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ADVANCED CORPORATE FINANCE DEEL 1
ACF session 1
Slide 4 p.2
Financial constraints/credit rationing:
a firm is constraint when it has a need for external finance and is unable to obtain
external finance
Lamont et al (2007): by financial constraints we mean frictions that prevent the firm
from funding all desired investments
Slide 1,2,3 p.3

Definition market failure: in this market their is a specific characteristic inherent to the
market where supply doesn t always meet demand.
Before in 1980, they said that the interest rate clears the market for external funds, if
demand is higher than supply, the interest rate will increase (new equilibrium).
However, credit rationing means that there exists firms willing to borrow at the
interest rate or even more, but are unable to obtain the loan. In these times, the said that
this credit rationing or market failure resulted of a large shock (1) or because of the
result of government intervention (2).
(1): If demand had a sudden large increase fromD1 to D2, banks may not be able to
observe this rise correctly, perception of the bank may be different (bv D*). Later on,
they realise it because of the still remaining excess demand, en they change their
perception a little bit more towards D , and again…until they finally get to D2. For
instance, there could have been credit rationing of 6 months.
 THIS IS NOT MARKET FAILURE!
(2): I f the market is working fine on their own, but because of government interaction
or government failure they set u a maximum of interest rate, demand will be higher than
what banks will be willing to offer
 THIS IS NOT MARKET FAILURE!
Later on, it has been proven that there is such a thing as market failure namely because
of asymmetric information between demand and supply: not both parties have the same
amount of information. Firms have information that banks cannot observe.
2 known characteristics that lead to market failure under asymmetric information are
adverse selection(1) and Moral hazard(2).
(1) the people approaching you aren t the people you want to be approached by such
as problematic firms who want a loan, or an insurance company where only risky
people apply. Bv. If 10% of your 100 customers are risky and the costs are 1000
per person when something goes wrong, that means that you will need 10 (10%
of 100)times a 1000 or 10 000 dollars. In other words, you will ask each
customer to pay dollars, for the risky people that s nothing, while for the safe
people that is a lot of money. The safe people wont take the deal and you will end
up with only risky people.

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(2) Once you are insured, you take more risks. Those 90% safe people of which
suddenly some of them are taking more risks, this mean that there will be more
risky people than the 10%.
Slide , , … p.
MODELS OF CREDIT RATIONING:

1. Stiglitz and Weiss model (1981) adverse selection
Banks face risky firms and safe firms, they now the distribution but NOT which
type each individual firm is. The safe firms have large certainty of repayment but
a lower return, while risky firms have low chances of success but when they do,
they have large returns. Banks choose their supply and thus implicitly set the
interest rate such that they maximize their profits. Logically, increasing the
interest rate will increase their profits… BUT safe firms will nit accept high
interest rates, only risky firms will. This means there is no linear relation
between interest rate and profits, because the higher the rate, the less safe firms
will apply for a loan, the more the pool will exist of risky firms. From a certain
interest rate, this will lead to adverse selection.
This means there exist a rational market failure: the profits will increase with the
interest rate to a certain level where safe firms start to drop out, from that point,
profits wil decrease with the interest rate. Rational for banks not to lend beyond
that point, even though there are firms with a positive demand for credit at such
a higher interest rate=credit rationed
2. Holmstrom and Tirole model (1997) moral hazard
This time, banks are facing firms with the same risk type, but hey do have
different levels of assets. So they have the same riskiness of firm/projects but a
different amount of ex-ante collateral. The chance of success does NOT depend on
the collateral of the firms, but on the EFFORT of the entrepreneur (high effort 
high chance of success and vice versa). Again banks will choose their supply as
such to maximize their profits and these profits will depend on the success of
entrepreneurs and thus their effort. BUT entrepreneurs also benefit from leisure,
the more effort, the fewer time left for leisure. In other words, they may promise
the bank they will exert a lot of effort, but once they receive the credit, change
their effort. The effort can not be observed by the banks which is why firms will
need to pledge a minimum level of assets to the bank, this way, firms incur some
of the investment risk themselves.
Now firms have something at stake, the bank is sure that they will exert high
effort. As a consequence, firms with insufficient assets or collateral will not get
their projects financed = credit rationed. Due to moral hazard under asymmetric
information, it is rational for banks to do this.
Slide 2,p. 5.
IMPLICATIONS OF FINANCIAL CONSTRAINTS FOR:

Exports, investment, asset growth, sales growth, employment growth. There will be less
development in technology than optimal, less employment than if they would have

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grown more, there will be an impact on liquidity an maybe even bankruptcy, also
investments will be lower than optimal.
PAPER ZIA (2008)

In Pakistan, their was a policy change, the government used to support the firms that
export by getting them cheaper interest rates on their bank loans, but due to the policy
change, this was no longer the case for yarn-exports and only for non-yarn-exports.
Before this change, both types of exports knew the same kind of trend, after the change,
there were big difference where yarn exports firms became constraint because they no
longer were subsidized. They had to reduce production and export. For public firms, this
wasn t a problem and they weren t credit rationed. They would get other non-subsidized
loans, the banks would meet their demands and there is no drop in export. Private firms
on the other hand were constraint, so there was a huge drop in export.
 Before the change, 50% of the subsidized loans went to public firms, stupid since they
apparently didn t even need it, certainly compared to private firms.
PARER CAMPELLO (2010)

In this paper, they look at constraint (rationed) and unconstraint firms; they made this
distinction by asking the firms if they are affected by the availability of finance or by the
cost of finance. In other words, they asked them if their demand was met: not affected
(unconstraint), somewhat affected (unconstraint), very affected (constraint). Campello
looked at the PLANS of firms that were constraint and those that weren t. Unconstraint
firms plan to cut far less expenditures compared to constraint firms. The constraint
firms cut especially market expenditures.
They also observed the cash management for USA and Europe. Unconstraint firms don t
seem to use up their cash; their cash holdings today compared to a year ago remains
about the same (EU and USA). While constraint firms burn out their cash! These firms
reserved cash for when a crisis would arrive, but when they need money and they cant
get a loan, they use their cash.
PAPER DESAY (2008)

In this paper, they investigate firms in countries that had an exchange rate crisis en
compare them to multinationals of the same countries who have a mother-firm in the
USA (dollars). Local firms will mainly loan from local banks that borrow from American
firms. So local firms repay the loan in roepies to the bank, and the bank pays back to
America. When big exchange rate rises and the collateral drops heavily in value, local
banks will stop giving loans. Exchange rate drops is good for export, there are a lot of
possibilities, but local firms are constraint and cant enjoy the opportunity of this drop
like MNC s can. MNC are able to overcome the constraints because they can call their
mother.
PAPER CHODOROW-REICH (2014)

This paper investigates, among others, how an increase in loans affects the employment
growth ratio. On average, 1% increase of loans  1,7% increase in employment rate. To
see if the bank is reducing its supply or not, and not just to your company, they look at
all the loans of the bank and excludes your own loans, you only want to see the effect
driven by the supply and not by the demand. It looks at the total change in loans others

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than yours. Measure of loans= measure of supply. This 1,7% is an average effect, this
doesn t mean that when loans increases with 1%, all firms will know a employment rate
increase of 1,7%. Thy look further and make a distinction between small, medium and
large companies. The increase is not sign. for large firms, the supply shock doesn t seem
to matter, it does for medium sized firms and even more for small firms. WHY? Small
firms are heavily dependent on bank loans, while large firms have other possibilities,
they do not need to cut back on employment. Small firms are also more risky and they
have less collateral (2 models).
They also give us evidence that when a firm has access (large firms) to other forms of
financing, such as the bond market, they are less likely to be rationed, when firms do not
have access, they don t have alternatives and these are rationed.
Overall, the biggest effect found for small firms with no access to the bond market, these
firms are most rationed.
ACF Session 2
Slide 2, p.1
Measuring financial constraints
First we had Fazari et al (1988) tried to find evidence at firm level, even without good
databases. Before the s, there were very few databases, only with a macro-
perspective. In other words there was only evidence of financial constraints on macro
level. (now we have much more databases containing financial information for every
company). They used investment-cash flow sensitivities (ICFS) to tell if a firm was
financially constraint or not.
Later, you have Kaplan and Zingales (1997) who had some critique on the ICFS. They
though it was a bad way to look at financial constraints.
You also have indices of financial constraints: (index is the some of few components)
- Kaplan-Zingales index (Lamont et al, 2001)
- Whited-Wu index (Whited and Whu, 2006)
- Hadlock-Pierce index (Hadlock and Pierce, 2010)
All these measures are INDIRECT measures! Balance sheet items will not give us a 100%
clear measures, SURVAY DATA can provide a DIRECT measure, directly asking firms if
they are constraint or not.
FAZARI ET AL:
First they state, that the capital market aren t perfect and that credit rationing exists. In
other words, they also believe that banks wont always give every bank the funds they
need to realize their optimal planned investments. In other words, realised investments
aren t equal to optimal planned investments when firms are constraint. They further say
that the amount of CASH a firm holds is very important, they see them as funds that are
always available en that the realised investments will depend on that their CASH FLOW.
Firms that face frictions will depend on their own cash flow.
𝐼/K =𝑄+𝐶𝐹/K+𝐶 𝑙 +ε 𝐾 :(estimated)

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I: investment level of every firm

K: capital expenditures/fixed assets
Q: market-to-book value, Tobin s Q= investment opportunity
CF: cash flow of every firm
CF/K: tells us something about the lack of external finance
Why is Q important? If the market value is higher than de book value, this means that
investors are expecting higher profits, so more investment opportunities bv. Building
more factories.
Fazari split up the group of firms into low dividend payout firms and high dividend
payout firms. The reason for this, is that high dividend payout firms aren t worried
about not being able to pursue the opportunities, they can simply go to the bank, in
other words these firms are not constraint. While on the other hand, low dividend
payout firms do worry, and might suffer frictions, they might need their cash because
they aren t sure the bank will give it to them, they are constraint.
(payout ratio= amount of cash of the firms you pay out)
Low dividend payout firms High dividend payout firms

Financially constraint Financially UNconstraint
High ICFS (sensitive, in the sense they Low ICFS (not sensitive)
might need the cash for investments)
Other authors have copied this approach by using firm size (smaller firms have less
access to several finance options, also asymmetric information are higher for smaller
firms, which leads to frictions for small firms since it is harder for banks to screen small
firms and small firms will have a higher ICFS), group membership (internal capital
markets, bv. In Japan firms can be part of a group with connections to banks, if you are
member, if you belong, your ICFS will be low, their membership of a group gives them
access to there own bank), …
KAPLAN AND ZINGALES:

Their research can be seen as the enemy of ICFS. They have shown that there is NO
theoretical reason to assume that ICFS increase monotonically with financial
constraints! Even if the true relationship between ICFS and financial constraints would
be monotonically increasing, then one should still not interpret different ICFS between
groups, differences driven by investment opportunities (Q) are not sufficiently
measured by Q because the market has only the perception of what the company would
do (information asymmetry). Also, if CF is very high, it will also have an effect on
investment opportunities. Also a few outliers can drive differences, if one company is an
outlier, this cold have a huge impact on ICFS.
Before, the higher the constraints and frictions, the higher the ICFS but it has never been
proven.
Kaplan et al made their point by using the 49 firms out of the study of Fazari defined as
low dividend payout firms. They combined this data with the 10-K filings
(accompanying letter of the CEO or CFO when the balance sheet and annual report is
reported) of these firms and information in newspapers about these firms.
Based on this information, they made a classification/ranking of constraints: NFC (not
financially constraint), LNFC (likely not FC), LFC and FC. According to Kaplan a firms

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that was financially constraint, had a lot of cash, but the reason was that their weren t
opportunities, for instance because of slow growth…
Surprisingly, their findings were: NFC and LNFC had the highest ICFS and LFC and FC the
lowest. No necessarily positive relation between FC and ICFS.
INDICES TO MEASURE FINANCIAL CONSTRAINTS

Some scholars have created indices to measure FC:
1) KAPLAN-ZINGALES INDEX (KZI)
They also use 4 categories of FC: NFC, NLFC, LFC, FC and the financial
characteristics predict to which category a firm belongs to. Ordered logit
estimation of financial characteristics on the 4 categories for the 49 countries
revealed that:
KZI = − , CF/K + , Q+ , Debt/TA −
39, Div/K − , Cash/K
For each firm, you will get one value for KZI, high or low and then you can even
compare things between these two. The higher KZI, the more constraint the firms
are.
CF/K: the more CF you have, the lower the index because you have more internal
funds, you are more profitable. So the smaller the chance you will be FC.
Q: market-to-book ratio: if you do not have investment opportunities, you also
won t be constraint. If Q is very high, you will have very good opportunities, so
only then the chance exist that you will be constraint.
Debt/TA: more debt, more risky and more likely to be FC.
Div/K: when you pay out more dividends, you aren t worried etc, see earlier.
2) WHITED-WU INDEX (WWI)
They built a structural model of investment, where financial constraints show up

as the shadow of cost of external financing. The Shadow of the cost affects the
substitution choice between investment today or investment tomorrow. In the
model, they have to choose to invest today or tomorrow (trade-off). If you have
enough internal funds, no problem to invest the optimal amount, but if you don t,
you will need external funding BUT you will stop at a certain point when it is to
costly and HIGHER than the cost of delaying further investment (trade-off).
WWI = , sales growth industry − , sales
growth firm− , CF/TA + , Debt/TA − ,
Divpos − , ln TA
If the sales growth of the industry is high, but the sales growth of the firms is low,
this means you are more constraint because compared to your industry, you will
have more opportunities to grasp and vice versa. These 2 do the same thing as Q
did previously. Only when there are investment opportunities, there will be a
possibility tot be constraint. Also size is important, the bigger the company, the
fewer the information asymmetry will be, the lower the cost will be and the lower
the FC is.

