Venture Capital and the Finance of Innovation

575 Pages·2011·6.31 MB·English

by  Andrew Metrick

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VENTURE CAPITAL &
THE FINANCE OF
INNOVATION
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VENTURE CAPITAL &
THE FINANCE OF
INNOVATION
SECOND EDITION
ANDREW METRICK
YaleSchoolofManagement
AYAKO YASUDA
GraduateSchoolofManagement,UCDavis
John Wiley & Sons, Inc.
EDITOR LaceyVitetta
PROJECTEDITOR JenniferManias
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LibraryofCongressCataloging-in-PublicationData:
Metrick,Andrew.
Venturecapitalandthefinanceofinnovation/AndrewMetrick,AyakoYasuda.—2nded.
p.cm.
Includesindex.
ISBN978-0-470-45470-1(hardback)
1. Venturecapital. 2. Technologicalinnovations(cid:1)Finance.I.Yasuda,Ayako.II.Title.
HG4751.M482010
332u.04154—dc22
2010020655
PrintedintheUnitedStatesofAmerica
10987654321
BRIEF CONTENTS
PREFACE TO 2ND EDITION—A READER’S GUIDE vii
ACKNOWLEDGMENTS xiii
CONTENTS xvii
PARTI
VC BASICS
CHAPTER1 THE VC INDUSTRY 3
CHAPTER2 VC PLAYERS 21
CHAPTER3 VC RETURNS 46
CHAPTER4 THE COST OF CAPITAL FOR VC 65
CHAPTER5 THE BEST VCs 83
CHAPTER6 VC AROUND THE WORLD 99
PARTII
TOTAL VALUATION
CHAPTER7 THE ANALYSIS OF VC INVESTMENTS 123
CHAPTER8 TERM SHEETS 146
CHAPTER9 PREFERRED STOCK 163
CHAPTER10 THE VC METHOD 178
CHAPTER11 DCF ANALYSIS OF GROWTH COMPANIES 195
CHAPTER12 COMPARABLES ANALYSIS 214
v
vi BRIEFCONTENTS
PARTIII
PARTIAL VALUATION
CHAPTER13 OPTION PRICING 231
CHAPTER14 THE VALUATION OF PREFERRED STOCK 252
CHAPTER15 LATER-ROUND INVESTMENTS 272
CHAPTER16 PARTICIPATING CONVERTIBLE PREFERRED STOCK 290
CHAPTER17 IMPLIED VALUATION 305
CHAPTER18 COMPLEX STRUCTURES 320
PARTIV
THE FINANCE OF INNOVATION
CHAPTER19 R&D FINANCE 339
CHAPTER20 MONTE CARLO SIMULATION 357
CHAPTER21 REAL OPTIONS 378
CHAPTER22 BINOMIAL TREES 400
CHAPTER23 GAME THEORY 419
CHAPTER24 R&D VALUATION 445
APPENDIXA SAMPLE TERM SHEET 466
APPENDIXB THE VCFI SPREADSHEETS 484
s
APPENDIXC GUIDE TO CRYSTAL BALL 487
GLOSSARY 512
INDEX 535
ND
PREFACE TO 2 EDITION—
A READER’S GUIDE
Many interesting developments have occurred in the world of venture capital since
thepublicationofthefirsteditionofthisbookin2006,whichpromptedustorevise
the book for the second edition. While the organization of the book remains
unchanged,manyofthechaptersaresubstantiallyrewritten.Forexample,inChapter
5, we re-ranked top VC firms, incorporating the latest performance statistics, fun-
draising and investment activities, notable exits, and (as always) our subjective
opinions. InChapter6,we examine further evidence ofthe deepening globalization
of the industry. In Chapters 3, 4, and 7, we analyze the impact of the 1999(cid:1)2000
InternetbubbleyearsontheVCriskandreturns,asinvestmentsmadeinthoseyears
are finally mature and thus now a part of the performance evaluation analysis. We
also incorporated expositional improvements throughout the book based on reader
feedback on the first edition.
AnotherfeatureoftheneweditionisthattheVCVmodel,usedextensivelyin
PartIIIofthebook,isnowavailableasaWeb-basedapplicationavailableonhttp://
VCVtools.com. Significant collaborative efforts went into developing this tool,
which we believe will be of interest to a broad audience, including practitioners
interested in valuing VC-backed company stocks and employee stock options.
THE ORGANIZATION OF THIS BOOK
Thebookisdividedintofourparts,withsixchapterseach.Eachofthesefourparts
hasamajorfinancetheme:thethemeofPartIistherelationshipbetweenriskand
return;thethemeofPartIIisthevaluationofhigh-growthcompanies;thethemeof
Part III is the analysis of capital structure; and the theme of Part IV is the rela-
tionship between strategy and finance. Overall, Parts I and II are heavy on data
anddefinitionsandareintendedtoprovidestudentswiththevocabularyofVCand
