Chapter 26—Entrepreneurial Finance and Venture Capital
MULTIPLE CHOICE
1. In the United States, the dominant source of venture capital funding today is from:
a.
Institutional investors
b.
Private U.S. individuals
c.
Private foreign individuals
d.
Bond issues
e.
Preferred stock issues
2. The venture capital contract allocates risk, return, and ownership rights between the entrepreneur and
the venture capital fund. The distribution of rights and responsibilities depends on all but which of the
following:
a.
The experience and reputation of the entrepreneur
b.
The attractiveness of the portfolio company as an investment opportunity
c.
The stage of the company’s development
d.
The negotiating skills of the contracting parties
e.
The distribution depends on all of the above.
3. Venture capitalists look to invest in companies with the potential of going public or being acquired at a
premium within a few years, and which offer investment returns of __________ % per year.
a.
10-15
b.
20-30
c.
25-50
d.
50-75
e.
at least 100
4. __________ are subsidiaries of financial institutions, particularly commercial banks.
a.
Financial venture capital funds
b.
Corporate venture capital funds
c.
SBICs
d.
Angel capitalists
e.
All of the above
5. Venture capitalists use __________ to minimize their risk exposure and to deny or delay additional
funding.
a.
participation rights
b.
staged financing
c.
ratchet provisions
d.
redemption options
e.
ownership right agreements
6. The financing of entrepreneurial growth companies (EGCs) differs from financing for mature, publicly
traded firms in that:
a.
EGCs rely heavily on external private equity while mature firms favor retained earnings
b.
EGCs can easily access public stock markets through IPOs whereas mature firms must
make frequent seasoned offerings
c.
EGCs are able to take advantage of the most economical form of funding-“bootstrap
finance”, while mature firms rely heavily on expensive outside equity financing
d.
EGCs typically face low cash requirements due to extreme profits from rapid growth,
whereas mature firms require increasing amounts of external financing to fund projects
e.
EGCs face few informational asymmetries when arranging financial contracts with
venture capitalists, while the management of a mature firm has a much better
understanding of future prospects compared to the firm’s potential shareholders
7. A firm with high levels of intangible assets is more likely to finance its operations with equity rather
than debt because:
a.
without tangible assets, equityholders are no longer residual claimants
b.
without tangible assets as collateral, the cost of debt significantly increases
c.
without tangible assets, it is difficult to achieve the rapid growth required by debt
providers
d.
equity provides a large pool of potential funding, which is therefore more accessible than
debt
e.
equityholders are more likely to excessively gamble on high potential payoffs
8. __________ provide large amounts of private equity funding to entrepreneurial growth companies
(EGCs) each year on a personal, more informal basis.
a.
Small business investment companies
b.
Financial venture capital funds
c.
Angel capitalists
d.
Corporate venture capital funds
e.
Venture capital limited partnerships
9. Limited partnerships are the dominant form of venture capital funds; however, this organizational
structure may encounter difficulties because:
a.
of numerous government regulations limiting the type of investments allowed
b.
they are unable to attract the best employees
c.
the “single-industry” focus related to the expertise of the general partners does not allow
for diversification benefits
d.
they must commit both capital and technical expertise to portfolio companies
e.
none of the above
10. Pat N. Pending is hoping to secure venture capital investment for her new firm. If Pat is involved in the
__________ industry and is located in __________, her chances of receiving funding will be
improved.
a.
health care; Texas
b.
financial services; New York
c.
biotechnology; New England
d.
information technology; California
e.
energy; Alaska
11. Staged financing refers to:
a.