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ADVANTAGE of this index: it is easier to use because you do not need to calculate
the Q (market value). Also, it is applicable to almost any dataset!
3) HADLACK-PIERCE INDEX (HPI)
They applied the same methodology as Kaplan and Zingales (10-k files… but on a
random sample of 356 firms. For all these firms they look at the 10k-files and classify
them from NFC to FC. They replicated the KZI BUT only find levereage and cash flow
to be robustly similar to KZI.
They replicated Kaplan because Kaplan wasn t looking at a random sample! He
worked with a very specific group of firms with low dividends payouts!! So it is very
logic that in the new sample, they aren t all the same!
They also replicated WWI and find only leverage, cash flow and size to be robustly
similar to WWI.
So the redid both BUT with a RANDOM and BIGGER sample and over a LONGER
period and it is also a more recent study! KZI was out-dated.
They even went further…
They then test a number of financial characteristics irrespective of any theoretical
model, they regress them and took a look if they play any role.
Their findings: none of these characteristics matter, only firms size and firm age!!! in
other words, none of them mattered once they put age and size into the regression!
(the older and the bigger, the less FC)
Ordered logit estimation of firm size and age on the categories of financial
constraints for the 356 firms revealed that:
HPI = − , ln TA + , ln TA)^2 −0,040age
Using KZI, WWI or HPI implies strong assumptions:
- parameter stability across samples
- parameter stability across time
Solution: if you wish to use these indices: apply the same methodology and
replicate these indices on your own sample, what was true 10 years ago is not
necessarily true today.
DIRECT MEASURES OF FINACIAL CONSTRAINTS (survey data)

The firms are questioned about FC, about actual applications for bank loans. So FC
are directly observable. The downside of this procedure, is that often there are no
financial characteristics about firms available.
DATA:
- World Bank data: BEEPS=Business Environment and Enterprise
Performance Survey (central and Eastern Europe) is for small businesses
- Small Business Finances survey (USA)
- Survey on the access to Finance of small and medium sized enterprise=SAFE
 ECB: every 6 months for Euro Area
 ECB+EC: every 2 years for Europenion Union

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Euro area vs. EU:the first is where they pay with euro s, are part of the
monetary union with one central bank: ECB, the latter are all the countries
that agreed upon the Maastricht verdrag.
EXAMPLE SURVEY RESEARCH SLIDES different parts p. …
1) Application for bank loans by SMEs across euro area countries

30-35% of Belgian firms applied for a loan, only around 5% of Belgian firms did
not apply because they feared rejection. The larger part, around 50% didn t apply
because they had enough internal funding! A lot of differences, especially for
those countries where the crisis came on very hard, such as Greece.
2) Outcome of applications for bank loans by SMEs across euro area
What was the result of application? In Belgium, 80-85% received loan when they
applied for it, some refused the loan because of the cost (too high), so only a few
were rejected. In Greece on the other hand, around 40% was rejected of those
firms that applied for a loan! Rejected means constraint, but you can go a little
further and also look at those who didn t accept the loan because of the high cost,
or those firms who only got part of what they needed and you can also look at the
firms who were discouraged, afraid they would be rejected (see next part as
well).
3) Obstacles to receiving a bank loan for SMEs across euro area
To see how many firms are constraint in the euro area, it is not enough to only
take those firms who were completely rejected into account. Also the others
mentioned above are constraint! The ICFS will be the same for all 4 categories,
because they are all constraint. The Southern countries are more constraint in all
categories.
What does this tell you about future growth/investments? Why should we be
worried? First, the future of Greece doesn t look very bright; their firms are
constraint for investments. We also don t think there will we coming growth
soon, so where will we get the cash to repay debt? Most firms are also
discouraged, not rejected!!! So they could have taken opportunities and done
investments but they were discouraged.
What is the task of the ECB? Worry about stability throughout the Eurozone. It is
1 instrument setting up 1 policy and somehow it is not equally transmitted to all
countries, not all countries have the same possibility of getting a loan.
TAKING INDERICT AND DIRECT MEASURES INTO ACCOUNT:
What are the determinants of access to external finance?
AT FIRM LEVEL AT COUNTRY LEVEL

size Business cycle (1)
Age Credit cycle (2)
Leverage (solvability) Institutions (3)
Cash flow (repayment capacity) Availability of a (public) credit register
(4)
--> robut factors always coming back
significant

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(1) When this is high, when it is booming, you will have less opportunities at the top
so you will also less likely be constraint. Also cash flow is influenced by the
business cycle: will be high when it is booming. Today, where are we in the
business cycle? In recession with g=0%, so no growth for the next year, the
average growth is 2% for developed countries, while it is 10% for developing
countries.
(2) Looking at the monetary policies, the financial sector development and quality.
Loans are trying to be as cheap as possible, so even with no growth, you can get a
loan when you have a good project.
(3) Has to do with the quality of the law. The quality of the law matters: high quality
will lead to much more loans because they find some quality solutions, contracts,
check ups etc., putting your own assets in your firm, effort…  covenants with
the loan are better where the quality of the law is high! (you can ask your money
back).
(4) What is a public credit register (PCR)? They record every loan any firm has,
they also give information about the borrower and the lender (the amount they
lend/borrow, the currency, has the firm failed to pay back on time with previous
loans… . It is a register where banks can observe all the loans of all the firms.
Credit bureaus give firms a certain credit rating AA,BBB,… . Both help for the
information asymmetry, they give the information needed to make important
decisions. In Belgium, the PCR is the National Bank; they do this because it is an
easy way to see how banks are supplying firms, to see how the credit goes in
Belgium, to get a better overview on such matters.
Why are PCRs so important? They enable banks to measure the risk of giving a
loan to a certain firm. This will also reduce the equilibrium credit rationing.
IMPACT OF CREDIT INFORMATION:
When there is a credit register, there will be more credit given by the banks! Countries
without such registers will know more firms with financial constraints. It also helps
small firms to obtain bank credit.
Also credit rights will have an impact on credit, because they give the lender protection,
and the more the law protects them, the more they will give credit.
ESTABLISHEMENT OF A PRIVATE BUREAU VS PUBLIC REGISTER
3 years after the installation of a bureau has a huge impact on the average private credit
to GDP ratio. In other words, a huge increase! For the installation of credit registers, the
increase is smaller, probably because bureaus say more about the risk and in general
give more information. With public register, the risks might not be seen; it depends a lot
on the richness of the register.
WHAT ABOUT DISCOURAGED BORROWERS?

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There is not much known about the discouraged borrowers yet. We do know that they
are more frequent (about 2x) than rejected borrowers. We do not know in which
category to put them. Could they have gotten a loan? We don t know… so are they
constraint or not? They are in need of finance, so yes.
1. What drives discouragement?

You need it, why does one apply while a another doesn t? The model of Kon and
Storey (2003) provides some insight. In this model, all firms need a bank loan for
their investment. The decision of good (safe) firms and bad (risky) firms to apply for
a loan is explained by the following equations:
The reason why one firm applies and another doesn t has to do with the ROI. When
the ROI is high, you are more likely to apply for a loan. When your ROI (total gain of
the loan) is higher than the total coast to get a loan, you will apply.
When the expected interest rate is very high (R), you are more likely not to apply.
Also, when the tax rate (t) is high, you pay less interest, so the higher the tax rate, the
more like you will be to apply. The opportunity cost (OC) is for instance when you
could have gotten credit more easily through the bond market, so the more
alternatives you have, the higher the OC will be and the more discouraged you will
get. The application cost (AC) is also been taken into account, it is the fixed
transaction cost to apply for a loan.
The difference between the ROI of good and bad firms are the AC/(1-se) and AC/se.
Banks make errors, the higher the errors are (se=screening errors), the lower the
AC/se ratio becomes for bad firms. If se=0, AC will go to infinity for bad firms so all
bad firms would be discouraged which would be a good thing of course! But
unfortunately, there are also se for good firms, which means that some of the good
firms have been perceived to be bad due to screenings errors.
The regression model is as followed where DB (discouraged borrower) equals 1 if a
firm is discouraged and 0 when it is not and applies for a bank loan:
 the higher the profit, less likely to be discouraged because you have a higher ROI,
so it is more likely to have a ROI that is bigger than the total cost, so we expect alfa1
to be negative.
 trade credit=OC: if you borrow a lot of money of suppliers, you are less likely to go
to a bank, we expect alfa2 to be positive. (the higher the OC, the higher the total cost,
the bigger the chance your ROI will fall below the total cost and you are more likely
to be discouraged)
 interest-rate: the higher the amount you must pay, the higher the total cost
 tax rate: a higher tax rate means there will be a larger part deducted from the
interest expenses and so the more interesting it seems to finance with debt? We
expect a negative impact.

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Size and age: The bigger you are, the more AC (fixed cost) will be relatively
smaller. The older you are, the more skills you will have to do these kinds of
applications. In both cases, your AC goes down, so we expect for both a negative sign
2. Are there real effects of discouragement? Due to the lack of loans?

Should we care about this? How can we find out? We use the same variables to
explain growth in employment, assets and added value. Therefore, we estimate the
following regression model:
Now the DB is also included, if you are discouraged, you have NO access, when you
apply, there is still a chance so we expect alfa0 to be negative.
Results:
DB has lower EG, AG and AVG. For instance the AG is 3,4% lower then a firm who did
apply for a loan.
In that period, when the research was done, the average EG was around 3%, since DB
have 2,7% less EG, this means there is almost no EG (3%-2,7%) for discouraged
borrowers!!
They further looked at the differences between those firms who were discouraged
and the firms who did apply and were either rejected or approved (in other words
we split up the applying group): between the rejected group and the DB we see no
significant difference since they both do not have access to loans the growth isn t
significantly different), however the difference between approved and DB is even
bigger than before the split up! It also proves that loans are the reason for growth
etc since we do not see a difference between rejected and DB.
3. Would discouraged borrowers be able to obtain bank loans?
If the approval value is high, the firm is likely to be approved, if it is low however, it
is likely to be rejected.
If approval = 1: applied + approved In this step we do not take DB into account

If approval = 0: applied+ rejected
Results show that most DB have low approval values, so it is better that they didn t
apply.

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4. Why would discouraged borrowers (not) be able to obtain loans?
 Altman Z-score: DB have lower Z-scores, so they are more risky.

 Financial pressure: DB have more financial pressure.
 Firm specific outlook: from the survey, they asked how the firm specific outlook is,
if it is deteriorating=1, other=0.
ACF Session 3: Capital Structure

1. How should we think about capital structure?
A benchmark: M&M irrelevance propositions.

If zou buy an asset a house today for . dollars and you sell it one year later…
We also assume a mortgage interest rate of 10%.
The return on assets depends on the type of mortgage we take.

When we take a look at the third scenario with a 45% price change, and we look at the
case where finance it with 50% mortgage, where does the 80% come from?
100.000145.000
50% mortgage, this means we need to pay back 50% of 100.000 and 10% of the 50.000
(interest) = 55.000
145.000-55.000=90.000 and we have paid 50.000 ourselves
so, going from 50.000 to 90.000 is an increase of 80%!
Where does the 360% comes from in the third scenario?
145.000 – (90.000 + 9.000) en dan delen door 10.000 (wat je zelf hebt betaald)
so, this is an increase of 360%!
Does the value of the house depend on the size of the mortgage?
It is independent, not connected! WHY??

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What does change with the size of the mortgage?

The potential/expected ROE changes AND the risk changes as well the more mortgage
you take on, the more the expected ROE BUT also the risk will rise, which is the reason
why we do not alsways seek higher mortgage. The higher the mortgage, the higher the
risk because of the higher SD (standard deviation).
M&M Proposition 1:
Independent of how you finance your firm, only the present value of your future cash
flows matter.
EXAMPLE: an all equity firms considers a project: invest 800$ today, and the payoff
tomorrow can be 1400$ if the economy is strong (50%) or 900$ if the economy is weak
(50%). The risk-free rate is % and the project s risk premium is 10%.
You discount at 15% which is the total risk of the project (10%+5%) 1+ 0,15
Total equity is the total amount of CFs that goes to the shareholders. 1000 is the value of
the company.

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Now, suppose we borrow 500$, in addition to selling equity. Note that the CFs of the
project are higher than the debt owed in each state. We also assume that debt is risk free
in the first proposition of M&M, in other words, Rdebt = Rrisk free= 5%.
The payoffs of debt and equity:
The value of equity is 500*. The value only depends on cash flows (expected), the total
value of the firm has not changed and is independent of the capital structure under this
proposition of M&M.
Why a e t the value of e uity 543 and the value of debt 457?
EQUITY:
the 15% is the WACC! And WACC is not the same as CAPM when the firms finances with
debt! The return that will be asked shall be higher because of the additional risk, it wil
will (for instance) 25%:so you will discount at (1+ 0,25).
1
DEBT: . 𝑥 + . 𝑥 =
1.15
Since debt is assumed to be risk free, the discount rate will also be adapted to (1+0,05).
This firm will never default, no default risk because in the beginning we said that the
cash flows are always higher than the debt the firm owed. But there is a financial risk
that the value of the equity could be lower that what is was at the beginning!

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M&M Proposition 2:
In a perfect capital market, the WACC of the firm is equal to the risk of the firm s current
and future CFs and is not affected by its choice of capital structure. So, the WACC does
not depend on capital structure.
Rwacc= Ra(risk of assets)=E/(D+E) x Re +D/(D+E) x Rd= Ru (risk of unlevered firm)
 E/(E+D)xRe=Ra-D/(D+E)xRd
 Re= (E+D)/E x Ra-(E+D)/E x D/(E+D) x Rd
 Re= E/E x Ra + D/EE x Ra – D/E x Rd
 Re= Ra + D/E x (Ra – Rd)
So, more financing with debt, means a higher risk of equity, investors will ask a higher
return. Ra is the risk without leverage, the second part of the equation stands for the
additional risk due to leverage, or the cost of the firm s financial risk.
If the size of the mortgage is 50%, and we look at the average: where does 20% comes
from? 15%+ (50%/50%)x(15%-10%)
The cost of capital of levered equity is equal to the cost of capital of unlevered equity
plus a premium that is proportional to the market value of debt-equity ratio.
With perfect capital markets the WACC is a constant function of leverage because as D/E
changes, Requity changes to compensate.
For really high leverage, Rdebt will change as well, debt was risk free because in the
example you could always pay it back (CF in bad times was 900 > 500). But for very high
leverage bv. debt and equity CF of is lower than debt interest hasn t
even been taken into account!! so the cash flows aren t big enough to repay the debt
 debt is no longer risk free a that point!

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EXPLENATION FIGURE:
- WACC is 15%, does it increase, decrease if you finance with more debt? (if you
go more to the right) : No, it stays the same in M&M proposition
- Cost of equity/capital: for Debt = 0, the WACC=Re=Ra!!! However, when we go
to the right and finance with more debt, the financial risk will increase, and
investors will ask for higher returns.
- Cost of debt: first it was 5% (risk free), but at a certain point when we have a
high amount of leverage that passes the CFs, cost of debt will go towards to
WACC, it cannot go higher than the WACC! If we have 100% of debt and the
cost would stay at 5%, this would mean that the WACC would decrease to 5%
as well… BUT according to M&M the WACC remains the level of % so the
cost of debt will increase to 15% when we finance with 100% of debt.
SUMMARIZE:
Business risk depends on which industry you are in, for instance, biology-sector, medical
products, … Where R&D and innovation can take years.
If the risk in CFs is constant, there is less risk. If it isn t and it goes up and down etc.
there is more risk.
Financial risk is not the same as default risk, default risk means you cannot repay your
liabilities.

