Entrepreneurial Finance
Structure
Lecture 1................................................................................................................ 2
Access to Finance................................................................................................ 2
Introduction to Entrepreneurial Finance..............................................................6
Evaluating Business Opportunities....................................................................13
Lecture 2.............................................................................................................. 18
Why financial planning?.................................................................................... 18
The Financial Plan.............................................................................................. 20
Ownership and Returns..................................................................................... 27
Valuation Methods............................................................................................. 34
Lecture 3.............................................................................................................. 40
Guest lecture : Entrepreneurship @ KUL..............................................................41
KU Leuven Research & Development (LRD)......................................................41
KICK................................................................................................................... 42
Lecture 4.1........................................................................................................... 43
Agency Conflicts & Control Rights.....................................................................43
Lecture 4.2........................................................................................................... 47
Term Sheets....................................................................................................... 47
Cash Flow Rights............................................................................................... 49
Compensation & Employment (Relationship of the founders to the company). 52
Structuring Deals............................................................................................... 56
Corporate Governance...................................................................................... 61
Lecture 5.............................................................................................................. 64
Staged Financing............................................................................................... 64
Debt Financing.................................................................................................. 69
Lecture 6.............................................................................................................. 73
Exit.................................................................................................................... 73
Venture Capital.................................................................................................. 73
Early Stage Investors (SKIP).............................................................................. 81
Lecture 7.............................................................................................................. 85
Lecture 12............................................................................................................ 85
Course overview................................................................................................... 85
1
,Lecture 1
Access to Finance
(= Access to external funding)
What are Financial constraints/credit rationing?
A firm is financially constrained if it has a need for external finance, but is
unable to obtain it.
o Someone needed to provide financial resources to this firm
o “by ‘financial constraints’ we mean frictions that prevent the firm
from funding all desired investments.”
“Reward/revenue, interest rate” and “Provided
funding”
In the equilibrium there is no one constrained
o Supply: Upwards: higher reward => more
people offering funding
o Demand: Downwards: the more you have
to pay to borrow, the less demand
In this equilibrium: no one is constrained, everyone wanting external
funding is being supplied
The interest rate clears the market for external funds
o If demand > supply, the interest rate will increase
o If demand < supply, the interest rate will decrease
Credit rationing: there are exist firms that are willing to borrow at the
equilibrium interest rate (or at a higher rate) but are unable to do so
o Credit rationing would not happen in previous equilibrium, there
would have to be some type of market failure
Market failure if it is the result of some characteristic that is inherent to
the market, if it is a feature of the long-run equilibrium. (= Frictions)
o There is typically asymmetric information between demand and
supply! Firms have information that finance providers cannot
observe.
o In the presence of adverse selection or moral hazard
asymmetric information can lead to market failure.
Models of credit rationing
Credit rationing can be rational under asymmetric information
For example, due to:
Adverse selection
Moral hazard
Adverse selection
Banks face borrowers with unknown risk type
o Unknown different Riskiness of firms/projects
Banks know the distribution of firm types in the economy, but not the
type of each individual firm
2
, Firms with risky projects have a low chance of success and thus of
repayment, but when they are successful, the return is very high.
Firms with safe projects have a high chance of success and thus of
repayment. When they succeed, the return is not particularly high.
Banks choose their supply (and thus implicitly set the interest rate) such
that they maximize their profits!
o So Ceteris paribus: higher interest rates lead to higher profits.
Twist in the model:
o Safe firms will not accept high interest rates
o Only risky firms accept high interest rates
This leads to adverse selection if the interest rate is too high!
Safe firms repay with high certainty, but their return is low
o High interest rates = high borrowing costs > return when successful
Risky firms repay with low certainty, but their return is very high
o High interest rates = high borrowing costs < return when successful
Bank profits no longer monotonically increase with the interest rate!
o So the assumption of increasing profits when interest rate increases
no longer holds
o Composition of firms you lend to change as well: You will lose more
safe borrowers and gain more risky borrowers (the pool changes)
Bank profits increase with the interest rate, up to the point when safe firms
start to drop out
o From that point onwards, bank profits decrease with the interest
rate.
It is rational for banks not to lend beyond a certain interest rate.
o Even though there are firms with a positive demand for external
funding at higher interest rates.
o The safe firms that are unserved are credit rationed in
equilibrium.
