Entrepreneurial finance is the study of value and resource allocation, applied to new ventures. It addresses key questions which challenge all entrepreneurs: how much money can and should be raised; when should it be raised and from whom; what is a reasonable valuation of the startup; and how should funding contracts and exit decisions be structured.
Contents
The Problem
Many entrepreneurs discover they need to attract money to fully commercialize their concepts. Thus they must find investors – such as their own employer, a bank, an angel investor, a venture capital fund, a public stock offering or some other source of financing. When dealing with most classic sources of funding, entrepreneurs face numerous challenges: skepticism towards the business and financial plans, requests for large equity stakes, tight control and managerial influence and limited understanding of the characteristic of growth process that start-ups experience.
On the other hand, entrepreneurs must understand the four basic problems that can limit investors' willingness to invest capital:
History
Venture capital as the business of investing in new or young companies with innovative ideas emerged as a prominent branch of Entrepreneurial finance in the beginning of the 20th century. Wealthy families such as the Vanderbilt family, the Rockefeller family and the Bessemer family began private investing in private companies. One of the first venture capital firms, J.H. Whitney & Company, was founded in 1946 and is still in business today. The formation of the American Research and Development Foundation (ARDC) by General Georges F. Doriot institutionalized venture capital after the Second World War. In 1958, the Small Business Investment Companies (SBIC) license enabled finance companies to leverage federal US funds to lend to growing companies. Further regulatory changes in the USA –namely the reduction of capital gains tax and the ERISA pension reforms- boosted venture capital in the 1970s. During the 1980s and 1990s, the venture capital industry grew in importance and experienced high volatility in returns. Despite this cyclicality and crisis such as Dot Com; venture capital has consistently performed better than most other financial investments and continues to attract new investors.
Importance
Financial planning allows entrepreneurs to estimate the quantity and the timing of money needed to start their venture and keep it running.
The key questions for an Entrepreneur are:
A start-up's Chief Financial Officer (CFO) assumes the key role of entrepreneurial financial planning. In contrast to established companies, the start-up CFO takes a more strategic role and focuses on milestones with given cash resources, changes in valuation depending on their fulfilment, risks of not meeting milestones and potential outcomes and alternative strategies.
Determination of the Financial Need of a Start-up
The first step in raising capital is to understand how much capital you need to raise. Successful businesses anticipate their future cash needs, make plans and execute capital acquisition strategies well before they find themselves in a cash crunch.
Three axioms guide start-up fund raising:
Four critical determinants of the financial need of a venture are generally distinguished:
Typically, venture capitalists are part of a fund. Their average size in Europe includes five investment professionals and two supports. They generate income through management fees (on average 2.5% annual commission) and carried interest ("Carry", on average 20–30% of the profits of the fund).
Valuation in Entrepreneurial Finance
Financial planning also helps to determine the value of a venture and serves as an important marketing tool towards prospective investors.
Traditional valuation techniques based on accounting, discounting cash flows (Discounted cash flow, DCF) or multiples do not reflect the specific characteristics of a start-up. Instead, the venture capital method, the First Chicago or the fundamental methods are usually applied.
Venture capital method
To determine the future value of a start-up, a venture capital investor is guided by the question: What percentage of the portfolio company should I have at exit to guarantee that I get the IRR committed with my investors?
The valuation of the future company can be broken down into four steps:
Usually there is more than one round of financing. Venture capital investors generally prefer staged investments to reduce the money invested at the higher risk and control entrepreneurs via milestones. Entrepreneurs benefit from dilution in future rounds by reducing the price of the shares to be exchanged for financing.
University Education
Entrepreneurial finance courses are offered in different universities, for example at Babson College, the Stern School of Business, the Kellogg School of Management and ESADE. Special centers to promote entrepreneurship within universities also cover finance topics, for example the Center for International Development at Harvard University, which works to generate shared and sustainable prosperity in developing economies