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No taxes, in other words neutral taxes with no impact on the WACC.

But they aren t neutral since they are deductible for debt.
No information asymmetry, all investors and debt holders know what managers know.
2. When is capital structure relevant?
DEBT AND TAXES:
Levered firm has a total value > unlevered firm

The difference in value is the interest taks shield = 35% of 400=140=952-812
- Annual interest taks shield= taks rate* interest payment
- $400 in interest expense
- PV of annual interest taks shield assuming perpetual (eeuwigdurende) debt:
PV = (D RDTC) / RD = D TC = 0.35*400
PV of taks shield is the taks chield itself!!! (Tc= taks chield)

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Now, the government is taking a share of the pie. But we can minimise that slice of the
government by sheilding inome with debt,more debt means more interest payment and
also less taxes that needs to be paid to the government! More debt- and
shareholders,means more value because a larger part is being payed to them.
(if i wouldnt be deductible, D/E proportion would have no impact)
Trade-off theory: (zie verder ook)

The actual value of the firm will go down at a certain point where the amount of debt is
too high, in other words there is an optimal amount of debt accompanied with the
maximum firm value, after that point, the value goes down.

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EXPLANATION FIGURE
- stippelijn is toen we te maken hadden met neutral taxes
- Cost of equity: more debt, more financial risk, so will go up and may even go
up slower then before more debt now means more value…
- Cost of debt: in the beginning it will be below the 5% because the interest is
deductible. When there is a lot of debt, it wont go up to 15% this time, 100%
of debt wont mean a cost of debt of 15% because the interest is deductible, so
it will be lower!
- WACC: in this case, the WACC will decrease. (as manager you would finance
entirely with debt, as investor you wouldn t
3. Trade-off theory

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- Direct costs (next to interest costs): financial distress cost, bv. If bank sues
you: legal and court costs, also if you do not pay the bank in time, the bank
charges you a penalty, if you go bankrupt, you will have to sell your assets at
very low prices…
- Indirect costs
When debt increases, the share for the government decreases AND you get an increase
in the distress share! So, you need to find an equilibrium or a maximum amount of debt
and equity to maximaze the value of the firm (trade-off)
TRADE OFF:
- advantages of debt (i-deductibillity)
- disadvantages of debt (financial distress)
What does this mean for a:
- company with high financial distress and will probably go bankrupt:assets
would be sold at 10% when there are few buyers
- same company but but has assets that could also be easily sold when there are
many buyers.

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For this one, the financial distress costs are much lower and they will be able
to go much further on the D/(D+E) –axes before the cost of debt rises a lot
compared the the first company!
uitleg deze slide zie eerder

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higher return when higher risk
also benefit of agency cost, if you have more debt, managers will try to benefit
themselves less because debt needs to be repayed!! Managers would be incentified to
grow, to built large firms and leverage will reduce wastefull investments,
overinvestments will be avoided! There is no obligation of a fixed return towards
shareholders, but it is obligated to repay debt holders!
eerste puntje: in this case you would only choose the most profitable projects to assure
the repayment of debt. By preserving ownership concentration, you will have fewer
shareholders, fewer shareholders to split the cost with. The more shareholders there
are, the less risk there is per shareholder and you will also care less in this situation.

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it is a trade-off between the benefits and costs of debtfinancing with an optimal D-level.
4. Pecking order theory
STARTING POINT: managers know more than investors about firm value- and that
investors recognize their disadvantage (asymmetric info)
This seems reasonablle, managers are better informed about the quality of a certain
project.
EXAMPLE: imagine companies O and U, to investors they both seem identical, but O s
managers know that their stock is overpriced, and U s managers know that their stock is
underpriced… they both have an investment project and need to raisemoney, should
they issue equity or debt??
For O, the futur isn t looking so bright  stock price will go down
The reason why O and U would issue debt, is asymmetric information.
Both firms don t want to give a signal and they will issue debt, that is why debt will be
preferred over equity and a higher ranking will be given to debt…

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Ranking Asymetric Information

- equity
- convertible stock/loans
- corporate bonds
- long term loans
- short term loans (you repay more quicqly than LT loan, so their will be less
info assym.)
- trade payables/supplier credit ($)
- internal financing!!!
($) the reason that it is rather high on the ranking, is because here you know your
suppliers, which means there will be less info assym. But it is a very expensive financing
method. For instance, if the supplier gives you 2% discount when you pay in the first 10
days, but you choose to have money for an additional 20 days, you actually pay 2% for
20 days of extra money, cash. For a year, this is about 20-30%!!!! This is a very high
interest rate!!!
Why do we still see equity issues?

 managers may try to commit to credible and trustworthy signals (bv. External
auditing). You could hire an audit team to make sure that external investors can
observe your firm objectively, the more effort you put in this, the less info asym.
There will be. Also, you can show high and real figures…
 managers could signal high quality by investing themselves, this way they
would have there own large stake. It signals that they believe it isn t overpriced
 issue equity after earnings announcements: show the figures first!
they don t see an optimal capital structure, but rather a cumulative outcome of the
past…, no grand plan for optimal structure.

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Profits should predict that the more profits you have, the less debt you wil have and the
more you will finance internally  trade-off theory: more profits,more debt because
of the interest deductibility benefit. There is more evidence for the pecking order theory.
5. Market timing theory
From POT to market timing…
according to this theory, the market would not totally vanish the overvaluation because
the markets are not semi-stron effecient according to this theory. If this is the case,
managers may be able to time the market and get overpriced equity issue without a big
price drop.
they do not prefer debt or equity, only care about the fact that market makes mistakes
about pricing from time to time…
the capital structure comes from decisions made in the past, if there were very
favourable prices in the past, the firm will have more equity and less debt and vice versa.
Also here there is no such thing as a grand plan, no trade-off between costs and benefits.

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Session 4:Financial Planning

1. Why financial planning?
For an overview of the company.

- to get a view on how much financing is needed and when? (amount and
timing)
- to get stronger negotioation power (in case external financing is needed),
show the banker your financial plan, what you have done and why you need
the loan, show what you will realise (realistic)
- to choose among projects/policy choices, to discriminate: project A or B… A
may need more cash but…
- to avoid suprises (assess feasibility, sensitivity analysis, scenario analysis: test
different scenario s for instance if g= % or g= %...
 MEDIUM/LONG TERM FINANCIAL PLANNING (3 years)-vooral dit zien
- about growth planning
- about growth financing
- about financial policy/stability
 SHORTVTERM FINZNCIAL PLANNING (monthly babsis, how much money do you
need at the end of every month) – less details
- about cash management
- about working capital management
OR WC= current assets – current liabillities

Met CA= inventories, customer credit, part of cash
Met CL= supplier credit, short-term liabillities
WC is the amount of money to finance current operations.
The definition of WC on the slide: you have more long term money than needed to
finance LT operations (fixed assets).
OR WC= supllier credit – customer credit
OR WC= ST liab- cash & eq.

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when a company grows, its fixed fixed assets will need to grow along.
BUT not every industry needs large investments in fixed assets to grow, for instance
they need more employees.
Growing has an impact on other things as well! Your customer credit will go up: if you
have more sales and give your customers the same sale terms, customer credit goes up.
This also goes for supplier credit when credit terms remains the same of the suppliers.
Q1: your WCR will go up and you will need more and more cash (WCR=cash drain)
In the example, your WCR goes up with 1, 3 or 5 while your profit doesn t increase in the
same amount, but it is much lower. The more you grow, the more cash zou need!! You
need cash in your company (pay back supllier otherwise you go bankrupt).

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the production & stock period is a cash outflow, the credit to customer is where you wait
to get paid, and when the customer finanny pays, you have a cash inflow. (you can take a
look at this for every month)
WCR wont be the same for every company:
- the market power of a company influences WCR via the terms you get from
your suppliers (credit from suppliers). For instance, Colruyt has a very strong
position towards its small suppliers, even in times of a crisis, Colruyt is able to
wait longer to pay its suppliers.
- It also depends on the industry:when a customer buys something from
Colruyt, he/she pays before he/she leaves the store. But when you buy a car,
you getmore time…
CASH-IN vs. REVENU: revenu are sales, you may sell today and your sales will go up
BUTonly after a few days you will receive the cash.
CASH-OUT vs. COST: cost is for instance depreciations but this isn t a direct cash-out.
2. What is financial planning?
What are the ingredients you need?

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You start with sales  profit and loss

Then you go to the asset side of the B/S. Followed by the liabilities side og the B/S
here you see how the assets are financed.
Next, you take a look at THE PLUG: it closes your model. On the B/S the assets equals
the liabilities and the plug makes these two equal and closes this way the model via the L
or A side of the B/S.
(you also need economic assumptions)
so first the I/S, then you multiply the assets by , . Then D* , and E* , …
the plug= dividends
the projected net income is 12,5$ but the equity is only increase by 7,50$, the difference
is paid out in cash dividends (plug).

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the parameters is usually based on past experiences (bv. Growth rate, cost of sales-
margin… . If past experiences aren t available, look at the competitors and use their
ratio s as benchmark.
You start with these parameters, and you base you model on these parameters, so that if
you need to make changes, or you need to adapt something, you adapt it in your
parameters, and because everything is connected, everything will be adapted in the
model.
Any third party should be able to use your model, so it should be simple and clear.

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3. The bank sector
Main types of external finance for Belgian firms/SMEs
 How big is the Belgian economy? GDP= sum of all the added value in BE:between 360
and 380 billion euros.
 How is the Venture Capital market in BE? 1 billion euros
 How important are the Business Angels in BE? 0,1 billion euros
 How important are bank loans? 170 billion euros granted to non-financial
corporations (nfc.) BUT only 120 billion euros taken! So their is a spare room of 50
billion euros= GAP between granted and taken loans.
How is the gap for small and large companies? EXAMEN

 small firms will depend more heavily on bank loans since they have less alternatives:
their will be a SMALLER gap.
 if the firm is smaller, it will have less collateral, it is also less easy to screen which
makes it more risky for banks so the granted amount will already be set at a lower rate
for small companies.
 GAP (small) < GAP (large)
those 4 baks dominate the sector, 85%-90% of the 170 billion euros.

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(seperate entities within a bank)

RETAIL BANKING: for us, where we go to cash money. Retail banking is when
a bank executes transactions directly with consumers, rather than corporations or other
banks. Services offered include savings and transactional accounts, mortgages, personal
loans, debit cards, and credit cards. The term is generally used to distinguish these
banking services from investment banking, commercial banking or wholesale banking. It
may also be used to refer to a division of a bank dealing with retail customers and can
also be termed as Personal Banking services.
PRIVATE BANKING: for large private companies because you bring a large amount of
money into the bank. Private banking is banking, investment and other financial
services provided by banks to private individuals who enjoy high levels of income or
invest sizable assets. The term "private" refers to customer service rendered on a more
personal basis than in mass-market retail banking, usually via dedicated bank advisers.
It does not refer to a private bank, which is a non-incorporated banking institution.
CORPORATE BANKING: for SMEs and large firms. The corporate banking segment of
banks typically serves a diverse range of clients, ranging from small to mid-sized local
businesses with a few millions in revenues to large conglomerates with billions in sales
and offices across the country.
How does it work? It collects deposits from households and companies and transform
them into bank loans (long term maturity). It takes from people who have money but do
not need it to the ones that need it but don t have money. This is a simple illustration of a
small bank, this is not applicable for a large bank, this is more complicated, see next…

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This is how it is for large banks, not just transform deposits into loans but also invest in
stock markets for higher returns than they get on loans, also in bonds or gold
(=investments in securities).
Also an insurance company bonds of countries  government debt! Bv. Greek debt
unfortunately.
Why were they in trouble in the crisis? Investments in bonds and in the banks
themselves, so loans were given to other banks! Bv. American banks
So on the slide, the right part has also a part of deposits that comes from other banks,
but also on the left side, the loans you give as a bank to other banks, not only to
customers.
Only a very small amount of equity, for large and small banks, WHY?
 WHY do you need equity? To decrease financial risk where the value of your assets is
lower than the debt you need to repay (o).
 WHY not have a large amount of equity? If you have less equity AND you are
perceived as a low risk company (which was the case for banks), the smaller the equity,
the higher your ROE will be! In the previous course, we learned that the more debt you
have, the higher your ROE will be BUT there is a financial risk BUT if the market doesn t
believe (fooled) in this risk  higher ROE.
REALITY? There is a risk of (o). This is why banks are regulated and need a certain
amount of equity  BASEL (next slides)
 Equity level depends on the riskiness of your assets

 20% example: for every 100 euros you invest at the bank, 20 euros= risk weight
and 8% of that risk weight has to be put into equity.
 What will banks do? Banks will be more likely to use deposits for OECD
government debt & cash.
This wasn t proper and it didn t truly take into account the true risks…

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laatste vierkantje: now there is a difference, it depends on the Rating! When you have an
AAA-rating, you do not have to have equity set aside.
8%was to little, so 12%, all the rest remained the same.

AA-rating for BE-government of Standard & Pool
Bmin-rating for Greece
AAA-rating for Germenay
3 main criteria that measure the riskiness of a company

(risk hedging poss.: bv. You have to provide collateral or you have to invest money of
your own)
previous lectures: what else was important to explain insolvency? Age (young: no
history to follow up), Size, Leverage (determine solvency) & Cash Flow (tells you
something about repayment capacity).

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 if your solvency is lower than 30%, you will be most likely unable to obtain a
loan.
 Risk hedging poss.: internally… collateral externally… government is giving
guaranty up to 70% for instance of the bank loan and they have a risk of 30%??)
bank lending will depend on the characteristics of the bank especially in the crisis, for
instance: bank with a large capital ratio of 12%, more likely to survive than one with
only 4%, the latter will grant less loans and will probably even need help of the
government.
ADVANCED CORPORATE FINANCING DEEL 2
Session 6: Venture capital

 EXAMEN: you don t need to know every number, but you should have an idea about
the size.
Gimv=biggest investors
Banks bv. KBC private equity
1. What is private equity (PE) and Venture capital (VC)?

