Venture Capital and the Finance of Innovation, 2nd Edition
September 2010, ©2011
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 first-year 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.
PART I VC BASICS.
Chapter 1 The VC Industry.
1.1 What is Venture Capital?
1.2 What Do Venture Capitalists Do?
1.3 The History of Venture Capital.
1.4 Patterns of VC Investment in the United States.
1.4.1 Investments by Stage.
1.4.2 Investments by Industry.
1.4.3 Investments by U.S. Region.
Chapter 2 VC Players.
2.1 Firms and Funds.
2.2 The Limited Partners.
2.3 VC Partnership Agreements.
2.3.1 Management Fees.
2.3.2 Carried Interest.
2.3.3 Restrictive Covenants.
Appendices: Key Terms and Conditions for Three VC Funds.
Appendix 2.A: EarlyBird Ventures I.
Appendix 2.B: Talltree Ventures IV.
Appendix 2.C: Owl Ventures IX.
Chapter 3 VC Returns.
3.1 Industry Returns.
3.1.2 A Gross-Return Index.
3.1.3 A Net-Return Index.
3.2 Fund Returns.
Chapter 4 The Cost of Capital for VC.
4.1 The Capital Asset Pricing Model.
4.2 Beta and the Banana Birds.
4.3 Estimating the Cost of Capital for VC.
Chapter 5 The Best VCs.
5.1 The Economics of VC.
5.2 The Best VCs: A Subjective List.
5.3 VC Value Added and the Monitoring of Portfolio Firms.
Chapter 6 VC Around the World.
6.1 The Global Distribution of VC Investing.
6.2 The Cost of Capital for International VC.
6.2.1 Baseline Model: The Global CAPM.
6.2.2 Objective and Extensions to the Global CAPM.
6.2.3 A Global Multifactor Model for Venture Capital.
PART II TOTAL VALUATION.
Chapter 7 The Analysis of VC Investments.
7.1 VC Investments: The Historical Evidence.
7.2 The Investment Process.
Chapter 8 Term Sheets.
8.1 The Basics.
8.1.2 Price Per Share.
8.1.3 Pre-Money and Post-Money Valuation.
8.2 The Charter.
8.2.2 Liquidation Preference.
8.2.3 Voting Rights and Other Protective Provisions.
8.2.4 Mandatory Conversion.
8.2.5 Redemption Rights.
8.3 Investor Rights Agreement.
8.3.1 Registration Rights.
8.3.2 Matters Requiring Investor-Director Approval.
8.3.3 Employee Stock Options.
8.4 Other Items.
8.4.1 Rights and Restrictions.
8.4.2 Founders' Stock.
Chapter 9 Preferred Stock.
9.1 Types of Preferred Stock.
9.2 Antidilution Provisions.
Chapter 10 The VC Method.
10.1 The VC Method: Introduction.
10.1.1 Exit Valuation.
10.1.2 Target Returns.
10.1.3 Expected Retention.
10.1.4 The Investment Recommendation.
10.2 The Standard VC Method.
10.3 The Modified VC Method.
Chapter 11 DCF Analysis of Growth Companies.
11.1 DCF Analysis: Concepts.
11.2 DCF Analysis: Mechanics.
11.3 Graduation Value.
11.4 DCF Analysis: The Reality-Check Model.
11.4.1 Baseline Assumptions for the Reality-Check DCF.
Chapter 12 Comparables Analysis.
12.1 Introduction to Comparables Analysis.
12.2 Choosing Comparable Companies.
12.3 Using Comparable Companies to Estimate the Cost of Capital.
Appendix 12.A: Potential Comparables for Semico.
PART III PARTIAL VALUATION.
Chapter 13 Option Pricing.
13.1 European Options.
13.2 Pricing Options Using a Replicating Portfolio.
13.3 The Black-Scholes Solution.
13.4 American Options.
13.5 Random-Expiration Options.
13.6 Reading Exit Diagrams.
13.7 Carried Interest as an Option.
Appendix 13.A RE Options: Technical Details.
Chapter 14 The Valuation of Preferred Stock.
14.1 Base-Case Option-Pricing Assumptions.
14.2 RP Valuation.
14.3 Excess Liquidation Preferences.
14.5 CP Valuation.
14.6 CP with Excess Liquidation Preferences or Dividends.
14.7 Combining RP and CP.
14.8 Comparing RP and CP.
Chapter 15 Later-Round Investments.
15.1 Series B.
15.2 A Conversion Shortcut.
15.3 Series C.
15.4 Dividends in Later Rounds.
15.4.1 Accrued Cash Dividends.
15.4.2 PIK Dividends.
15.5 Beyond Series C.
Chapter 16 Participating Convertible Preferred Stock.
