Venture Capital and the Finance of Innovation

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