Private Equity refers to unregistered equity and equity linked securities sold by private
and public operating companies or partnerships to financial buyers. So PE isn t only
pure equity, but also linked. Business plans and documents are given to about 5 experts
to look at and not to the public (that is the case for public equity).
PE contains VC funds and buy-outs (see next lecture).
Venture Capital is a subset of private equity and refers to equity investments made for
the launch, early development or expansion of a business

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DISTINCTION:
Private equity investing may be broadly defined as investing in securities through a
negotiated process.
Venture capital can be described as the business of building businesses. VC isn t just
about funding, but also about being actively involved strategy, orientation… compared
to public equity…, VC is about being a key player in the built-up of the company.
2. The European venture capital and private equity market at a glance
In 2013: 55 billion euros raised only in that year (in total around 500 billion), not all of it
was invested. Only 38 billion was invested in private equity (VC and Buy-outs).
Divestments=exits and the funds that followed from that.
Going from 2006 to 2007 we can see a drop, this is where the financial crisis started in
the US, but is was more in 2009 where the crisis had arrived in Europe. In 2009, there
was not only a financial crisis but also an economic crisis.
On a yearly basis, approx. how many firms raise VC finance?

 3000 ( on European level) companies that get/raise venture capital and have they
have a lot of potential. isn t much BUT it s an important market because they
mostky are the corner-stone companies or the big companies.

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Left circle: amount invested (that 38 billion)

Mostly in buy-outs, less money per deal ???
Right circle: number of companies
Mostly start-ups and later-stage ventures.
Seed = very early stage financing

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The business of building business

 Home bias = VC in BE want to invest in firms in BE or maybe in NL, but not to far.
Why? you want good deals and therefore you need to know a lot about them, when the
firms are close, you are more likely to know more about them via insider knowledge or
your connections etc. Also the differences in legal forms/situations in the different
countries can cause a raise in the complexity. Last, face-to-face interaction is important
and the closer the company, the easier this can take place.
So the domestic investment are very big BUT there are also quit some cross-border
deals possible, it happens more often. For instance, if you are an investor on your own.

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 some BE firms were also able to obtain funds from the US, mostly when they had
already obtained funds before and even more likely when there is a cooperation
between the investors from the US and a BE investor(s) who is more closely situated to
the firm and has knowledge. The BE investor will also most likely take a leading position
in the group of investors.
Industry statistics: location of the venture capital is taken into account, how much
money the VC is managing. Mostly the UK with a lot of VC.
Market statistics: location of the portfolio company is taken into account, investment
based on the portfolio company. Here it is more equally spread.
0,3% of GDP

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0,02% of GDP (industry stat) europe
(Market stat)
UK is just above the EU BUT buy-out is very advanced in the UK, that is how you get a
large chunk for the UK for private equity (buy-out= part of PE as is VC)

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In which industries will VC most likely invest?

- ICT (information, communication, technology)
- Health
- Biotechnology
The company must have high growth potential!! So not only high-tech companies,
but companies with high growth potential such as Brantano bv.
more detailed… Buy-out appear more equally spread

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4. Why do venture capital markets exits?

There are a lot of options to choose from such as home funds, mum and dad, F s now
also known as f s: friends, family, fools and fans  for crowd-funding , banks… So why
do VC markets exists?
First, what are the differences between bank financing and VC financing?
- debt financing vs equity or equity linked financing = KEY DISTINCTION
- VC are about building businesses (active) and banks will first have a talk with
you but once you get the loan, the bank wont help you with the strategy,
orientation etc.
- Different returns potential: for the bank, that is a fixed interest (meestal
althans, als de bedrijven niet in de problemen geraken), for the VC there is no
upper bound, the sky is the limit , and the lower bound is when you would
lose all the money you have invested.
- When you talk with banks, they will look at the Cfs of your company and the
history of the Cfs and they will also ask for collateral. They ask for the
collateral in case things go bad so that the bank would still obtain the CF s by
selling it.  VC: no talk about collateral or any other personal investments
of the entrepreneurs E s , but they make use of contracts where they shift
risks from the investors towards the E s. VC wont look at the CFs because in
many cases there wont be CFs yet or a history of CFs (new start up for
instance , but they will look at the team, product/service,…
- A VC will be a financial partner of the company for 3-7 years, not 1 (short
term) (to short) and not 20 years either (long term) while banks give out
short term, MT and LT debt financing.
 So, WHY do VC market exists?
E s might want the involvement of VC… BUT why aren t banks involved? Or why don t
they do that?
The older and larger a firm is, the more options it will have… VC provides for a specific
niche! VC are niche players for types of companies that aren t suitable for obtaining
bank loans banks don t have the needed financial structure, some of the banks are
providing separate departments for Private Equity though, for instance KBC private
equity).

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WHY DO VENTURE CAPITAL FIRMS EXIST? THEORY AND CANADIAN EVIDENCE.

(Raphael Amit, James Brander and Christoph Zott):
VC reduce information asymmetry! Using certain techniques… types of info ass. :

 HIDDEN INFORMATION: before the contract is signed (the company will talk
as if their company is the greatest pink situation, maybe leave out some things…
 HIDDEN ACTION: after the contract is signed the VC cannot babysit the
company every they and control the actions that the companies undertake...)
The hidde i fo atio p o le :

• Sellers Withdraw High Quality Products from the Market
– CLASSIC EXAMPLE: The lemon problem  zie ook AFSA
– ASSUME: Buyers of used cars can only assess average quality of cars on
the market; sellers know exact quality
– WHAT HAPPENS?
• Maximum price buyers are willing to pay is the one charged for
average quality used cars
• Sellers of above average quality cars have no incentive anymore to
sell. They withdraw from the market: adverse selection
• Average quality of offered used cars drops even further. Market
gets flooded with lemons, and it becomes even less likely that deals
are made. (Possible counter measure: provide warranty.)
• Result - VCs Reluctant to Invest in Early Stage Technology Firms
– ASSUME: Only entrepreneur knows the quality of the project; VC does not
– WHAT HAPPENS?
• VC prices the deal based on valuation of average project
• High quality entrepreneurial projects are withdrawn from the
market for venture capital financing. Although deserving, they may
fail to obtain adequate funding phenomenon of under-
investment

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• Average quality of offered projects declines, maybe even to a point

where no early stage technology firm gets funded anymore -
market failure
– POSSIBLE COUNTER MEASURES: Due diligence; Staged investment;
Collateral; Track record; Learning etc.
So, when there are a lot of E s looking for VC, the high quality E s will drop out because
they don t want to pay the high price, while the other bad E s do not mind to pay the
higher price.
Counter measures for the bank?
 mostly the use of collateral, but not all companies have such collateral, for instance
firms who invented a certain technology who don t have track record yet…
Counter measures for VC?
 Due diligence (can take up to 3-9 months!!!): it costs a lot of money to do this, banks
only get the fixed interest and in other words do not have the money to do such due
diligences, that is why banks will use simple and cheap measures: COLLATERAL
So, VC use more advanced and costly measures to reduce information asymmetry.
The hidde a tio p o le :

• Inefficient Contracts fm. Unobservable Action
– CLASSIC EXAMPLE: Car insurance
– ASSUME: The actions of car owners after a contract is signed cannot be
perfectly observed by insurance companies
– WHAT HAPPENS?
• Insurance buyers will act in their own self interest and probably
neglect the self interest of the insurance seller: moral hazard
• Insurance sellers cannot force car owners to be more careful
because car owners actions are unobservable
• Insurance sellers foresee these problems. Offered contracts are
inefficient in the sense that they account for the costs of hidden
action possible counter measure: e.g. deductible
• Early Stage Technology Firms Cannot Expect Fully Efficient Contracts
– ASSUME: Venture Capitalist cannot perfectly observe the entrepreneur s
effort
– WHAT HAPPENS?
• Entrepreneur has incentive to act in own self-interest since
contract has already been signed and actions are unobservable
(extreme case: entrepreneur takes the money and runs
• Venture Capitalist anticipates this problem (perceived as a cost)
when designing a contract
• As a result, early stage technology firms may get contracts that are
not as efficient as they could be if effort were clearly observable
– POSSIBLE COUNTER MEASURES: Monitoring; Entrepreneur keeps higher
stake in the company; performance requirements etc.

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Banks are very limited in finding solutions for these previous problems, they do make
use of clauses (clausules) etc but they mostly make use of the collateral. If the company,
after signing the contract and receiving the loan, suddenly starts to take on more risks,
the bank can still just sell the collateral  VC goes further in terms of counter
measures, more costly, can carry more costs because of the higher possible returns they
could receive (banks only have the interest).
BANKS VERSUS VENTURE CAPITAL: PROJECT EVALUATION, SCREENING, AND

EXPROPRIATION. Masako Ueda, :
So, VC target companies who would find it very difficult to get bank loans, in other
words, companies with little collateral, high growth potential, high risk banks don t
want this, VC do and they shift the risks towards the E s , high profibillity potential in
the future…
ENTREPRENEURIAL FINANCE: BANKS VERSUS VENTURE CAPITAL. Andrew Winton,

Vijay Yerramilli, 2007):
Also take into account INETELCUAL PROPERTY!! VC have portfolio s of companies and
it can be that a certain intellectual property could be useful for another company in the
portfolio E s don t want that the VC uses their intellectual property for other
companies which is why they will be more likely to go to the banks since banks aren t
interested in building businesses .
Some companies have a low probability of success, but when it does: JACKPOT! This isn t
a possibility for banks, but it is for VCs, they take on more companies and when one
succeeds it can cover the other failures => HOMERUN compensate the other
investments).

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CONCLUSION: VC target this niche where they specialise in reducing information

asymmetry using measures that banks cannot do due to a lower fixed return (interest).
Also, if your company for instance need 10.000 euros, do not go to a VC!!! This amount is
way to small; the due diligence itself will cost more!
5. Venture capital models
This is a typical US-model, also for the EU but in the EU it is more complex (see later).
GPs are the general partners that set up the firm and manage the VC funds. They raise
financing from the LPs (limited partners) who just give the financing, but they do not
wish to be involved to limit their liability (so they are not involved in the management).
GPs will look for interesting companies (about 15-25). These companies will get an
initial investment, and often accompanies by rounds of investments linked to the
progress of the company.
The purpose of all this and what GPs want of course, is to get more back in the end, for
instance: GP  100
GP  200
This isn t an easy job!! For this, you need a good selection, good managing, and good
exiting of the company!
GPs get a fee (%)in the size of the fund on a yearly basis (between 1,5%-3%). The
%depends on the name and reputation of the GP. The carry in this example is 20%.
CARRY= 200 – 100 = 100  20%of this equals a carry of 20 which goes to the GPs, the
rest (80) goes to the LPs (provide financing and are passive).

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LPs in the VC context, who are they?

 Academic institutions (few), banks, capital markets, corporate ventures (bv. Goodle
ventures), funds of funds (raise a fund to put in a fund instead of putting it into
companies directly , …
Government is a very important LP for VC, less/not so much for buyouts! The
government wants to support entrepreneurs new ones …

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Founders and sometime

Investment
others are owners of the WHINSEAD CAPITAL MANAGEMENT, LLC (or Sub-S) Committee
Management Company
The General Partner of : Advisors
Limited Partners
WHINSEAD Venture Partners, LP I In addition to GP. Others
Sometimes a “Side
Car Fund” especially
A $200 MM VC/Buyout Fund might share in 20% carried
interest – possible
in Emerging Markets intermediate LP for this
purpose.
WWW VP I: Ten Year Life Cycle Possible Extension
Fund Hierarchy
Partners (Sr-Jr)
Principals
0 1 2 3 4 5 6 7 8 9 10 11 12 Directors
Associates (Sr-JR)
Analysts
Annex fund in bad times
Take Down Schedule

10% initial Then as needed (usually complete by yr 7 or 8) $200 mm total
0 1 2 3 4 5 6 7 8 9 10
PROBLEM:
MGMT Fee @ 2%
$40 mm total fee – leaves only $160 mm to invest
$4mm $4mm $4mm $4mm $4mm $4mm $4mm $4mm $4mm $4mm Fee often declines at end of Investment Period
Investment Period Portfolio Company Growth Harvest/Liquidation Period

~ Years 1 to 4 Period ~ Years 5 to 10 +
~ Years 3 to 7
Portfolio formation Intense exit efforts AND IF RETURNS ARE LOOKING GOOD,
2nd, 3rd, etc Rounds START A SUCCESSOR FUND AT END OF
Intense value-add Most of Carried Interest occurs INVESTMENT PERIOD, AFTER $X ARE
Some realizations here INVESTED OR AT DESIGNATED TIME PERIOD
First round (not necessarily A --Trade sales - Typically 20% of gains FUND I FEES REDUCED BUT NOT
round) commitment to all portfolio -- IPOs ELIMINATED
companies -- Not necessarily liquidity - Generally all funds returned
-- Distribute shares to LPs? before carry (caution: “Claw Back”
Second round to earliest deals -- How are returns measured
may occur with shares? - In Emerging Markets often a
-- Gatekeepers!! “hurdle rate”
Buyouts: Leverage as needed or
available
WHINSEAD Venture Partners, LP II -- A $300 MM VC/Buyout Fund
WHY ROUNDS?
What does this mean for actual Starts ~ Year Four of Fund I
number of investments? 2% Fee, but a bigger fund = $60 MM total
The GP here is called Whinsead Capital Management. The fund contains $200million,
raised from the LPs. The economic lifetime is 10 years (extensions are possible, for
instance to assure an appropriate exit).
The management fee is %. This isn t very realistic to give the GPs % each year, this
would mean $4 MM each year (10 x 4 = 40 MM) and result in only $160MM left to
invest… More realistic is when the management fee decreases when the fund ages,
otherwise a large part of the fund wouldn t be used to invest.
Investment period (Y1-Y4): this is the start of the portfolio s.

Portfolio company growth period (Y3-Y5): 2nd and 3rd rounds of investments, here
you also go from selection toward adding value to the selected companies
Harvested/liquidation period (Y5-Y10): the exit will take place between year 5 and
10 (maybe 11extension) and in this period the VC will prepare the company for IPO, if
that isn t a possibility, VC can also look at possible mergers and acquisitions, looking for
interested partners.
In this slide, they only mention 1 fund, but the moment you realise a certain amount of
exits (first adding value followed by extracting value), you will start to set up a second
fund only if you were successful. Only when you were able to show your ability to select
firms and in adding value, you will be able to raise an additional fund. In that case, GPs
will receive more money, extra management fee will be placed underneath the green
balk .

