# Venture Capital and the Finance of Innovation, 2nd Edition

# Venture Capital and the Finance of Innovation, 2nd Edition

ISBN: 978-0-470-45470-1 November 2010 576 Pages

## Description

**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 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.

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### Student

**Part I VC Basics**

**Chapter 1 The VC Industry 3**

1.1 What Is Venture Capital? 3

1.2 What Do Venture Capitalists Do? 9

1.3 The History of Venture Capital 10

1.4 Patterns of VC Investments in the United States 14

Summary 19

Key Terns 20

References 20

**Chapter 2 VC Players 21**

2.1 Firms and Funds 21

2.2 The Limited Partners 27

2.3 VC Partnership Agreements 30

Summary 41

Key Terms 42

References 42

Exercises 42

Appendices: Key Terms and Conditions for Three VC Funds 43

**Chapter 3 VC Returns 46**

3.1 Industry Returns 46

3.2 Fund Returns 53

Summary 62

Key Terms 63

References 63

Exercises 63

**Chapter 4 The Cost of Capital for VC 65**

4.1 The Capital Asset Pricing Model 65

4.2 Beta and the Banana Birds 69

4.3 Estimating the Cost of Capital for VC 74

Summary 79

Key Terms 80

References 80

Exercises 80

**Chapter 5 The Best VCs 83**

5.1 The Economics of VC 83

5.2 The Best VCs: A Subjective List 86

5.3 VC Value Added and the Monitoring of Portfolio Firms 95

Summary 98

Key Terms 98

References 98

**Chapter 6 VC Around the World 99**

6.1 The Global Distribution of VC Investing 99

6.2 The Cost of Capital for International VC 111

Summary 119

Key Terms 199

References 119

Exercises 120

**Chapter 7 The Analysis of VC Investments 123**

7.1 VC Investments: The Historical Evidence 123

7.2 The Investment Process 135

Summary 144

Key Terms 145

References 145

**Chapter 8 Term Sheets 146**

8.1 The Basics 147

8.2 The Charter 151

8.3 Investor Rights Agreement 155

8.4 Other Items 159

Summary 161

Key Terms 161

References 162

Exercises 162

**Chapter 9 Preferred Stock 163**

9.1 Types of Preferred Stock 163

9.2 Antidilution Provision 173

Summary 176

Key Terms 177

References 177

Exercises 177

**Chapter 10 The VC Method 178**

10.1 The VC Method: Introduction 178

10.2 The Standard VC Method 184

10.3 The Modified VC Method 185

Summary 192

Key Terms 192

References 192

Exercises 192

**Chapter 11 DCF Analysis of Growth Companies 195**

11.1 DCF Analysis: Concepts 196

11.2 DCF Analysis: Mechanics 198

11.3 Graduation Value 204

11.4 DCF Analysis: The Reality-Check Model 207

Summary 212

Key Terms 212

References 213

Exercises 213

**Chapter 12 Comparables Analysis 214**

12.1 Introduction to Comparables Analysis 215

12.2 Choosing Comparable Companies 219

12.3 Using Comparable Companies to Estimate the Cost of Capital 224

Summary 226

Key Terms 227

References 227

Exercises 227

Appendix 12.A: Potential Comparables for Semico 228

**Part III Partial Valuation**

**Chapter 13 Option Pricing 231**

13.1 European Options 232

13.2 Pricing Options Using a Replicating Portfolio 234

13.3 The Black-Scholes Solution 238

13.4 American Options 242

13.5 Random-Expiration Options 243

13.6 Reading Exit Diagrams 245

13.7 Carried Interest as an Option 247

Summary 248

Key Terms 249

References 249

Exercises 249

Appendix 13.A RE Options: Technical Details 250

**Chapter 14 The Valuation of Preferred Stock 252**

14.1 Base-Case Option-Pricing Assumptions 253

14.2 RP Valuation 254

14.3 Excess Liquidation Preferences 257

14.4 Dividends 259

14.5 CP Valuation 261

14.6 CP with Excess Liquidation Preferences or Dividends 263

14.7 Combining RP and CP 266

14.8 Comparing RP and CP 268

Summary 269

Key Terms 270

References 270

Exercises 270

**Chapter 15 Later-Rounds Investments 272**

15.1 Series B 272

15.2 A Conversion Shortcut 277

15.3 Series C 278

15.4 Dividends in Later Rounds 282

15.5 Beyond Series C 285

Summary 288

Key Terms 288

Exercises 288

**Chapter 16 Participating Convertible Preferred Stock 290**

16.1 Binary Options 291

16.2 The Valuation of PCP 292

16.3 The Valuation of PCPC 294

16.4 Series B and Beyond 296

Summary 303

Key Terms 303

References 303

Exercises 303

**Chapter 17 Implied Valuation 305**

17.1 Post-Money Valuation Revisited 306

17.2 Measurements of Portfolio Value 310

17.3 Down Rounds? 314

17.4 How to Avoid Valuation Confusion 317

Summary 318

Key Terms 318

Exercises 319

**Chapter 18 Complex Structures 320**

18.1 Management Carve-outs 320

18.2 Dealing with Partners 327

18.3 A Complex Example 329

Summary 334

Key Term 334

Exercises 34

**Part IV The Finance of Innovation**

**Chapter 19 R&D Finance 339**

19.1 R&D Around the World 339

19.2 Two Touchstones 345

19.3 How is R&D Financed? 349

19.4 Where Do We Go From Here? 354

Summary 355

Key Terms 356

References 356

**Chapter 20 Monte Carlo Simulation 357**

21.1 Decision Trees 379

21.2 Real Options in R&D 381

21.3 The Valuation of Real Options 382

21.4 Risk-Neutral Probabilities 388

21.5 Drugco, Revisited 395

Summary 398

Key Terms 398

Exercises 398

**Chapter 22 Binomial Trees 400**

22.1 The Black-Scholes Equation, Revisited 400

22.2 Multiple Strike Prices and Early Exercise 409

22.3 Dividends 411

Summary 417

Key Terms 418

References 418

Exercises 418

**Chapter 23 Game Theory 419**

23.1 What Is Game Theory 419

23.2 Simultaneous Games 423

23.3 Sequential Games 433

23.4 Game Theory and Real Options 438

Summary 443

Key Terms 443

Exercises 444

**Chapter 24 R&D Valuation 445**

24.1 Drug Development 445

24.2 Energy 455

24.3 The Forest and the Trees 464

Summary 464

References 465

Exercises 465

Appendix A Sample Term Sheet 466

Appendix B The VCFI Spreadsheets 484

Appendix C Guide to Crystal Ball® 487

Glossary 512

Index 535

**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.