a partial or full sale of company shares to a
financial buyer. This exit is often associated with intermediate company performance.
There are several types of investors. Venture capitalists (VCs) are professional investors who raise
their own funding from institutional investors. They invest these funds in a portfolio of
entrepreneurial companies, with the objective of generating returns for their institutional investors.
The first external funders of a company are often family, relatives, and close friends, colloquially
referred to as the “three Fs”: “family, friends, and fools.”. Next there are “angel investors,” private
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,individuals who invest their own money without previous relationships to the founders. Then, there’s
corporations that invest often with strategic motive. Moreover, there’s FinTech that lead to UCOs
and crowdfunding that either allow companies to raise money in return for some rewards or early
access to product under development OR peer-to-peer platforms that allow companies to raise loans
provided by private individuals or professional investors OR platforms that raise equity. Governments
can also be a source of funding for entrepreneurs.
The 2nd framework is FUEL (an acronym standing for Fundamental structure, Underlying motivation,
Expertise and networks, and Logic and style).
Whose money is invested and
how much? Who makes the key
decisions?
Also differs per investor type.
Investor differences w.r.t.
expertise &network have impact on
investors behaviour and attractive-
ness for potential entrepreneurs.
logic = investment criteria used to
make investment decisions = Fit &
invest step of FIRE. Style = Ride &
Exit steps of FIRE.
Puri & Zarutski
VC-financed firms achieve larger scale exit ( but not more profitable) than non-VC-financed firms.
Failure rates of VC-financed firms are lower, mainly driven by the lower failure rates in the initial
years after receiving VC. After the internet bubble, the performance in those firms narrow.
VC-financed firms are relative to other new firms very close to irrelevant in numbers. Though, in
employment they have more impact. VCs also invest heavily in employment. Both in number of
employees and wages. Especially in the first several years.
Typically, VC invests in firms with no immediate revenues. There’s little difference in measures of
profitability between matched VC and non-VC-financed firms before VC-financed firms are exited via
acquisition or IPO. This means that the key firm characteristic on which VC focuses is scale or
potential to scale, rather than short-term profitability. So VC financed firms that grow rapidly and
eventually become large players in the economy. VC-financed firms are larger than non-VC-financed
firms (in employment and sales) at each age of the life cycle prior to first exit. This size difference
becomes larger with firm age. So actual or potential scale of employment and sales is an important
criterion in how venture capitalists choose which firms to finance.
The cumulative probability of failure is lower for VC-financed firms over non-VC-financed firms. There
seems to be a window over which VCs allow firms to continue and grow (first years), but once this
period is over VCs are just as likely to shut their firms down. So the difference in failure percentage
comes from the first years. This suggests that VCs make the biggest difference in the early years of
firms’ life cycles, or that they select firms that are much less likely to fail early on. VC-financed firms
are much more likely to be acquired and go public than non-VC-financed firms. VCs either promote
3
, or select their companies to exit via these routes earlier (perhaps by making them grow early in the
life cycle).
When VC-financed firms fail, they are significantly larger in terms of employees and sales, and are
less profitable at the time of failure. This suggests that venture capitalists invest heavily in all their
firms for an initial period until they have a better sense of which ones will be the successes in their
portfolios.
VC-financed firms backed by high reputation investors have lower failure rates and higher acquisition
rates than those backed by low reputation investors. Though, both have higher acquisiton and IPO
rates than do non-VC-financed firms. And both have lower failure rates than non-VC-financed firms.
In some industries, there’s more VC-financed firms than others, such as computers & tech.
Lecture 1 – about chapter 1
The four steps of the FIRE framework are consecutive. There are four steps, that happen only after
the previous one has been done.
For entrepreneurial finance you have the combination of creative/right brain intuition of the
entrepreneurs and the left brain logic of corporate finance.
Then, with regards to the Puri & Zarutskie paper. Companies that have high ambitions tend to attract
venture capital, that rarely get successful. So VC financed firms are often small firms that have high
growth and the scaling potential. Often, they also tend to bin the high-tech industry. Though, when
they are successful, they are really successful and grow a lot! When they grow successfully, they
change the industry and they kill a lot of other jobs in the industry.
It’s hard to find data for VC as it comes from different datasets. It’s hard to decide whether the firms
grow because of VC capital and the support they get from that, or is it because of the skills of the VC
fund managers that can pick the good skills.
They matched VC funded companies with non-VC funded companies with similar characteristics.
Though, what are similar companies? Therefore, creating proper control groups is hard.
Policy-makers could support VC, because it creates growth. Though, you can also increase funding
universities, because that’s where the growth potential comes from. Also, we should consider if
having more start-ups is always good.
In the exam, you state upsides and downsides and then you end with that we need more research to
find out.
Policy-makers could for example improve the possibilities to show who has growth potential.
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