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In Europe (more complex), many different types of players:
1. Funds
These are the ones we have just discussed and are the most typical (the LP-GP
funds). Here it is all about return realisation. This type of fund has a specific age.
The other don t have that.
Here you get that $200MM (in parts, not all at once).
2. Captive or semi captive funds
= institutional investors KBC private equity, ING…
3. Private investment corporations
For instance, google ventures, marc coucke
4. Listed investment firms
For instance GIMV, the GIMV-model.
Here they have a buffer of cash, there will also be cash you don t need after the
exit and the return to the LPs, this has an influence on the B/S. so 1 has another
structure compared to 4.
 2,3,4 are also about return realisation but here there are also other motives, for
instance:
- Banks: they will select companies that could come in handy in the future, that
could realise strategic benefits, for access to future business
- Also corporates will invest in technologies that could also come in handy etc.
Slide 35: what are the implications of LP-GP?  Sophie????

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5. What do VCs do?
Generic Value Chain

Assessing Managing/
Due Deal Exiting
Business Plan Monitoring
Diligence Structuring Deals
& Model Deals
• Executive • Management • Valuation • BoD • Trade sale

summary team • Financing • Managing in crisis • IPO
• Powerpoint • Financial instrument • Recruiting • Repayment of pref.
presentation accounts • Profit/loss • Raising further funds shares/loans
• Napkin • Technology sharing • Secondary sale
• Property • Company
rights management
• Customers • Exit à Term sheet,
shareholder agreement
Sourcing Deals
Formulating Strategies, e.g., for adding value
Managing the partnership
Raising the next fund

39
First, the VC receives the business plan (BP), gives it the 1-minute-look (=looking at the
summary), and the 10-minute-look (goes a bit further..).
Next is the due diligence, getting insight in the intelectual property, the team,
customers…
Deal strucuting: To do this invesmtent, how many shares do we need to ask? At what
price? to answer these question, there will be a need to valuation. The financial
instruments most frequently used are the preferred stock. Setting up the term sheet (=
the basis characteristics of the deal, contractual agreement for the exit).
Once the deas has been accepted, we can move over toward the managment and
monitoring of the deal.this also regards taking seats in the Bod (Boardof directors),
managing in crisis, recruiting and raising further funds.
Last is the exiting deals.
(sourcing deals = filter??)
Nota onder de slide:
Due diligence can take up to - months

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Trade sale M&A : Much more important in terms of number of exits than IPO
Financing instrument: Why important? Why not all common stock?
Consider following example:
ENT has invested € k, VC € m; VC owns /
If company is sold for € k
ENT makes profit of / . k– k=€ k
VC makes loss of / . k– m=€ k
VC needs downside protection
5.1. Due diligence
PURPOSE:
• Rationalize deal flow on basis of fund characteristics and strategy (2000 BPs to
cover and only few people to do it AND you also want to be actively involved…
you need to remove the ones you are not interested at all!)
• Build a base of knowledge of a new sector
– Refine background
– Build sector judgment
– Accumulate investment judgment
When you are in a meeting with E s, they might say we are the only ones who are
doing this… but by looking at a lot of BPs that you already had received previously,
you have actually built a base of knowledge, you might already seen a PB similar to
one presented to you right now, by reading previous BP and doing research around
them, zou know stuff about the market and industry… this all serves the base of
knowledge)
• Determine SWOT
– Characterize what is fixable; what is not
– Develop a real options thought process
• Identify milestones and related capital needs
if there is no competition, there is a great chance that there isn t a market for it
• Establish or test basis for valuation
• Create framework for term sheet preparation and negotiation
(Term sheet: what are the milestones, what do you expect them to achieve…
• Ideally, create a mutual benefit for investor and entrepreneur

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You start with 2000 proposals and you give them the 1-minute look, followed by the 10-
minute test and 1 hour test  these are called the pre-qualifiers
This gives you 300 meetings and only 150 of them are actively persued, deals that the VC
would want but the VC needs more information first (due diligence, negotiations,
valuations)
All ending in about 20-50 deals that will be financed.
Phase 1. Pre-Qualifiers: Factors exogenous to the merits of the company

Fund Characteristics and the Company:
• Relevance of fund-history in the industry
– A new industry (if you are interested in a new industry, you need to ask
yourself if it is attractive?)
– Incremental company or technology in the industry
– Business model analysis relative to industry
– Type of business: basic, tech-driven, product, service
• Fit into the fund portfolio (does the company fit into the portfolio? Is 1+ 1 = 3? VC
want to create synergies. There might be a problem if the VC invest in a
competitive company of one in the portfolio…
• Match with strategies of other portfolio companies
• Stage of development experience AND capacity (What is the capacity the firms
still has? Can the VC invest in a start-up in the early stage and can it do follow-up
rounds? This is often mentioned in the clauses. Being an investor in the early
stage bares a lot of risks. If you cannot follow, your return will be lower than
those of the investors that came along later. )
• Geographic location
• History of exits in the sector (look at the exit potential)
– Public market or trade sale
– Valuations
– Average time from funding to realization
3 types of E s:
 Risk capital providers: those are the ones that look up the email adresses (on the
agentschap ondernemen of ALL the Vcs and they send an email to all of them.
The chance of getting a fund is low for them = overshopped

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 Than you have the ones that only go to 1 VC, the VC that is the closest to them,
which isn t a good way either.
 The third group does is wright, think about which VC would suit them well…
This shows the selection preferences, shows where, how much capacity they have,
they put up a maximum which has to do with the capacity of the VC.
If the company only needs a smallamount, it shoulds go to a VC.
Company basic history: (what are the basic characteristics of the company? What
does the team look like? Capital structure? Also look at the previous seed investors
to see if the quality of the initial investor has got what you need, if not, that company
will be excluded)
• Source of the idea/technology
• Who is the prime mover?
– An entrepreneurial self-starter
– A hired-gun

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• Organizational structure
• Capital structure
• History and age of company
• Prior seed investors, if any
– Complexity of seed deal
– Role of the angels
– Corporate VC
• Prior VC participation
– Who, when, what role?
Fund-raising savvy:
• Has the founder-entrepreneur raised capital in previous activity?
– In what setting?
– From what/whom?
– Valuation reasonableness
– Familiarity with common venture capital deal terms
• Experience bootstrapping or with angels
• General reputation in community
– As entrepreneur
• Concept originator, promoter, maverick, launcher, operator?
– As executive
• Entrepreneur in residence at a fund?
• Has the business plan been over-shopped
– Has plan distribution been controlled
– Non-disclosure agreement required?
How did this business plan get on my desk?

– If over the transom, did the entrepreneur qualify my fund?
• Through discussion with my portfolio CEOs?
• My website
• My branding?
– If by referral, from whom?
• Another VC wanting to lead?
• Another VC looking for a lead?
• A corporate venture capital fund?
• One of my portfolio CEOs?
• An intermediary?
• My attorney or accountant?
It is good when there is already a VC interested and wants to take the lead. As E s, you
should also do your own due diligence, sometimes the E s are annoyed because the
CEO s don t know anything about their business and this is a way to avoid this.
Plan Completeness and Sophistication:

• Executive Summary
– Opening paragraph: the one-minute test
– Content: the ten minute test
• Commercial context of the business/technology
– Must provoke immediate interest in
• Management chapter

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• Financial forecasts: size, scale, rate and pace of growth

• Capital needs analysis
– Is the nature of the business, its model, its strategy, its capability and
assets, its commercial context, its revenue model, and needs clear?
• Does the team fit the business
• Obituary description or accomplishment driven
• Action oriented casting of talent with task
• Match of team with opportunity
• Personal risk-oriented characteristics
Business Plan Characteristics:

• Is the plan
– a product of consensus among the team?
– formulated by one team member?
– written by an outsider?
– readable and well organized?
– a white-paper or a data/experience driven?
• Vision without substance
– overburdened with spreadsheets?
• Detailed description of the customer ?
• Serious analysis of competitive environment ?
• CONSISTENCY: does the operating and financial data, match with product
development and marketing ?
• Plausibility of numbers--credibility
• Is the plan suggestive of auto-diligence ? Auto-diligence: did the team itself look
at what risks there might be and what could happen?
Phase 2. General Endogenous Qualifiers: The Merits of the Team and the Company
A Very Old Debate Among VCs:
• Some VCs believe company s product and market are key.
» Bet on the horse.
• Others believe is all about management, management, management.
» Bet on the jockey.
Bet on the Horse…examples:

• Tom Perkins of Kleiner Perkins looked at a company s technological position.
Was the technology superior to alternatives and proprietary?
• Don Valentine of Sequoia assessed the market for the product or service. Is the
market large and growing? Is it well defined?
» Cisco was turned down by many other VCs because the team was considered weak.
» Valentine invested in Cisco anyway. He saw a huge market.
Bet on the Jockey…examples:

• Arthur Rock, investor in Fairchild and Apple, emphasized the quality, integrity
and commitment of the management team.
» A great management team will find a good opportunity even if they have to make a
huge leap from the market they currently occupy.

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 HORSE!!!!
• A bad management team does not necessarily kill a good idea, but
• A bad idea is rarely overcome by a good management team.
• Poor management is much more likely to be fixed by new management than a
poor idea is likely to be fixed by a new idea.
• When a management team with a reputation for brilliance tackles a business
with a reputation for bad economics, it is the reputation of the business that
remains intact. Warren Buffett
The Seven Deadly Questions:

The Seven Deadly Questions are an assembly of questions that just about every investor
asks routinely, in whole or in part, in one way or another. They are dangerous because
they sound innocent, but the answers can speak volumes about the management team.
1. Your customer is who?

• Kill:
These three segments of the router market that need . . . And make their decisions on
the following basis . . . Over a selling cycle that takes . . . Days
 Be Killed:
The purchasing agent.
2. Which competitors keep you awake at night?

• Kill:
Another start-up that has an alternative approach, but this we will beat them in the
following ways. . .

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• Be Killed:
We’re so ahead that we don’t have competition.
. Growth. How big and how fast?

• Kill:
$ million in to 5 years with total venture capital of $ 5 million.
• Be Killed:
$ million in ten years.
. Tell me again, you make your money how?

• Kill:
By making, selling and distributing proprietary products at a gross margin of 80% to
this set of customers with these sustainable advantages. . .
• Be Killed:
We were hoping you could tell us.
. How much money do you need, and why?

• Kill:
We need $ million for an month program that will accomplish these milestones
and tell us the following . . .
• Be Killed:
It depends. We’re worried about dilution.
. So, what do you think your little company is worth?

• Kill:
Based on our progress and a comparables, somewhere in the range of . . .
• Be Killed:
What do you think?
. Who y all been talkin to?

• Kill:
Several established venture funds who said they will speak with other VCs. They are ...
• Be Killed:
My cousin Vinny and the urologist next door.
Top Ten Lies (Mistakes) of Entrepreneurs:

• Our projections are conservative
• Oracle consulting forecast that our market will be $ billion by
• Amazon will sign our deal next month
• Key employees are set to join us as soon as we get funded
• We have no competition
• We need you to sign a nondisclosure agreement
• IBM is too slow to be a threat
• We re glad the bubble has burst.
• Our patents make our business defensible
• All we have to get is % of the market
• https://www.youtube.com/watch?v=Oe5c9KK3ZIs

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ACF session 7: Venture Capital

Today: what do Vcs do? Performance?
Due diligence can take up to - months

Trade sale M&A : Much more important in terms of number of exits than IPO
Financing instrument: Why important? Why not all common stock?
Consider following example:
ENT has invested € k, VC € m; VC owns /
If company is sold for € k
ENT makes profit of / . k– k=€ k
VC makes loss of / . k– m=€ k
VC needs downside protection
Today we will see deal structuring valuations, contracts… , managing/monitoring

deals and also exiting deals what happens after -7 years, you have several exit
options).
5.2. Valuation and Capital Tables

THE QUESTION: What percentage of the company do I need to own today in order to
meet my targeted rate of return at the probable time of exit? in the E s perspective: if I
receive x euros, how much do I need to give in return?)
DCF is the superior method but it will be simplified due to uncertainty, multiples is
another method but used less. The VC-method is the bridge between the previous two.
Conventional VC Method:
• Principle: Base present value on an expected terminal value discounted back
with a high discount (or hurlde) rate.
• Major operand: Instead of using cost of capital as discount rate, VC uses a target
rate of return, i.e., yield needed to justify risk and effort.

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Step 1: Look at the possible time of exit (5-7 years after the investment).
Step 2: Think about the key financial figures in a success scenario at the time of exit
(bv. Look at the earnings) which will be generated.
Step 3: Multiply by a multiple based on previous experiences or on the market
multiples…
Step 4: Discount back to today.
Step 5: you become the expected value of the firm (then you can also calculate the
amount of shares you should get given the amount of your investment)
Stages of Investing: Required return (Not dogma!, US based): (results from one
specific VC):
Seed:very early stage, when a VC invest in the seed-stage, they willask a higher return
because many seed-stage firms will be unsuccesfull, this is to compensate this risk ( a
higher return potential).
(results of different Vcs):1996 (old study)
Expansion: later stage of investments.

BE & Neth. know lower required returns.
Elements of required return:
CAPM-return
+ illiquidity premium (you invest in NOT-quoted firms)
+ premium for value-adding and monitoring (VCs also want to be compensated for
their active involvement in adding value etc.)
+ premium for over-optimism (even in the pessimistic scenario made by the E s, it is
often even optimistic)

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Relation between required return and evolution of company value:

(firm value at investment: 100):
# Years 30% 50%
3 220 338
5 371 759
7 627 1,709
This table represent what you think at the time of the investment. This is mostly
followed by failures (a lot of start-ups will fail unfortunately) but the reason of creating
portfolios is that 1 success can compensate the other failures (Homerun).
If shareholders require a return of 50% then they expect the value of the company to be
approx. 7 times higher after 5 years!
If you want to realise these required returns, you have to invest in high growth/ high
potential firms.
(for VC it is not interested to invest in bv. A pizza-restaurant, because there is not a lot of
potential for high growth for instance)
Valuation Example:
A) Assumptions:
• Estimation of exit year—7 years
• Net Income projections in exit year or in new markets, an index of value—$25
MM(success scenario)
• Average P/E of industry comparables—11 (could also have been based on
previous experience)
• Existing capital structure of company—1 MM shares of Common Stock (CS)
• VC s targeted rate of return per year for portfolio company profiled—50%(high
rate, start-up stage)
• VC s investment amount in round 1 -$3.5MM
B) A six-step approach:
 STEP 1:Estimate the company s terminal value at a future date this may be the
exit phase for the VC) when the company has achieved positive cash flows and
profitability. Calculate by using a PE multiple times the exit year s net income.
Example: $25mm x 11PE
 STEP 2: Calculate discounted Terminal Value. Calculate the company s
discounted terminal value(Present Value (PV) of the future income streams over
the holding period)
Example: DTV = $25mm x 11PE
(1 + 50%) ^7
=$16.1mm
 STEP 3: Required ownership at exit (no additional financings).

