Decided to put here some of the notes from the excellent class that I am currently taking at Chicago GSB, called entrepreneurial finance and private equity. Most of the notes will be case-based, but some of them will be general truths, that could be of general interest. Again, this is meant to be the collection of “wisdom”, not the classical lecture notes, no definitions of formulas here. [VC – stands for venture capital[ist] here]
The first case was about Visible Interactive, a corporation whose business idea was to “provide the interactive, programmable, portable device for the museum audio tours“. Below will be some of the key learnings from this case.
Because the market for the company’s product was so small, the issue with exit from this investment arose: if this is a $50 million dollar company (in net worth), you will never be able to do an IPO, because the minimum size of equity has to be about $150MM = $50MM minimum IPO size * 1/3 typical share of the company to be sold to the public.
One of the risks that nobody thought of was the risk of Apple dropping the Newton (Apple Newton was the hardware platform for our “museum tour” device). In fact, if that happened, all the hardware modification work as well as software writing would have to be done anew.
Prof. also mentioned the venture-leasing companies. Since our devices are so expensive, will any venture-leasing company lease those Newtons to us? No, because if something happens to us (and us being a small business in the early stage, it is highly likely that something will happen) then what will they do with these 100’s of used Newtons? Likewise, no commercial bank will finance the purchase of these kind of devices that have very limited area of use. Only equity finances highly-specialized assets!!!
A classic was that the management team had no experience in working in “cash-constrained environment”. [This tells me that all of the former Soviet Union people must be great candidates for small businessmen, because all their life was in the cash-constrained environment…].
An otherwise a sure no, this deal is worth trying [according to prof.] because it has this chance to be tried at Smithsonian, the most well-known museum in the US. My take on it was to invest only in the trial and then decide. !!! IN VENTURE BUSINESS SCALE DOESNT MATTER BUT THE CONCEPT RISK MATTERS !!! This makes tremendous sense, more accurately, scale matters only after the concept risk has been removed.
In the early stage the discount rate of 50% applies. In other words the risk of the new venture justifies the cost of equity at the 50%. Further in the discount rate field: we calculated that a normal, average public company would have a cost of equity at about 12% at that time (in VC everything is very approximate, so “average public company” is OK). So having made the projections of this Visible corporation and having discounted them at this rate prof. goes ahead and says, well this one has only 25% chance that her cash flows will be as stable as those of the public company and discounts everything by 12% / 0.25 = 48%. I would be OK with this, if he just said, well their risk is 50% adn thats it. But not the “probability-adjusted APV” as he puts it.
[He is a practitioner much more than an academic, and this is good – he says often, thats how the industry does it, whether it is rigorous or not and this is really great, to have a guy who combines insights from the both worlds]
The second part of the class was devoted to the term sheet. The wisdom here is that in VC the terms are sometimes more important than the price. I think is makes sense – when returns are from -100% to infinity it is not so much price per share that matters, but the downside protection. That;s what prof. said in the end: a VC cares about the downside protection, while an entrepreneur cares about his upside.
Another brilliant one: it is a malpractice to go into the venture deal without calculating where will every single nickel come from, that it is required to take this venture to the point where it becomes liquid. This is related with the venture investment experience at UIG, where I worked before the MBA. It is always like that: you pay your initial equity contribution and then you are forced to pay the subsequent ones, because you havent arranged for the next rounds of financing! And as usually, the projections are too aggressive etc..
Golden rule: he, who has the gold, makes the rules, i.e., it is the VC that sets the terms in the venture deal.
One final comment: in the venture deal a VC often gets warrants from the company that are set very cheaply: “penny warrants”. So the entrepreneur cares not about the price, but about the # of them, to protect his share in the business.
Thats about it for the wisdom of the 1st class…
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