knowledge of the key industry facts. Although these two parts contain some new
definitions and approaches, most of the material should seem familiar to a VC
practitioner.Incontrast,PartsIIIandIV aremoretheorybased andprovide anew
perspective on the evaluation of VC and other high-technology investments.
Although these latter two parts might seem experimental to a practicing VC,
financial economistswill recognizethe material asa straightforwardtranslation of
well-known methods.
vii
viii PREFACETO2NDEDITION—AREADER’SGUIDE
In Part I, “An Introduction to VC”, we provide an overview of the VC
industry,withdiscussionsofhistory(Chapter1),majorplayers(Chapters2and5),
performancemeasurement(Chapters3and4),andglobalpatterns(Chapter6).The
discussionofriskandreturninChapters3and4provideakeytranslationbetween
thelanguageofVCandthelanguageoffinancialeconomics—atranslationthatwe
rely on heavily throughout the book.
In Part II, “Total Valuation”, we provide data and methods used to value a
high-growth company. We first review the investment process used by VCs and
provide data on their historical performance (Chapter 7). We next describe the
structure of VC transactions (Chapters 8 and 9) and then demonstrate the industry-
standardtechniqueforthevaluationofVCinvestments(Chapter10).Thistechnique,
known loosely as “the venture capital method”, requires that analysts estimate
company values far into the future. Although such estimates will always contain a
fair amount of guesswork, we show how to use a “reality-check” model to frame
theseestimates(Chapter11)andhowtouseevidencefromcomparablecompaniesto
provide an additional input for the investment decision (Chapter 12).
In Part III, “Partial Valuation”, we take the total valuation (Part II) as given
and analyze the special features of VC transactions. In most VC transactions, the
investors receive preferred stock with several special features. When there are
manyVCinvestors,thecapitalstructureofthecompanygrowsquitecomplex,with
each investor holding a unique place in the capital-structure hierarchy of the
company.InPartIII,weshowhowtodividethetotalvaluationofthecompanyinto
its component parts (partial valuation) for each investor. The key step in this
analysisistherecognitionthatallflavorsofpreferredstockcanberepresentedasa
portfolioofoptions.InChapter13,weshowhowtheclassicoption-pricinganalysis
ofBlackandScholescanbeextendedtoVCsettings.Wethenapplythisextended
analysis to the valuation of preferred stock (Chapters 14, 15, and 16). The tech-
niques used in these chapters can also be used to refine some industry-standard
measures of company valuation (Chapter 17) and to estimate the partial valuation
of complex nonstandard transaction structures (Chapter 18).
PartsIIandIIIofthebooktaketheperspectiveofaventurecapitalistmaking
aninvestmentinahigh-technologycompany.InPartIV,wetaketheperspectiveof
thecompanydecidingwhattodowithVCmoneyorothercapital.Specifically,we
develop a framework for modeling investment in “research and development”
(R&D). Since VC-backed companies typically spend a significant fraction oftheir
capitalonR&D,anunderstandingofR&Dfinanceiscrucialforboth VCsandfor
financial decision-makers at technology companies of all sizes. After introducing
typical kinds of R&D investment problems (Chapter 19), we study several of the
most interesting and cutting-edge techniques in finance, including Monte Carlo
analysis (Chapter 20), real options (Chapter 21), binomial trees (Chapter 22),
andgametheory(Chapter23).InChapter24,wepullallofthesetoolstogetherand
solve the investment problems originally posed in Chapter 19.
Several appendices supplement the text. Appendix A provides an example
“term sheet” VC contract developed by the National Venture Capital Association.