VC investment in start-up firms, early-stage expansion spending, or later-stage funding for
mature companies
b.
the practice of VC partners initially providing capital commitments which are
subsequently drawn out in stages over time
c.
the practice of VCs initially advancing funds to a company with the requirement that
certain performance objectives be met before the next stage of funding commences
d.
the extensive and sophisticated covenants employed in VC investment contracts which
preserve exit opportunities at various stages of commitment
e.
the almost exclusive reliance on convertible securities in VC contracts which allow
participation in upside gains in many stages of EGC expansion
12. VCs most often receive some form of convertible security in exchange for their capital. This form of
financing is optimal for both the VC and entrepreneur because:
a.
it decreases the VC’s risk yet maintains their right to participate in upside potential, while
allowing the firm to construct a variety of contracting arrangements with different investor
groups
b.
it provides a steady cash flow to VCs while simultaneously placing the entrepreneur ahead
of the VCs as claimant if the firm fails
c.
it provides participation in upside gains and allows the entrepreneur to initially transfer
more of the firm’s business risk to VCs
d.
it allows VCs to exercise control over the entrepreneur while providing the entrepreneur
full rights to all upside gains
e.
it offers VCs the opportunity to decrease risk while offering entrepreneurs the opportunity
to enhance their position as claimant if the firm fails
13. Responding to the claim that venture capitalists exploit struggling entrepreneurs, the CEO of a VC
fund states that roughly half of their investments are complete write-offs. If a VC fund loses l% of its
investment in k of the s entrepreneurial growth companies it supports, what average return is required
on the n profitable investments in order that the VC fund achieves a portfolio return of r%?
a.
w1%
b.
w2%
c.
w3%
d.
x%
e.
w4%
14. Which of the following is not a differentiating feature of venture capital and private equity funds from
the typical publically traded financial corporations?
a.
Venture capital and private equity funds are relatively free from the Securities Act of 1933
b.
Venture capital and private equity funds are relatively free from the Security Exchange
Act of 1934
c.
Venture capital and private equity funds are relatively free from the Investment Company
Act of 1940
d.
Venture capital and private equity funds are relatively free from the Bank Holding
Company Act of 1937
15. Rank from low to high the asset values
a.
Venture Capital Funds, Hedge Funds, Pension Funds, Bank Assets
b.
Hedge Funds, Venture Capital Funds, Pension Funds, Bank Assets
c.
Hedge Funds, Pension Funds, Venture Capital Funds, Bank Assets
d.
Hedge Funds, Pension Funds, Bank Assets, Venture Capital Funds
16. Which of the following types of Venture Capital Funds are associated with Commercial Banks?
a.
Small business investment companies
b.
Corporate venture capital funds
c.
Financial venture capital funds
d.
Venture capital limited partnerships
17. In the United States, firms in which state receive the greatest amount of venture capital investments?
a.
New York
b.
Texas
c.
Florida
d.
California
18. The term sheet _____________ protects the venture group’s ownership rights in the event that the firm
sells new equity shares under duress
a.
Ownership right agreements
b.
Ratchet provisions
c.
Repurchase rights
d.
Stock option plans
19. The term sheet ______________ allocates board seats and voting rights to the venture capital group
a.
Ownership right agreements
b.
Ratchet provisions
c.
Repurchase rights
d.
Stock option plans
20. The current typical capital structure of private equity funds is
a.
10% Equity 90% Debt
b.
20% Equity 80% Debt
c.
30% Equity 70% Debt
d.
100% Debt
MATCHING
Match the following terms with their best description:
a.
preserve exit opportunities for VCs
b.
specify the distribution ownership
c.
protects the venture group’s ownership
d.
provide incentives for portfolio-company managers
1. ratchet provision
2. demand registration rights
3. participation rights
4. repurchase rights
5. stock option plans
6. ownership right agreements
Match the term with the correct description:
a.
Financial venture capital funds
b.
Angel capitalists
c.
Small Business Investment Companies (SBICs)
d.
Venture capital limited partnerships
e.
Corporate venture capital funds
7. Subsidiaries or stand-alone firms established by non-financial corporations eager to gain access to
emerging technologies by making early-stage investments in high-tech firms
8. Subsidiaries of financial institutions generally set up both to nurture portfolio companies that will
ultimately become profitable customers of the corporate parent and to earn high investment returns
9. Funds established by professional venture capital firms which act as the general partners in organizing,
investing, managing, and liquidating the capital raised from other partners
10. Wealthy individuals who make private equity investments on a more ad hoc basis
11. Federally chartered corporations established as a result of the Small Business Administration Act that
invest in entrepreneurial growth firms
SHORT ANSWER
1. Define modern venture capital.
2. What are two features of early venture capital funds that can still be observed today?
3. What was the fundamental change in the U.S. venture capital market that occurred during the late
1970s, and what factors drove the change?