16.1 Binary Options.
16.2 The Valuation of PCP.
16.3 The Valuation of PCPC.
16.4 Series B and Beyond.
Chapter 17 Implied Valuation.
17.1 Post-Money Valuation Revisited.
17.2 Measurement of Portfolio Value.
17.3 Down Rounds?
17.4 How to Avoid Valuation Confusion.
Chapter 18 Complex Structures.
18.1 Management Carve-outs.
18.2 Dealing with Partners.
18.3 A Complex Example.
PART IV THE FINANCE OF INNOVATION.
Chapter 19 R&D Finance.
19.1 R&D Around the World.
19.2 Two Touchstones.
19.2.1 Drug Development.
19.2.2 Energy Innovation.
19.3 How Is R&D Financed?
19.4 Where Do We Go from Here?
Chapter 20 Monte Carlo Simulation.
20.1 Event Trees.
20.2 Simulation with Continuous Probability Distributions.
20.3 Simulation with Multiple Sources of Uncertainty.
Chapter 21 Real Options.
21.1 Decision Trees.
21.2 Real Options in R&D.
21.3 The Valuation of Real Options.
21.4 Risk-Neutral Probabilities.
21.5 Drugco, Revisited.
Chapter 22 Binomial Trees.
22.1 The Black-Scholes Equation, Revisited.
22.2 Multiple Strike Prices and Early Exercise.
Chapter 23 Game Theory.
23.1 What Is Game Theory?
23.2 Simultaneous Games.
23.3 Sequential Games.
23.4 Game Theory and Real Options.
Chapter 24 R&D Valuation.
24.1 Drug Development.
24.3 The Forest and the Trees.
Appendix A Sample Term Sheet.
Appendix B The VCFI Spreadsheets.
Appendix C Guide to Crystal Ball®.
Ayako Yasuda is an Assistant Professor of Management at the Graduate School of Management, University of California, Davis. She was previously a faculty member in the finance department at the Wharton School of the University of Pennsylvania; prior to her Ph.D. she worked at the Investment Banking Division of Goldman, Sachs & Co. Dr. Yasuda received a BA and Ph.D. in Economics from Stanford University. She has won numerous research grants and has been published in the Journal of Finance, Journal of Financial Economics, and the Review of Financial Studies.
- New co-author: Ayako Yasuda is Assistant Professor of Management at the Graduate School of Management, University of California, Davis and former faculty member in the finance department at the Wharton School of the University of Pennsylvania; prior to her Ph.D. she worked at the Investment Banking Division of Goldman, Sachs & Co.
- New unified treatment of investment decision making combining total valuation and partial valuation analysis.
- New rankings of the “best venture capitalists.”
- New web-based model (VCVtools.com) allowing easy visualisation and valuations of multiple term sheets in a start-up.
- Refined version of “reality-check” valuation model to allow for greater flexibility in growth assumptions.
- Updated risk-return and cost-of-capital calculations.
- Updated industry data showing large changes in venture capital investments since 1999.
- Streamlined exposition of real-options methodology, with new connections to venture capital valuation.
- Discussion of challenges facing venture capital in the second decade of the 21st century.
- Innovative model for the valuation of start-ups.
- The relationships between risk and return and strategy and finance in venture capital.
- Historical statistics on the performance of venture capital investments.
- Total Valuation: the data and methods used to value a high-growth company.
- Partial Valuation: how to visualise and evaluate the special features of VC transactions such as convertible preferred stock, participating preferred stock, payment-in-kind dividends, and liquidation preferences.
- Framework for modeling investment in "research and development."
- Cutting edge techniques such as Monte-Carlo analysis, real options, binomial trees, and game theory.
—Paul A. Gompers, Eugene Holman Professor of Business Administration & Director of Research, Harvard Business School
"Despite the increasing importance of the venture capital
industry, until now there was no reference that could provide
practitioners with a specialized grounding in finance. With clear
explanations and practical models, Metrick’s book can fill
this gap. I enthusiastically recommend this book to all venture
—Ted Schlein, Partner, Kleiner Perkins Caufield & Byers
"Investors in young, fast-growing companies have a new way to
calculate their value without regard to the prices of other
companies’ stocks. This is an important advance, because most
other appraisal methods for start-ups are based on relative
valuation, which – as we saw at the top of the Internet
bubble – grossly overvalues a new company when comparable
companies in the same industry are also overvalued."
—Mark Hulbert, The New York Times, Dec. 31, 2006 --This text refers to an alternate Hardcover edition.
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