Entrepreneurial Finance: This article will be the first in a series I am running on the subject of entrepreneurial finance. Entrepreneurial Finance is the process of making financial decisions for new ventures. New ventures are inherently different from established ventures, as are entrepreneurs inherently different from conventional business managers. The financial decisions faced by each are starkly different as well.
Why is Finance Different for New Ventures than for Established Corporations?
Entrepreneurs face very different finance challenges than do corporate managers. The most obvious, which most entrepreneurs are familiar with, is "financing". To the average entrepreneur, this means simply "finding money". It is this process of finding investors that tends to consume nearly all of the focus of most entrepreneurs. While extremely important, it is not the only financial decision that an entrepreneur faces. (New Venture Financing will be covered in depth in a later installment).
Notice how the discussion above flowed naturally, interchanging "financing" and "investing". This is the first fundamental difference between corporate finance and entrepreneurial finance.
1. In entrepreneurial finance, investment decisions and financing decisions are the same thing.
Corporations can sell financial claims in the market at market rates. They can also often fund projects through allocation of internally generated funds. New ventures, on the other hand, do not have a market for their financial claims, and thus must raise funds for projects from investors. The result is that corporations can often finance projects with expectations of a positive net return on investment for which an new venture would reject the same project unless they can raise investment.
Likewise corporations can diversify their risk. Through risk management techniques, established corporations can shift project risks in order to reduce overall corporate risk. New ventures are usually typified by the entrepreneur bearing most of the risk herself, undiversified.
2. Portfolio Theory (valuation based on risk) does not apply to new ventures cleanly.
Entrepreneurs have limited mechanisms by which they can signal and communicate their true intentions. This creates potential moral hazard and information asymmetry. In contrast, the public corporation has many formal, standard mechanisms by which information is communicated and incentives are aligned.
3. The Entrepreneur must signal intentions to investors often by willingly undertaking irreversible, undiversifiable financial risks.
Given the different risk profiles, new ventures are difficult to accurately value. In practice, the value of most new ventures is largely derived as a function of the value of its options. Called "real options analysis", this approach applies options valuation techniques to real-world decisions. Venture capital firms are well known for applying sophisticated options valuation strategies to their portfolio of companies and decisions about if, when and how much to fund various financing rounds.
4. Real options analysis is a valuable technique for valuing the entire venture.
New ventures are illiquid by definition. They are closely held, private companies which have no explicit market value. The process of creating a market for investment in the new venture is known as creating liquidity, or achieving liquidity. Most venture capital firms plan their portfolio around expectations of liquidity events. Once liquidity is achieved, the firm's value can be harvested.
5. Liquidity is the only way in which new ventures return value to investors.
This leads to the final fundamental difference between corporations and new ventures: the entrepreneur. In an established corporation, the shareholders are the residual claimants. Incentives are aligned accordingly. But in a new venture -- one in which the entrepreneur is still participating -- the ultimate residual claimant is the entrepreneur herself. It is the entrepreneur who has undertaken disproportionate risk, undiversifiable risk, intangible risk in the form of personal sacrifice. It is therefore no surprise that it is the entrepreneur who finds herself necessarily driving valuation goals for the venture.
6. The Entrepreneur is the ultimate residual claimant and driver of valuation goals.
Next, Who is an Entrepreneur? Primary objectives, and the importance of signaling.