Moral Hazard
Banks face borrowers with same risk type, but different assets
o Same riskiness of firms/projects
o Different amounts of ex-ante collateral
Chance of project success does not depend on firms’ collateral.
(=”Onderpand”)
Chance of project success depends on effort of the entrepreneur.
o High effort → high likelihood of project success
o Low effort → low likelihood of project success
Banks choose their supply of external funding to maximize profits.
o Profits depend on the success of the entrepreneurs and thus on the
effort of the entrepreneurs.
Twist in the model:
o Entrepreneurs also benefit from leisure (=”Vrije tijd”),
o The more effort their exert, the less time they have for leisure.
3
, Entrepreneurs might promise to exert high effort but change their effort
once they have received the funding.
Banks cannot observe the effort of the entrepreneur
o Firms will need to pledge a minimum level of assets to the bank
o This way, firms incur some of the investment risk themselves
Only if firms have sufficient “skin in the game,” can the bank be sure that
entrepreneurs exert the necessary effort. Firms with insufficient assets
cannot convince the bank that they will exert effort.
o They are credit rationed, and their projects will not get funded.
Importantly, due to moral hazard under asymmetric information, it is
rational for banks not to lend to some firms (those with insufficient
pledgeable assets).
o It is a mechanism for the banks to show that you have the right
incentive to work sufficiently hard (to prevent collateral being
seized)
o You might have the right motivation but not the right assets! =>
Financially constrained
o So firms without collateral are credit rationed
Even when a firm wants to put in the effort and has a positive
NPV, and just doesn’t have collateral (= information friction)
Implications of fi nancial
constraints
Financial constraints have important
consequences for:
o Exports
o Investments
o Asset growth
o Sales growth
o Employment growth
o Startup formation
Plotting changes in exports for different types of product
Policy change => for some firms it became harder to get
credit
Some firms couldn’t get external funding because subsidy
stopped
Drop in Exports because of more difficult access to
external funding
Cut in expenditures during crisis
Constrained firms (want funding but don’t have access) had to cut expenditures a
lot more (compared to non-constrained) during crisis
Same types of firms but difference in savings during crisis
Cash holdings (1y ago vs. today)
4
Structure
Lecture 1................................................................................................................ 2
Access to Finance................................................................................................ 2
Introduction to Entrepreneurial Finance..............................................................6
Evaluating Business Opportunities....................................................................13
Lecture 2.............................................................................................................. 18
Why financial planning?.................................................................................... 18
The Financial Plan.............................................................................................. 20
Ownership and Returns..................................................................................... 27
Valuation Methods............................................................................................. 34
Lecture 3.............................................................................................................. 40
Guest lecture : Entrepreneurship @ KUL..............................................................41
KU Leuven Research & Development (LRD)......................................................41
KICK................................................................................................................... 42
Lecture 4.1........................................................................................................... 43
Agency Conflicts & Control Rights.....................................................................43
Lecture 4.2........................................................................................................... 47
Term Sheets....................................................................................................... 47
Cash Flow Rights............................................................................................... 49
Compensation & Employment (Relationship of the founders to the company). 52
Structuring Deals............................................................................................... 56
Corporate Governance...................................................................................... 61
Lecture 5.............................................................................................................. 64
Staged Financing............................................................................................... 64
Debt Financing.................................................................................................. 69
Lecture 6.............................................................................................................. 73
Exit.................................................................................................................... 73
Venture Capital.................................................................................................. 73
Early Stage Investors (SKIP).............................................................................. 81
Lecture 7.............................................................................................................. 85
Lecture 12............................................................................................................ 85
Course overview................................................................................................... 85
1
,Lecture 1
Access to Finance
(= Access to external funding)
What are Financial constraints/credit rationing?
A firm is financially constrained if it has a need for external finance, but is
unable to obtain it.
o Someone needed to provide financial resources to this firm
o “by ‘financial constraints’ we mean frictions that prevent the firm
from funding all desired investments.”