4. What is the reason for the success enjoyed by institutional venture capitalists?
5. What effect does the stage of company development have on the VC financing?
6. What does the distribution of rights and responsibilities in the venture capital contracts depend on?
7. What is the purpose of putting covenants in the venture capital investment contract?
8. Why do VCs almost always receive some type of convertible security instead of common stock for
their investment in a firm?
9. New Venture Corporation (NVC) is negotiating funding from a venture capital fund. After some
intense negotiations the parties agree with NVC on funding of $f0 million for a r% annual expected
return. They agree that NVC will execute an IPO in t years at which time the firm is expected to have
net profits of $np million and to sell at a P/E ratio of pe, which would put the company’s value at $cv
million.
a.
What is the value of the venture capital company’s stock in NVC immediately following the
IPO?
b.
What portion of NVC’s equity (in part a.) will the venture capital fund receive?
c.
How will your answers change in parts a. and b. if the venture capital fund requires a cr%
return?
the experience and reputation of the entrepreneur
b.
the attractiveness of the portfolio company as an investment opportunity
the stage of the company’s development
d.
the negotiating skills of the contracting parties
the overall state of the VC market
10. How do VCs exit an investment?
11. What are the areas of differences between European and U.S. venture capitalists?
12. Explain why entrepreneurial financing decisions are so heavily influenced by informational
asymmetries between the owner and provider of funds. How does this informational asymmetry affect
the relationship with suppliers of capital?
13. Discuss the historical significance for venture capital financing in the United States of the following
two events that occurred in the 1970s:
•
reduction in the top personal income tax bracket from 35 to 28 percent, and
•
the “Prudent Man Rule”
14. You run a large venture capital portfolio. Your required return on the overall portfolio is a percent.
Your portfolio is comprised of p projects. Unfortunately, each project has a substantial probability of
losing all invested capital. If this happens you lose your entire investment in that firm. How much do
you need to charge each project to ensure that your expected overall return will be a percent if the
likelihood of failure for each project is
a.
0 percent
b.
b1 percent
c.
c1 percent
15. The relationship between venture capitalists and investors is riddled with agency problems. Describe
some of the characteristics of investments in entrepreneurial projects that make the agency problem
difficult to manage.
16. Staged financing is often used to provide funding for new ventures to limit risk exposures. Explain the
concept of staged financing and discuss how it mitigates the potential misuse of funds available to
entrepreneurs. In particular, how might an entrepreneur invest excess capital if future prospects looked
dim and staged financing was not employed?
17. Advanced Computer Works Corporation (ACW) has approached a venture capitalist for $c0 million in
new funding to support the firm’s rapid growth. The risk of ACW is such that the venture capitalist is
entitled to r% compound annual (expected) return. Both parties agree that ACW should plan to execute
an IPO in three years at which time the firm is expected to have net profits of $np0 million and to sell
at a price / earnings ratio of er. What would be the percent equity stake the venture capitalist will
receive in exchange for its $c0 million investment?
ESSAY
1. Limited partnerships are the dominant form of business organization in the venture capital industry.
Discuss the drawbacks associated with the other three types of institutional venture capital funds.
2. Critically assess the following statement:
“The rates of return required by venture capital funds are exorbitant. New firms are often charged in
excess of 50 percent. In addition, new start-up ventures are charged the most, when they can least
afford to pay. Government regulators need to step in and limit the required rates of return charged by
venture capitalists.”
3. Describe the magnitude of the investment returns expected by venture capitalists from their portfolio
companies and the justification for them.
4. Entrepreneurial growth companies differ from large, publicly traded firms in four important ways.
Discuss the four ways.
5. Why do EGCs frequently rely on private equity financing?
6. The sponsoring firm acting as the general partner for a venture capital limited partnership has four
main responsibilities. What are they?
7. Compare / contrast venture capital funding in the United States and Europe.