Chapter 16

THE FUTURE OF
ENTREPRENEURIAL FINANCE:
A GLOBAL PERSPECTIVE

Material from ENTREPRENEURIAL FINANCE: STRATEGY, VALUATION, AND DEAL STRUCTURE, by Janet Kiholm Smith, Richard L. Smith, and Richard T. Bliss, © by Stanford University, all rights
reserved. Instructors may make copies of PowerPoint Presentation contained herein for classroom distribution only. Any further reproduction, distribution, or use of this material, in any way or
by any means, is strictly prohibited without the prior written permission of the publisher.
 Learning Objectives
• Review conceptual differences between entrepreneurial
and corporate finance
• Describe methods for addressing the challenges of
entrepreneurial finance
• Recognize the potential for new research to address the
unresolved issues related to entrepreneurial finance
• Understand how international differences contribute to
variations in entrepreneurial activity
• Understand that change in the market for new venture
creation and financing is inevitable
• Recognize the implications of change for new venture
investors and entrepreneurs
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 Completing the Circle
• Then entrepreneur’s investment and financing
decisions are interdependent
• Investment value depends on the entrepreneur’s
ability to diversify
• Evaluating the role of active investors
• Dealing with information problems
• Contracts that align incentives
• Evaluating real options and strategic choices
• Harvesting the investment
• Evaluating opportunities from the entrepreneur’s
perspective
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 Completing the Circle
• The entrepreneur’s investment and financing
decisions are interdependent
– underdiversification exposes the entrepreneur to
venture-specific risk
entrepreneur’s required rate of return will be higher
a diversified investor will place a greater value on the
venture
– financial contracts that allocate more venture risk to
the diversified investor can enhance project value
and make all claims worth more

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 Completing the Circle
• Investment value depends on the entrepreneur’s
ability to diversify
– the entrepreneur’s required return depends on the
fraction of total wealth committed to the venture
– total wealth includes financial and human capital
– greater wealth  more ability to diversify
– reducing entrepreneur’s investment can enhance
value
• pursue the venture on a smaller scale
• bring in an outside investor
• reduce the duration of the commitment
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 Completing the Circle
• Evaluating the role of active investors
– angel investors and VC firms are often involved in
managerial aspects of a venture
– active investors expect a return on both financial
and human capital investments
– the involvement of investors can add value by
changing both expected return and risk

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 Completing the Circle
• Dealing with information problems
– information asymmetry creates a significant
barrier to attracting outside investment
– entrepreneurs are often overly optimistic about
the ventures prospects
– ways to overcome information problems
• business plan
• milestones/staging
• reputation
• certification
• perfomance-based ownership/compensation
• signaling
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 Completing the Circle
• Contracts that align incentives
– entrepreneur must have incentive to exert
maximum effort
– incentive conflicts among investors
• creditor may prefer security over venture value
• Evaluating real options and strategic choices
– new ventures often represent a portfolio of real
options, which may be interdependent
– analyze using decision trees, game trees, and
simulation

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 Completing the Circle
• Harvesting the investment
– harvesting alternatives can have a significant
impact on venture value
– the investment decision is often based on certain
assumptions about harvesting
– parties to the venture may have different
incentives when it comes to harvesting
– market conditions may impact harvesting options

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 Breaking New Ground

• Extending portfolio theory to consider high-risk

investments
• Valuing high-risk, long-term investments
• Valuing portfolios of complex real options
• Assessing the risk characteristics of new venture cash
flows
• Valuing multiple-period cash flows from an
underdiversified entrepreneur’s perspective
• Choosing between corporate and private
entrepreneurship

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 Breaking New Ground (cont’d.)
• Is persistent venture capital firm success due to skill or
good luck?
• How do financial wealth and the opportunity cost of
human capital affect an individual’s decision to undertake
a high-risk entrepreneurial venture?
• How does the rate of innovation affect the allocation of
resources devoted to entrepreneurial activity?
• How can entrepreneurial activity be promoted in
organizations?
• What social and economic institutions foster
entrepreneurial activity and can communities develop
such institutions?
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 Public Policy and Entrepreneurial Activity
• Can innovation and entrepreneurial activity be
fostered by public policy?
– U.S. and other countries’ success with high-tech, high-
growth ventures
• Distinction between opportunity-based and necessity-
based entrepreneurship
• Early-stage entrepreneurial activity by country (Figure
16.1)
– agrarian economies have high levels of entrepreneurial
activity
– industrialize countries with large, established companies
have lower entrepreneurial activity
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Figure 16.1