 To calculate the Required Final % ownership (RFP) at the Exit Date:
Investment: $3.5mm
DTV=$16.1mm
RFP=Investment/DTV
=21.74%

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Assumes no further financing rounds (no 2 nd, 3rd … rounds of investments . It

happens that a VC only invests one time BUT it is more realistic that they will
finance a 2nd, 3rd or even 4th round.
 Step 4 A: Determine # New Shares. (under the assumption of no further
investment rounds, if there were additional rounds  step 4B)
Existing shares: 1,000,000
RFP = 21.74 % or 0.2174
# New Shares = (1,000,000/(1-.2174)- 1,000,000)
= (1,000,000/0.7826)- 1,000,000
= 1,277,778 – 1,000,000
= 277,778
 STEP 4B: Allowing for an additional round.
 Calculate the retention ratio ( the % retained after one subsequent
Common stock financing round of 20% and incentive options for 25% of
CS have been awarded)
retention ratio= (1/ (1.2)/1.25)=66% (divide RFP by this %)
 Calculate the Required Current Percent Ownership on Day 1
 This % accounts for how much of the equity is retained, after
subsequent rounds and options have been awarded.
 The Required Current Percent Ownership
=21.74% divided by the retention ratio (66%)
=32.94%
 Step 4C: Shares needed allowing for further dilution.
Original shares= 1,000,000
Revised RFP = 32.94%
New Shares with dilution
=(1,000,000/(1.00-.3294))- 1,000,000
= (1,000,000/0.6706) – 1,000,000
= 1,491,202 – 1,000,000
= 491,202 new shares to be issued
 Step 5A: Share price with no future dilution. (no subsequent rounds)
Price per New Share with no dilution:
Total amount to be invested = $3,500,000
Number of new shares with no dilution = 277,778
$3,500,000/277,778= $12.60 per new share of CS
 Step 5B: Share price with full dilution. (with subsequent rounds)
Price per share with dilution:
Total amount to be invested = $3,500,000
Number of new shares with dilution = 491,202
Price per share = $3.5mm/491,202
= $7.13
 STEP 6A: Pre-money value no dilution.
PRE-MONEY VALUE: based in the valuation we have made, before the
investment. Pre-money = post-money - investment
POST-MONEY VALUE: after investments with the new shares (more shares
outstanding than for the pre-money value).

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Pre-money valuation with no dilution

Existing number of shares of CS outstanding times the price per new share.
1Million shares x $12.60/new share
=$12.60million
 STEP 6B: Post-money valuation with no dilution (same amount as step 2 result)
Existing number of shares of CS plus new shares of CS times the price per new
share.
1,277,778shares x $12.60/new share
=$16,100,003
 STEP 6C: Pre-money valuation with full dilution.
Total number of existing shares outstanding times the price per new share
1,000,000 shares x $7.13/new share (fully diluted)
=$7,130,000
 STEP 6D: Post-money valuation with full dilution.
Existing number of shares of CS plus new shares of CS times the price per new
share
1,491,202shares x $7.13/new share (fully diluted)
=$10,632,270
Acceptable or Unacceptable Dilution (= your slice of the cake is decreasing):

• Dilution is more acceptable if the new shares are sold at a price greater than
previous sale (the value here will increase)
– Percentage of ownership is less, but the total value of shares owned is
greater
• Dilution is unacceptable if the new shares are sold at a price equal to or less than
the previous sale (typically protected via clauses in the contract)
– Percentage of ownership is less, and the total value of shares owned is
same or less
– When value of shares is less, shareholders suffer a smashdown
Dilution and Value are Linked:

• Any infusion of capital from sale of equity is necessarily dilutes the percentage of
ownership associated with previously sold shares
• The goal of an entrepreneur in selling equity in successive stages is justify a
higher share price by increasing the value of the company
• The total pie should grow faster than the number of slices: drive value!

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Startup Company Capital Structure

The Expanding Pie
I. Formation of Company
Founders A, B and C each purchase 1,000,000 shares of Common Stock at a purchase price of $.001 per share.
Person No. of Shares % of Shares Value
Founder A 1,000,000 33.33% $1,000

Founder B 1,000,000 33.33% $1,000
Founder C 1,000,000 33.33% $1,000
Total Post-Financing 3,000,000 100.0% $3,000
Valuation Founder A Founder B
33% 33%
$1,000 $1,000
Founder C
33%
$1,000
24
Typical capitalization tables.

Share price of 0.001 dollar: initial value is very low because you want it to be able to
grow. Going from 0.001 to 1 dollar is easier than going from 100 to 325 for instance!
II. Hiring of Chief Executive Officer &

Establishment of Option Plan
The Company hires a chief executive officer who purchases 1,000,000 shares of Common Stock at a purchase price of $.01
per share. Additionally, in order to attract additional key employees, the Company establishes an employee stock option
plan and reserves 1,000,000 shares of Common Stock for issuance under this plan. The pre-financing valuation is $30,000
and the post-financing ownership structure and valuation are depicted in the following table and pie chart.
Person No. of Shares Percent of Shares Value
Founder A 1,000,000 20.0% $10,000

Founder B 1,000,000 20.0% $10,000
Founder C 1,000,000 20.0% $10,000
President 1,000,000 20.0% $10,000 Founder B Founder C
Stock Opt. Plan 1,000,000 20.0% $10,000 20% 20%
$10,000 $10,000
Total Post-Financing 5,000,000 100.0% $50,000
Valuation
Founder A Stock Option
Plan
20%
20%
$10,000
$10,000
President
20%
$10,000
25
Here you went from 0.001 to 0.01 dollars per share. Hiring a CEO is not necessary but
when you do, you need to establish an option plan.
How dilution works
• First round of financing: expect 25-50% dilution
• Second round: perhaps 30-40% dilution
• Third round: perhaps 20-25% dilution
• One immutable piece of the pie: employee stock

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III. Initial Venture Financing Round

The Company needs capital to complete product development. Accordingly, the Company completes a $10,000,000
venture capital financing at a purchase price of $2.00 per share, representing a pre-financing valuation of $10,000,000
(5,000,000 shares with a value of $2.00 per share). The shares sold in the financing are typical, venture capital Series
A Preferred Stock with each share of Series A Preferred Stock being convertible into one share of Common Stock.
This financing results in the following ownership structure and post-financing valuation:
Founder A 1,000,000 10.0% $2,000,000 Founder A

10%
Founder B 1,000,000 10.0% $2,000,000 President $2,000,000 Founder B
Founder C 1,000,000 10.0% $2,000,000 10% 10%
$2,000,000 $2,000,000
President 1,000,000 10.0% $2,000,000 Stock
Founder C
Stock Opt. Plan 1,000,000 10.0% $2,000,000 Option Plan
10%
10%
Series A Inv. 5,000,000 50.0% $10,000,000 $2,000,000 $2,000,000
Total Post-Financing 10,000,000 100.0% $20,000,000

Valuation Series A Inv.
50%
$10,000,000
The pre-money value here is 5000.000*2 (5000.000 comes from the previous slide, the
number of shares before investment, the 2 is the price/share at time of the investment).
Founder A went from 10.000 to 2000.000 dollars value even though his slice of the pie
decreases!!!
IV. Series B Preferred Stock Financing

The Company’s product development is progressing favorably, but an additional $20,000,000 will be required to
complete development. Accordingly, the Company undertakes a $ 20,000,000 Series B Preferred Stock financing at a
purchase price of $4.00 per share, representing a pre-financing valuation of $40,000,000 (10,000,000 shares with a
value of $4.00 per share). Like the Series A preferred Stock, each share of Series B Preferred Stock is convertible into
one share of Common Stock. This financing results in the following ownership structure and post-financing valuation:
Stock
Option Plan
Founder A 1,000,000 6.66% $4,000,000 6.66% President
$4,000,000 6.66%
Founder B 1,000,000 6.66% $4,000,000 $4,000,000
Founder C 1,000,000 6.66% $4,000,000 Founder A

6.66%
President 1,000,000 6.66% $4,000,000 $4,000,000
Series A Inv.
Stock Opt. Plan 1,000,000 6.66% $4,000,000 33.3% Founder B
6.66%
$20,000,000
$4,000,000
Series A Inv. 5,000,000 33.33% $20,000,000
Founder C
Series B Inv. 5,000,000 33.33% $20,000,000 6.66%
$4,000,000
Total Post-Financing 15,000,000 100.0% $60,000,000 Series B Inv.

33.3%
Valuation $20,000,000
The pre-money value here is 10.000.000*4.

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V. Initial Public Offering

The Company needs substantial additional capital to expand the scope of its manufacturing and sales and marketing operations. Accordingly,
the Company decides to undertake an initial public offering. As a result of the offering, the shares of Series A and Series B Preferred Stock held
by the venture capital investors will be automatically converted into Common Stock at the conversion rate of 1 share of Common Stock for each
share of Preferred Stock, and all shares sold in the offering will be Common Stock. A total of 5,000,000 are to be sold by the Company. The
shares will be sold at a price of $20.00 per share, representing a pre-financing valuation of $300,000,000 (15,000,000 shares with a value of
$20.00 per share). This public offering will result in the following ownership structure and post-financing valuation.
Founder A 1,000,000 5% $20,000,000
5% n
Founder B 1,000,000 5% $20,000,000
la
Opti ck
00
on P
Sto
00,0
t
$2 5% den
0
i
$20,0
es
Founder C 1,000,000 5% $20,000,000
, 00
Pr
00
rA
de
0,0
un
Fo 5% ,000
President 1,000,000 5% $20,000,000 Series A Inv. 0,0
00
$ 2 d er B
25%
Foun
Stock Opt. Plan 1,000,000 5% $20,000,000 $100,000,000 5% 0
00,00
$2 ,0
0
Series A Inv. 5,000,000 25% $100,000,000 Founder C

5%
$20,000,000
Series B Inv. 5,000,000 25% $100,000,000

Series B Inv. Public Investors
Public Investors 5,000,000 25% $100,000,000 25% 25%
$100,000,000 $100,000,000
Total Post-Financing 20,000,000 100.0% $400,000,000

Valuation
Slices decreases but the value increases! Sometimes founders are afraid of losing control
and having nothing to say as their slices decreases…
5.3. Term Sheet
What Is A Term Sheet?

• A letter of Intent that summarizes the key economic, financial, governance and
legal terms of a potential Venture Capital investment. The basis terms,
agreements.. Include also the answers to What if something happens… .
• It is usually non binding
• Exclusivity upon (after) acceptance of terms. No longer negotiations with others
• It is negotiable (balancing between the different parties)
• Distinguish between terms that favour the investor and those that favour the
company
Term Sheet: The 12 Most Contentious Issues:

1. Valuation:
a. This is art, not a science - it begins with the usual financial methodologies,
but rapidly expands into subjective, non-financial areas.
 Is it a hot area; how experienced is the management team; are
other investors interested; time horizon to profitability, etc.
b. The entrepreneur will fare better if there is a horse race - get more than
one VC bidding on an investment.
There is always some discussion about the valuations, debates about the basic
assumptions. Typically starts from the financial point of view, also soft data will have
an influence though ?? . Also overshopping has an influence: it makes you look
desperate, also make sure you do not start to late to look for VCs (6-9moths ahead
usually) and make sure there are different players interested. For instance, Abblings
and its 2nd round of investments had 40 interested investors!! This provides you with
high leverage in terms of negotiation!

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2. Company control: shareholder leverage:

The sheer voting power of the shareholders --statutory
i. Power to elect directors
ii. Power to veto significant transactions
 Mergers and sales
 Any senior security
 Redemptions and repurchases of securities
 Amendments of articles of incorporation and bylaws
The voting power of the shares is important, it can contain the ability to block certain
decisions (veto) but it can also give the owner the ability to elect members for the
BoD. REMARK: it s not because you have + % of the shares, that you will have all
the power and that you can say anything you want (alles voor het zeggen hebben),
there can be things hiding in the clauses for instance…
3. Company control: composition of the board:

a. Boards are usually not more than 7 directors
i. Usually a balance of VCs, founders and outside directors
b. VCs who invest in a series of preferred stock are usually given a
guaranteed right to elect a specific number of directors
c. Observer rights: the pros (a bone to throw investors) and the cons (loads
up the board room)
i. A bone to throw investors vs. changing the personal dynamic in the
board room
d. Chemistry and commitment!
The board has the task of strategic decision-making. If you are a lead investor, you
will negotiate a seat, maybe even one for a co-investor.
To many seats no decision possible
Less or to little seats  not enough to make good decisions
 Balance between the two!
The OBSERVER will not own a seat , but will be allowed to join the meeting and will
be able to share their views, but will have LESS legal liabilities (Why?was iets met
USA?).
4. Dividends:
Dividends negotiated as a kicker
a. Levied on original purchase price of shares
b. Typically proposed at T-Bill rates
c. Cumulative, not compounded (most frequently like this)
Cumulative: not paid in one year, shift to the next year or all at once at the time of
exit for instance. (Bv. No dividends paid for the 5 years? At exit all years will be paid).
Compound: paying/getting dividends on dividends.
So cumulative and compound is very good for the investors, interesting for VCs (they
get dividends for sure, and even dividends on dividends!),but most of the time it is
not compound.
5. Liquidation Preference:
a. A tool that enables favourable treatment for preferred shareholders. It is
invoked upon sale or merger; liquidation & winding up

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b. Intended to protect investors. Pay attention to the multiple on the value of

the initial investment that preferred shareholders would receive.
c. Participating preferred vs. non-participating preferred
Where the investor first recovers his defined preference (usually
the principal invested , and thereafter participates in any
remaining distribution of proceeds side-by-side with the common
stockholders on a common equivalent share basis
P.P.  the investors will receive as first 1X, 2X or 3X their investment and when
the firm is successful it will also get part of that, if the firm fails it also gets a part
but it will be rather low.
N.P.P.  You will first get what the E s are obliged to give to you according to
your preferences, the rest goes to the E s because you are not participating.
C.S. (common stock)  you only receive get that part of ownership of the value of
the firm being sold.
EXAMPLE:
VC: 20% in firm Y (investment: 2m)
$1 share, 1X liquidation preference, no preferred dividends
Others: 8m common shares
What if firm gets sold for m vs. m? VC gets…
Firm sold for 3M VC gets VC gets non- VC gets common

participating participating shares
preferred preferred
VC 1x2M+20%x1M 1x2M 20%x3M
= 2,2M =2M =0,6M
Others 80%x1M =1M =2,4M

=0,8M
In this case of an unsuccessful exit, the VCs would be having a loss in case of CS
(O,6< 2M) and NPP would be better than CS. The PP would have the best results
for the VC in this case and would still be acceptable for the E s if we assume that
the E s invested . .
Firm sold for 30M VC gets VC gets non- VC gets common

participating participating shares
preferred preferred
VC 2M+20%x28M =2M 6M 20%x30M
=7,6M =6M
Others 80%x28M =24M =24M

=22,4M
In the case of the successful exit, the VC won t get only M in the NPP case, but M
because he will change his preferred shares into CS when things are going well!!
This shows how you can SHIFT RISKS when things are going bad en when things
are going good, how they both and benefit from the deal.