“Reward/revenue, interest rate” and “Provided
funding”
In the equilibrium there is no one constrained
o Supply: Upwards: higher reward => more
people offering funding
o Demand: Downwards: the more you have
to pay to borrow, the less demand
In this equilibrium: no one is constrained, everyone wanting external
funding is being supplied
The interest rate clears the market for external funds
o If demand > supply, the interest rate will increase
o If demand < supply, the interest rate will decrease
Credit rationing: there are exist firms that are willing to borrow at the
equilibrium interest rate (or at a higher rate) but are unable to do so
o Credit rationing would not happen in previous equilibrium, there
would have to be some type of market failure
Market failure if it is the result of some characteristic that is inherent to
the market, if it is a feature of the long-run equilibrium. (= Frictions)
o There is typically asymmetric information between demand and
supply! Firms have information that finance providers cannot
observe.
o In the presence of adverse selection or moral hazard
asymmetric information can lead to market failure.
Models of credit rationing
Credit rationing can be rational under asymmetric information
For example, due to:
Adverse selection
Moral hazard
Adverse selection
Banks face borrowers with unknown risk type
o Unknown different Riskiness of firms/projects
Banks know the distribution of firm types in the economy, but not the
type of each individual firm
2
, Firms with risky projects have a low chance of success and thus of
repayment, but when they are successful, the return is very high.
Firms with safe projects have a high chance of success and thus of
repayment. When they succeed, the return is not particularly high.
Banks choose their supply (and thus implicitly set the interest rate) such
that they maximize their profits!
o So Ceteris paribus: higher interest rates lead to higher profits.
Twist in the model:
o Safe firms will not accept high interest rates
o Only risky firms accept high interest rates
This leads to adverse selection if the interest rate is too high!
Safe firms repay with high certainty, but their return is low
o High interest rates = high borrowing costs > return when successful
Risky firms repay with low certainty, but their return is very high
o High interest rates = high borrowing costs < return when successful
Bank profits no longer monotonically increase with the interest rate!
o So the assumption of increasing profits when interest rate increases
no longer holds
o Composition of firms you lend to change as well: You will lose more
safe borrowers and gain more risky borrowers (the pool changes)
Bank profits increase with the interest rate, up to the point when safe firms
start to drop out
o From that point onwards, bank profits decrease with the interest
rate.
It is rational for banks not to lend beyond a certain interest rate.
o Even though there are firms with a positive demand for external
funding at higher interest rates.
o The safe firms that are unserved are credit rationed in
equilibrium.
Moral Hazard
Banks face borrowers with same risk type, but different assets
o Same riskiness of firms/projects
o Different amounts of ex-ante collateral
Chance of project success does not depend on firms’ collateral.
(=”Onderpand”)
Chance of project success depends on effort of the entrepreneur.
o High effort → high likelihood of project success
o Low effort → low likelihood of project success
Banks choose their supply of external funding to maximize profits.
o Profits depend on the success of the entrepreneurs and thus on the
effort of the entrepreneurs.
Twist in the model:
o Entrepreneurs also benefit from leisure (=”Vrije tijd”),
o The more effort their exert, the less time they have for leisure.
3
, Entrepreneurs might promise to exert high effort but change their effort
once they have received the funding.
Banks cannot observe the effort of the entrepreneur
o Firms will need to pledge a minimum level of assets to the bank
o This way, firms incur some of the investment risk themselves
Only if firms have sufficient “skin in the game,” can the bank be sure that
entrepreneurs exert the necessary effort. Firms with insufficient assets
cannot convince the bank that they will exert effort.
o They are credit rationed, and their projects will not get funded.
Importantly, due to moral hazard under asymmetric information, it is
rational for banks not to lend to some firms (those with insufficient
pledgeable assets).
o It is a mechanism for the banks to show that you have the right
incentive to work sufficiently hard (to prevent collateral being
seized)
o You might have the right motivation but not the right assets! =>
Financially constrained
o So firms without collateral are credit rationed
Even when a firm wants to put in the effort and has a positive
NPV, and just doesn’t have collateral (= information friction)
Implications of fi nancial
constraints
Financial constraints have important
consequences for:
o Exports
o Investments
o Asset growth
o Sales growth
o Employment growth
o Startup formation
Plotting changes in exports for different types of product
Policy change => for some firms it became harder to get
credit
Some firms couldn’t get external funding because subsidy
stopped
Drop in Exports because of more difficult access to
external funding
Cut in expenditures during crisis
Constrained firms (want funding but don’t have access) had to cut expenditures a
lot more (compared to non-constrained) during crisis
Same types of firms but difference in savings during crisis
Cash holdings (1y ago vs. today)
4