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 Public Policy and Entrepreneurial Activity
• Amount and source of R&D funding (Figure 16.2)
– wealthier countries have high levels of R&D, primarily
from business expenditures
– in countries with relatively low R&D spending, most
of the funding is from non-business sources

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Figure 16.2

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 Public Policy and Entrepreneurial Activity
• Categorizing countries by their comparative
advantage (Porter 1990)
– factor-driven
• rely heavily on natural resources
– efficiency-driven
• small and medium-size manufacturing; productivity
focused
– innovation-driven
• mature economies; shift to service sector
• Prevalence of high-growth entrepreneurship
(Figure 16.4)
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Figure 16.4

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 Public Policy and Entrepreneurial Activity:
Some Caveats
• Fostering entrepreneurial activity means tradeoffs
– may conflict with existing social mores
– can interfere with labor market dynamics
– may divert resources from established businesses
• Policymakers must have clear objectives in mind
– institutional entrepreneurship or individual initiative
– necessity vs. opportunity-driven
– innovative vs. replicative entrepreneurship

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 The Role of Institutional Structure in Stimulating
Entrepreneurial Activity
• An institutional structure likely to stimulate new
venture activity does the following:
– facilitates assessment of risks and rewards
– limits exposure to risk and increases expected rewards
– both facilitates and limits risk-taking by the entrepreneur
– includes patient investors with minimal need for liquidity
– has a tax system which favors capital investment
– facilitates diversification and pooling of risk
– provides easy access to public capital markets
– makes investment decisions that are predominantly
market-driven
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 The Role of Institutional Structure in Stimulating
Entrepreneurial Activity
• Facilitates assessment of risks and rewards
– accessible, reliable and low-cost information on market
size, characteristics, production and distribution costs, etc.
– clustering of new ventures can facilitate information flow
– rise of the Internet and other technological advances
• Limits exposure to risk and increases expected
rewards
– establishment and enforcement of property rights (both
formally and informally)
– protection of intellectual property

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 The Role of Institutional Structure in
Stimulating Entrepreneurial Activity
• Both facilitates and limits risk-taking by the entrepreneur
– bankruptcy laws limit downside risk to the entrepreneur
– institutional and societal acceptance of failure
– labor force mobility
• Includes patient investors with minimal need for liquidity
– pension funds, endowments, and other institutions that can invest
significant sums in new ventures
– preference for equity, precludes most banks
– Investors bring technical and managerial expertise

– has a tax system which favors capital investment

– facilitates diversification and pooling of risk
– provides easy access to public capital markets
– makes investment decisions that are predominantly market-driven
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 The Role of Institutional Structure in
Stimulating Entrepreneurial Activity
• Has a tax system which favors capital investment
– tax systems based on income (vs. value added) encourage
entrepreneurial activity
– low capital gains tax rates and the ability to defer/time
gains encourages investment in new venture equity
• Facilitates diversification and pooling of risk
– VC funds and angel groups
– syndication of investments

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 The Role of Institutional Structure in
Stimulating Entrepreneurial Activity
• Provides easy access to well-functioning, public
capital markets
– allow investors and entrepreneurs to diversify more easily
– provide monitoring and a way to incentivize and
discipline managers
– facilitates exit strategies with lower transaction costs
– disclosure requirements and efficient information
transmission allow companies to go public sooner

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 The Role of Institutional Structure in
Stimulating Entrepreneurial Activity
• Makes investment decisions that are predominantly
market-driven
– subsidized programs can lower the cost of funds and
foster entrepreneurial activity
– capital allocation decisions should still be driven by a
profit motive and competition for funds

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 The Future of Entrepreneurial Finance
• Methods of selecting new venture investment
opportunities will improve
– investors and entrepreneurs will develop better
methods for deciding whether to pursue
opportunities
– data available for assessing potential rewards and
risks can be expected to get better and more
accessible
– better ways to structure deals will be developed

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The Future of Entrepreneurial Finance (cont’d.)

• Changes in the set of investment opportunities

will threaten existing institutions
– the rate of technological progress will change
– the direction of technological progress will change
– promising new opportunities can arise anywhere
– clustering of entrepreneurial activity will persist

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The Future of Entrepreneurial Finance (cont’d.)
• Changes in the competitive climate threaten
existing institutions
– competition among investors will intensify
– competition among investors will be increasingly
global
– the rate at which capital flows to new opportunities
can be expected to increase
– new competitive structures will emerge

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