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6. Anti-dilution: (protects VCs who are already in the company)

 Protect existing investors from the adverse impact experienced when a company
issues new securities at a lower price than that paid by the existing investors
 Need first to understand conversion mechanics of preferred stock into common:
Defining the conversion ratio (how many CS will you receive for 1 preferred
share)
 Different flavoured formulas
a) Full ratchet
b) Narrow-based weighted average formula
c) Broad-based weighted average formula
d) No protection
 Antidilution protection:
- Price-based anti-dilution (i.e., protects against issuances of new stock priced
below the purchase price of an existing class of shares)
- The basics of price-based antidilution protection
o Protection is effected through adjustment to the conversion rate of the
preferred
o Usually, the conversion rate of the preferred begins with a 1:1 ratio
o Conversion rate is determined by dividing the purchase price by the
conversion price E.g., for preferred stock purchased for $ . , the
conversion price is initially set at $1.00 (i.e., a 1:1 ratio)
- What is the purpose of price-based antidilution protection?
 Invoked only where the per share price of new stock is lower than
the purchase price of outstanding stock
 Usually applied only in financing transactions; there typically are
carve-outs to avoid antidilution protection where it is not
applicable
 Benefits existing stockholders by increasing the conversion ratio of
their outstanding preferred
- There are three types of price-based antidilution protection:
o Ratchet based antidilution
 High volatility
o Narrow-based weighted average antidilution
 Medium volatility
o Broad-based weighted average antidilution
 Low volatility
- The type of antidilution protection will determine the volatility of the
adjustment to the conversion rate

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EXAMPLE:
A preferred  first round of VCs. 0,50 per share: value has been destroyed! The pre-
money value is 3M (you attract new financing and value goes down because of thelower
price per share).
a)• Full-Ratchet i.e., simple
simpleand
andcomplete
completerevision
revision to conversion
’
price
“Full-Ratchet” (i.e., to conversion price)
Revised conversion price: $.50/share
Conversion ratio: $1.00/$.50 = 2
Thus:
2,000,000 "A" Preferred convert to 4,000,000 Common
Capitalization after 2nd round:

Common Stock 3,000,000 shs
Option reserve 1,000,000
“A” Preferred 4,000,000
“B” Preferred 2,000,000
10,000,000 shs
“A” Preferred = 4,000,000

10,000,000 = 40%
So for 1 pref. Sh. You would get 2 CSs.
The original investors increased their ownership significantly  additional hit!!
(With full-ratchet)
b) Narrow-Based Antidilution Protection only preferred stock included

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“N ”
’
(only Preferred Stock included)
Conversion price x ( # of Pre Money Preferred shares + # of new shares that the new
investor would have received for the new money @ the old price/share) ÷ (# of Pre Money
Preferred shares + # of new shares that the new investor will receive @ the new price/share)
$1.00 x 2,000,000 + 1,000,000 (new investors situation with old price)

2,000,000 + 2,000,000 (“ “ “ with new price)
Revised conversion Price: $.75/sh.

Hence the conversion ratio =$1.00/$.75=1.33
Thus: 2,000,000 "A" Preferred 2,666,667 Common
Capitalization after second round:

Common Stock 3,000,000 shs
Total 8,666,667 shs
"A" Preferred = 2,666,667

8,666,667 sh. = 31%
No additional hit, ownership % is not protected.
“Bro ”
’
c) Broad-based Antidilution Protection all components of capitalization included
Conversion price x ( # of Pre Money fully diluted shares outstanding + # of new shares that the
new investor would have received for the amount of new money that is invested @ old price/
share) ÷ (# of Pre Money fully diluted shares outstanding + # of new shares that the new investor
will receive for the amount of new money that is invested @ new price/share)
$1.00 x 6,000,000 + 1,000,000
6,000,000 + 2,000,000
Revised conversion price: $.875/sh.
Hence the conversion ratio = $1.00/$.875 = 1.143
2,000,000 "A" Preferred 2,285,714 Common
Capitalization after second round:

Common Stock 3,000,000
Total # of Shares 8,285,714
"A" Preferred = 2,285,714

8,285,714 = 28%
d) No price-based protection
The results where A starts at % :

– Full ratchet: A increases to %
– Narrow-based: A declines to %
– Broad-based: A declines to %

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– No protection: A declines to %
7. Stock Option Pool:

- Based on the company s headcount requirements over a -18 month period—
normally a 20% to 25% component.
- This is a component of the capitalization that dilutes every existing shareholder
equally. New investors will often seek to refresh the option pool prior to the
round so as to bring it up to about 20% of the POST investment capital base
- Stock Ownership By Employees:
E s have to take this into account.
8. Vesting for Founders (and other protection):

- Most founders want full recognition for time spent developing the technology
 i.e., 100% vested
- Most VC s will refuse to invest unless a substantial portion of founders stock is
subject to standard vesting
 i.e., 20-30% vested only
 Administered as a buy-back
- Highly emotional, negotiated issue - leverage is everything
Vesting: you own all the shares but the company can buy back the shares at the
original price.
EXAMPLE: 4 year vesting with one year cliff:
Cliff
100,000
share
te
certifica
Cliff vesting* Vesting* of remaining 75,000 shares

at 1/36th per month (2,083 shares)
25,000 50,000 75,000
shares shares shares Fully
vested vested vested vested
1 year 2 year 3 year 4 year
*Unvested shares subject to company right to repurchase at

cost
Usually for CEOs.

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The employee is a key employee and get 100.000 shares. If you leave after 6 months, you
wont get what you could have gotten if you have staid and created value…
One year later, . shares will go to the employee, afterword s this will be calculated
monthly (no longer per year) and each month after Y1 the employee will get 2083
shares (75.000/36 months). And when the employee creates value, this is positive for
him as well because your shares will be worth more!
For founders, the situation is different, you would get the 25.000 immediately,
guaranteed because of the work you already have done before!
9. Play or Pay:
 Compels participation by existing investors in future rounds
 Carrot and stick approach to the next round
 Use of this provision is trending up in the current climate;
Especially where co-investors include lesser-known funds
If an investor cannot not provide a follow-up on finance, for instance there are 4
investors and 1 cannot follow, the other 3 will have to search for another + put more
money in that company which could damage their portfolio!  Play (invest) or Pay (be
punished): targeted towards investors that are already in the company and they will pay
if they cannot play, they will have to convert their preference shares into CS and they
will no longer have preferences while the remaining investors will enjoy better
preferences than you did at the original state.
10. Tag Alongs or Drag Alongs: (are actually exit provisions)

Tag Along
a. Investors have pro-rata right to participate in offer to buy another
investor s position
b. Generally standard, but compare to:
Drag Along
c. Give one investor or series the right to sell company and drag all other
investors into the sale
d. Inequitable when the series has > 1X liquidation
e. Negotiation push backs?
11. Milestones and Tranches:

- Role and importance of capital needs analysis
- Align capital needs with projected accomplishments
- Investors to preserve real option issue capital on milestone completion
a. Difficult to establish bright-line measures
b. Often price differential for each tranche
 Complex and costly to document
 Intensifies details on capitalization table
If investors dont believe these milestones will be achieved/delivered and VC leaves,
it will be dificult to find new ones.
12. Exit Provisions (realising return):

- Rights to approve or provoke sale of company
- Redemption rights

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 A redemption right is another feature of preferred stock. It lets investors

require the company to repurchase their shares after a specified period of
time.
- IPO rights (VC want to have the right of certain things concerning IPOs, having a
say in the IPO)
a. Threshold of offering
b. Selection of underwriter
c. Piggy-back rights: entitle investors to register their shares of common
stock whenever the company conducts a public offering, subject to certain
exceptions
5.4. Value adding and monitoring
Paper: VENTURE CAPITALIST GOVERNANCE AND VALUE ADDED IN FOUR

COUNTRIES. Sapienza, Manigart, Vermeir)
The rapid internationalization of markets for venture capital is exEXECUTIVE
panding the funding alternatives available to entrepreneurs. For venture
SUMMARY capital firms, this" trend spells intensified competition in markets' already"
at or past saturation. At issue for both entrepreneurs and venture capital
firms is how and when venture capitalists (VCs) can provide meaningfttl
oversight and add value to their portfolio companies beyond the provision
of capital. An important way VCs add vahte beyond the money they provide is through
their
close relationships with the managers of their portfolio companies. Whereas some VCs
take a very
hands-off approach to oversight, others become deeply involved in the development of
their portfolio companies. Utilizing surveys of VCs in the United States and the three
largest markets in Europe (the United Kingdom, the Netherlands, and France), we
examined the determinants of interaction between VCs and CEOs, the roles VCs assume,
and VCs' perceptions of how much vahte they add through these roles'. We examined the
strategic, interpersonal, and networking roles through which VCs are involved in their
portfolio companies, and we analyzed how successful such efforts were. By so doing we
were able to shed light on how and when VCs in four major markets expend their
greatest effort to provide oversight and value-added assistance to their investment
companies. Consistent with prior empirical work, we found that VCs san' strategic
involvement as their most important role, i.e., providing financial and business advice
and fimctioning as a sotmding board. They rated their interpersonal roles (as mentor
and confidant to CEOs) as next in value.
Finally, they rated their networking roles (i. e., as contacts to other firms and
professionab) as third most important. These ratings were consistent across all four
markets. VCs in tire United States and the United Kingdom were the most involved in
their ventures, and they added the most value. VCs in France were the least invoh,ed and
added the least vahw: VCs in France appeared to be least like others in terms of what
factors drove their efforts. Our theoretical models explained a greater proportion of
variance in governance and value added in the United States than elsewhere.
Clear patterns of behavior emerged that reflect the manner in which different markets
operate. Among the European markets, practices in the United Kingdom appear to be
most like that in the United States.

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Determinants of Governance (Face-to-Face Interaction)

We operationalized VC governance or monitoring of ventures as the amount of fiwe-to-
face interaction VCs had with venture CEOs. We found some evidence that VCs increase
monitoring in response to agency risks, but the resuhs were mixed. Lack of experience
on the part of CEOs did trot prompt significant additional monitoring as had been
predicted. A more potent determinant was how long the VC-CEO pairs worked together:
longer relationships mitigated agency concerns and reduced monitoring. Contra o, to
expectations, perceived business risk in the form ofVCs'satisfaction with recent venture
performance had little impact on face-to-face interaction. Monitoring was greatest in
early stage ventures, indicating that VCs respond to high uncertainty by increased
information exchange with CEOs. We measured two types of VC experience and found
different patterns for the two. Generally speaking, VCs with greater experience in the
venture capital industry required less interaction with CEOs, whereas VCs with greater
experience in the portfolio company's indust O' interacted more frequently with CEOs
than did VCs without such experience.
Determinants of Value Added

We argued that VCs would most add value to ventures when the venture lacked
resources or faced perceived business risks, when the task environment was highly
uncertain, and when VCs had great investing and operating experience. Contrary to
expectations, VCs added most vahte to those yentares already performing well. As we
had predicted, VCs did add relatively more value when uncertainty was high: e.g., for
ventures in the earliest stages and for ventures pursuing innovation strategies.
Finally, we found that VCs with operating experience in the venture's focal industry
added significantly more value than those with less industry-specific experience. These
results are consistent with anecdotal evidence that entrepreneurs have a strong
preference for VCs with similar backgrounds as their own. We found no evidence that
experience in tfre venture capital industry contributed significantly to value added.
Together, these results suggest that investigations of the social as well as economic
dimensions of venture building may prove a fruitful avenue for future study.
Overall, the resttlts showed that value-added is strongly related to the amount of face-
to-face interaction between VC-CEO pairs and to the number of hours VCs put in on each
individual venture.
In this old study, it seems that most VCs spends around 60% of their time on post-
investment activities.

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Study of Mirjam Knockaert. How frequently and important are these different activities?
The daily management (operational tasks) are rarely done. VCs activities are usually
more on a strategic level (hiring new CEOs and CFOs, less about hiring employees, using
their network, finding additional finance…
a. Exit
You have done the investment, after 3- years of involvement you hope to cash once
you exit the company.
These are diverse exit routes companies can take once they decided the do divestments.
Trade sales are where the firm sells to another firm. Sale to the management doesn t
occur often. IPO and quoted equity together is also rather rare.
You do not want to sell a bad firm to your colleagues, this would damage your
reputation and you wont be able to do business with them anymore with those investors
in the future.

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6. Performance
A. Portfolio company performance
What happens with the companies within these portfolios? Who can obtain VC and
what happens when they do?
Paper: On the life cycle dynamics of venture-capital- and non-venture-capital-

financed firms Manju Puri & Rebecca Zarutskie
This study compares VC-backed firms with non-VC-backed firms who do have
similar characteristics.
US-study.
Time zero = time of matching.
The growth in the number of employees is much higher and increases faster for VC-
backed firms. This is important looking from the perspective of the government since
VC is important to create jobs.

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Also sales are higher for VC-backed firms. Overall, VC-backed firms clearly grow
faster!
60000
Average Sales (thousand)
50000
40000
30000
US firms
20000 EU firms
10000
0
1 2 3 4 5 6 7 8 9 10
Years after VC investment
At matching time, there is no perfect matching between US en EU firms. When we

take a look at the average sales, something is more interesting in the US to get VC
over there…
180
160
Average employment
140
120
100
80 US firms
60 EU firms
40
20
0
1 2 3 4 5 6 7 8 9 10
Years after VC investment

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Also the sales of VC-backed firms in the US are higher en grow faster.
What distinguishes US-VC s from EU-VC s?

 US: In the initial round, the US-VC s do much more financing compared to the
ones in EU. This, to stimulate growth! (because of the higher initial financing,
there is more employment possible, more investment possible, the firms are
able to realise more…  so more funding!
 US: here VC s are more involved, helping in terms of recruiting strategy, with
finding more interested investment opportunities, which can result in higher
sales!  add more value!
 US: There, VC s can be more picky , selective because they have more start-
ups to select from (a bigger pool). This makes it also possible to develop
better selection capabilities  better selection! (probably)
 The size of the funds themselves are very different as well! For example: the
GP manages a fund of million invested by the LP s. This fund is then
divided and spread over the PC s portfolio companies AFTER subtracting
the fee for the GP of course (bv 90 million left). For BE, a fund of 100million is
already a lot. They spread the fund over the PC s and usually ot already stops
there. In the US, these funds can take up to 100 billion, which means they are
less restricted in the investment it wants to do, they enjoy advantages of
bigger scaled funds!
!!!! too big is also not good, not efficient…  EFFECIENCY SCALE: in BE below
this scale, in US the VC-market is better developed and more efficient.
 More certification. For instance, when a renowned investor like KKK invests
in your company, you get a KKK-stamp, a quality-stamp! if KKK wants to
invest in your company, people will think your company must be of great
quality…
B. Fund performance (VC as an asset class)
These are AVERAGES!

EU: IRR (internal rate of return)

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 last couple of years, VC doesn t really look interesting. VC have required

returns (in seed stage this can go up to 80%!) and as you see, it is not what you
will probably get ON AVERAGE! A lot of PC s fail and the good ones need to hit a
homerun to cover this but this is not always the case…
 VC s are involved in the early stage which means higher risks and again
translate into required higher returns. They find it hard to generate these returns
and need additional government intervention. That is where the government
comes in, they like the fact that these PC s, backed by VC s generate a higher
employment rate!
The previous slide was based on average numbers, but of course there are funds
that are very successful! When a GP generates a second fund, after the first one
was very successful, there will be a lot of competition between the LP s and the
GP will be able to negotiate better fees etc. (omgekeerd with unsuccessful funds)
Paper: The performance of private equity funds. Ludovic Phalippou &

Oliver Gottshalg)
Not so rosy as an asset class ON AVERAGE, but the top is able to raise sizable
returns!

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ACF Session 8: Buy-outs (BO)

1. Introduction
A buy-out is the process whereby a manager or management team—which may be

(part of) the existing team or one assembled specifically for the purpose of the buy-
out—acquires a business (the target) from the target's current owners.
 Later-stage investment
2. The different types and origins of buy-outs
• MBO: Management buy-out

– the present management of the target company is the driving force in the
purchase (existing man. Team together with financing party buys from the
current owners)
• MBI: Management buy-in
– an external management team acquires control of the target company
again with a financing party
– often initialised by the financing party, not so much by the management
team
• (Dis)advantages?
– MBI is more RISKY, the new man. Team is not experienced with the firm
– MBO has inside information, knows the company, knows the market…
– Why MBI? It might bring a new perspective…
• BIMBO: Buy-in management buy-out (combination of MBO & MBI)
– Part of the existing management team is being complemented with new
ones
 SBO: Secondary buy-out (buy-out after a buy-out)
– A target currently owned by a private equity provider and management is
acquired by another private equity provider who backs the same
management team.
– The management team and PE-player buys, a new PE providers backs up
the same management team and the previous PE-player can leave
– EXAMPLE: Pizza Hut, he was able the increase his stake by doing a second
BO (he became majority owner)
 Why could a sale to different financial investors still be attractive isn t the
lemon already completely squeezed ?
o When the previous PE-provider leaves, this is mostly the case when they
cannot provide more value… so why could it be interesting for a second
PE-player to come in?
– If the first PE-player was a smaller investor and there are so many growth
ambitions, a second bigger player is needed (usually from the UK or US,
there are the bigger ones)
– Time structure of the fund also plays a roll, the fund has a limited life time.
If you are at the end of the economic life and there is still a possibility to
add value, a SBO is a possible exit.
 LBO: Leveraged buy-out
– Heavily use of debt financing

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 MEBO: Management-employee buy-out

 IBO: Institutional buy-out
– Financial institution takes the lead and finds a suitable management team
Origin of Buy-outs: (where do BO come from, what would be the typical case of where
they emerge from?)
• Succession within family businesses
– Current managers wanting to give it through to family
• Divestment of a division
– A bigger corporation wants to get rid of a department, division and the
new management team sees value that the corporation can t see anymore
• Public-to-private transactions
– Why go from public to private? If you are a smaller firm on the market,
there will be a lack of liquidity and you wil have a lot of costs due to
providing information also about strategy or why a certain product launch
wasn t successful etc.
– through a MBO and sometimes it goes back public again
• The withdrawal of a different financial investor Secondary = SBO
3. The typical structure of buy-outs and the parties involved
Mostly a very simple structure, what follows is already even a more complex structure:
Most of the time, it is a simple structure: a management team teamed up with banks (not
even a PE-provider but it is also a BO)
Bigger companies will need more money to buy and therefore will use PE-providers.
Also the VENDORS might provide financing to still benefit if things go well.
 BANKS: mostly syndicate of banks and there friends lawyers, accounts,…
 INVESTORS (PE): also not only PE-players, but also there team of advisors…
 MANAGERS: this is also the case for the management team, they also bring their
people into the game
For a BO to take a place, a NEW entity, a new company will be established (with banks
giving debt to this new entity) and then the newco buys the target company.
Sometimes there is a newco1 (only equity) and a newco2 (equity & debt) and the latter
one buys the target company. Both equity and debt are important for the buyout!

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REMEMBER…
buyout on both sides of this slide: PE-backed!

BO is the biggest chunk in terms of numbers of investment
4. The sources of finance used to fund a buy-out
These are typically for

the management team
 SENIOR DEBT: Debt that takes priority over other unsecured or otherwise more
"junior" debt owed by the issuer. Senior debt has greater seniority in the issuer's capital
structure than subordinated debt. Debt can have different maturities which are in turn
connected with different returns. In the event the issuer goes bankrupt, senior debt
theoretically must be repaid before other creditors receive any payment. Protected with
collateral, lower risk.
 MEZZANINE FINANCE: subordinated debt (between equity and debt)
 REASONS TO MEZZANINE
The use of mezzanine debt provides benefits to both lenders and the borrowing
company. The company taking out the debt gets to borrow at a lower rate than it would

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pay on straight subordinated debt. A mezzanine type loan may be the only way that a
company can get a subordinated loan. The lender gets the benefit of participating in the
better results forecast by the additional borrowing. If the borrower is successful in
putting the newly borrowed mezzanine financing to work, the return to the lender will
be much higher than just providing a subordinated loan.
 ORDINARY SHARES: this is the other extreme, that has a lot of risk and in turn
requires a higher return
 BO uses all of these sources in a package to improve the financial structure and
increase return!
TERMS:
Vendor finance  when the vendors provide financing
Structuring a buy-out:
1. Determine how much finance is needed
- What is the target co worth it? (valuation plays a critical roll)
- What are the additional costs?
2. Ascertain how much of that finance can be taken as debt
- How much can you get from the banks? (cheapest source of
financing)
3. Determine how much funding the management team is able to invest

- what is the maximum amount the managers can invest?
- After the management funds, the cycle could stop here, but most of
the time you will need more
4. The balancing figure is normally supplied by the venture capital institution
 Each of the parties has different requirements to meet, each party has
different goals and ambitions (when a VC invest X, they will look how much
they can get back at exit)
Example: MDIS case:
• In March 1993 there was a management buy-out of MDIS, a computer business
owned by McDonnell Douglas
• The division was bought out for £ 125M

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 Value = 125 million pounds (normally you need to do the valuation yourselves)
 Debt = 60 (you do not want to raise too much debt, you need to be able to repay)
 Balance = 64 million
• How much of the ordinary shares (ownership%) would you provide to the
management team?
 You would expect 2% (1/65)
 BUT: this is not interesting for the management team to work there ass of but
to only get 2%... they do more efforts, they make more costs
 Solution: DIFFERENTIAL PRICING: they will get shares at lower prices:
o Determining the equity split: Give management proportionately more
of the equity than their investment alone warrants
o For instance, management can buy ordinary shares at £1 each, but PE
institutions pay £10 per share – Management get13,5 % of the equity
o Man.team get 1000.000 shares (1 pound) and VC: 64000.000 (10)
o Any problems?
If someone wants to boy the company at 5 pounds/share, this would
be great for the man.team but very bad for the VC. This could create
conflict between the two
 in reality: a combination of things
1 year later after the initial investment, a BO takes place at 250 million pounds.
First repay debt (15M has already been paid, so 45M left to repay).
After debt is repayed, the preferences shares are next, followed by the ordinary shares.
Those will be split by using the 15% and 85%.

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ENTRY RATIO:
- 75,2= 64/0,85= implied value of the company
- 6,7=1/0,15=implied company of the company
 11,2. In reality this can take a number up to 40! It tells us that the
shares are expensive for the BO-investors compared to the man.team.
The purpose is to increase this ratio from the perspective of the BO-
investors.
5. The process by which the transaction takes place, monitoring & value adding
and exit
When we compare this proces with the one of the VC, there are 2 main differences in the
following 2 steps.
 in STEP 1: Beauty contest: intermediaries organise this contest, they contact BO-
investors with a business plan made by the man.teams. The intermediaries choose the
most pretty one. This is different from the process with VC, because with a BO, the
business is already there and you do not need to build the company from scratch VC s
do). (DCF techniques used for BO!)
 in STEP 4: the term sheet negotiation includes very different contract clauses (not
rounds in this case, but only 1 specific deal which needs to be structured)

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Sources of value creation:
What are the options?

4 paths: (volgorde volgens IMPOTANCE)
1) A higher EBITDA: Optimize operating cash flows and balance sheet
- Realizing higher sales volumes at the same selling prices and margins;
- Realizing higher gross margins, either by using higher selling prices or by
negotiating lower purchase prices;
- Reducing costs by working more efficiently.
- Non-productive assets and working capital: cleaning B/S via reducing WCR,
selling irrelevant assets.
2) Time
- Increase the growth expectations (going from a stable situation to (again) an
increase via for instance establishing new markets)
- Reduce the risk
3) Repayment of debt (specialiteit van de BO)

Simple example: at the time of the buy-out the firm creates an EBITDA of 100
and the firm is valued at 500, or 5 times EBITDA. The transaction is financed
with 200 share capital (provided by both private equity investors and
management and debt. The firm s EBITDA remains constant after the
buy-out; half of this (50) is used to service the debt. If the company is sold
after 5 years (at the same EBITDA-multiple of 5) -- average annual return for
the shareholders?
 only debt is being repaid nothing else!
 value is again 500, 5X50=250 is repaid after 5 years
500-50 (300-250=50 is what you still need to repay) = 450 left for SHs
 Initial 200 = 450/(1+r)^5  r=18%
In this example, there were no operational clean-ups, used the same
multiple… Only the debt was being repaid and that gives you a 18% return!
(this was however without taking transaction costs into account)

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4) Higher multiple upon exit (you hope for this)

- Buy low, sell high : buy when multiple is low and sell when it is high. This is
not sustainable however, predictions are mostly wrong!
- Not a sustainable investment policy
Ethical issues:
Do PE investors really add value or

• are they fast-buck artists ,
• who destroy employment,
• evade taxes (for instance, by using debt financing to take advantage of i-
deduction), and
• cause financial distress in portfolio firms through excessive leverage (ontex).
Academic research ON AVERAGE (there are cases with good or bad news too)
• Financial performance generally improves after the buy-out (e.g., Cressy,
Munari and Malipiero, 2007; Guo, Hotchkiss and Song, 2011).
• 70% of buy-outs remain in the possession of the PE investors for five years or
longer (Strömberg). So those fast-buck artists are very exceptional.
• For employment the answer is more complex (e.g., Davis, Haltiwanger, Jarmin,
Lerner and Miranda, 2011; Lutz and Achleitner, 2009), i.e. PE investors are
neither angels nor demons
 some studies say an increase, others say a decrease
 a combination of studies: the first 3 years the employment decreases
(restructuring and some activities are less relevant) BUT from Y4 and Y5
the employment increases and they get higher wages, mostly because of
they hire of more skilled people.
 so not necessarily a bad thing for employment, there is a shift between
the types of employment.

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ADVANCED CORPORATE FINANCE DEEL 1

Slide 1,2,3 p.3

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MODELS OF CREDIT RATIONING:

IMPLICATIONS OF FINANCIAL CONSTRAINTS FOR:

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PAPER ZIA (2008)

PARER CAMPELLO (2010)

PAPER DESAY (2008)

PAPER CHODOROW-REICH (2014)

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Measuring financial constraints

𝐼/K =𝑄+𝐶𝐹/K+𝐶 𝑙 +ε 𝐾 :(estimated)

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I: investment level of every firm

Low dividend payout firms High dividend payout firms

KAPLAN AND ZINGALES:

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INDICES TO MEASURE FINANCIAL CONSTRAINTS

1) KAPLAN-ZINGALES INDEX (KZI)

2) WHITED-WU INDEX (WWI)

They built a structural model of investment, where financial constraints show up

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3) HADLACK-PIERCE INDEX (HPI)

DIRECT MEASURES OF FINACIAL CONSTRAINTS (survey data)

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EXAMPLE SURVEY RESEARCH SLIDES different parts p. …

1) Application for bank loans by SMEs across euro area countries

TAKING INDERICT AND DIRECT MEASURES INTO ACCOUNT:

What are the determinants of access to external finance?

AT FIRM LEVEL AT COUNTRY LEVEL

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IMPACT OF CREDIT INFORMATION:

ESTABLISHEMENT OF A PRIVATE BUREAU VS PUBLIC REGISTER

WHAT ABOUT DISCOURAGED BORROWERS?

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1. What drives discouragement?

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2. Are there real effects of discouragement? Due to the lack of loans?

3. Would discouraged borrowers be able to obtain bank loans?

If approval = 1: applied + approved In this step we do not take DB into account

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4. Why would discouraged borrowers (not) be able to obtain loans?

 Altman Z-score: DB have lower Z-scores, so they are more risky.

ACF Session 3: Capital Structure

A benchmark: M&M irrelevance propositions.

The return on assets depends on the type of mortgage we take.

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What does change with the size of the mortgage?

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No taxes, in other words neutral taxes with no impact on the WACC.

2. When is capital structure relevant?

DEBT AND TAXES:

Levered firm has a total value > unlevered firm

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Trade-off theory: (zie verder ook)

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