Venture Capital and the Finance of Innovation

• About The Book iiAbout The Authors viiAcknowledgments xiPreface xiiiAbout The Instructor Website xviiPart I VC Basics1 The VC Industry 11.1 What is Venture Capital? 11.2 What Do Venture Capitalists Do? 61.3 The History of Venture Capital 61.4 Patterns of VC Investment in The United States 111.4.1 Investments by Stage 111.4.2 Investments by Industry 121.4.3 Investments by U.S. Region 14Summary 15Key Terms 15References 15Appendix: Note on Authors’ Calculations Made for Exhibits 1-4 and 1-5 162 VC Players 172.1 Firms and Funds 172.2 The Limited Partners 232.3 VC Partnership Agreements 252.3.1 Management Fees 252.3.2 Carried Interest 272.3.3 Restrictive Covenants 32Summary 35Key Terms 35References 36Exercises 36Appendices: Key Terms and Conditions for Three VC Funds 36Appendix 2.A: EarlyBird Ventures I 37Appendix 2.B: Talltree Ventures IV 37Appendix 2.C: Owl Ventures IX 383 VC Returns 403.1 Industry Returns 403.1.1 Definitions 403.1.2 A Gross-Return Index 423.1.3 A Net-Return Index 423.2 Fund Returns 453.2.1 Definitions 453.2.2 Evidence 51Summary 53Key Terms 53References 54Exercises 54Appendix: Note on the Three VC Return Indices Shown in Exhibits 3-3 and 3-4 554 The Cost of Capital For VC 574.1 The Capital Asset Pricing Model 574.2 Beta and The Banana Birds 614.3 Estimating the Cost of Capital for VC 64Summary 69Key Terms 69References 69Exercises 705 The Best VCs 725.1 The Economics of VC 725.2 The Best VCs: A Subjective List 755.3 VC Value Added and the Monitoring of Portfolio Firms 83Summary 85Key Terms 85References 866 VC Around The World 876.1 The Global Distribution of VC Investing 876.2 The Cost of Capital for International VC 986.2.1 Baseline Model: The Global CAPM 986.2.2 Discussions of Country Betas and Extensions to the Global CAPM 1006.2.3 A Global Multifactor Model for Venture Capital 103Summary 105Key Terms 105References 105Exercises 106Part II Total Valuation7 The Analysis of VC Investments 1077.1 VC Investments: The Historical Evidence 1077.2 The Investment Process 117Summary 124Key Terms 124References 1248 Term Sheets 1258.1 The Basics 1268.1.1 Investors 1268.1.2 Price Per Share 1278.1.3 Pre-Money and Post-Money Valuation 1278.1.4 Capitalization 1288.2 The Charter 1298.2.1 Dividends 1308.2.2 Liquidation Preference 1318.2.3 Voting Rights and Other Protective Provisions 1328.2.4 Mandatory Conversion 1328.2.5 IPO Ratchet Provision 1328.2.6 Redemption Rights 1328.3 Investor Rights Agreement 1338.3.1 Registration Rights 1358.3.2 Matters Requiring Investor-Director Approval 1368.3.3 Employee Stock Options 1368.4 Other Items 1368.4.1 Rights and Restrictions 1378.4.2 Founders’ Stock 137Summary 138Key Terms 138References 138Exercises 1389 Preferred Stock 1399.1 Types of Preferred Stock 1399.2 Antidilution Provisions 1479.3 IPO Ratchet Provisions 150Summary 151Key Terms 151References 151Exercises 15210 The VC Method 15310.1 The VC Method: Introduction 15310.1.1 Exit Valuation 15410.1.2 Target Returns 15510.1.3 Expected Retention 15610.1.4 The Investment Recommendation 15710.2 The Standard VC Method 15710.3 The Modified VC Method 159Summary 164Key Terms 165Reference 165Exercises 16511 DCF Analysis of Growth Companies 16711.1 DCF Analysis: Concepts 16711.2 DCF Analysis: Mechanics 16911.3 Graduation Value 17411.4 DCF Analysis: The Reality-Check Model 17711.4.1 Baseline Assumptions for the Reality-Check DCF 177Summary 181Key Terms 181References 182Exercises 182Appendix 11.A: Cost of Capital: Technical Details 18212 Comparables Analysis 18312.1 Introduction to Comparables Analysis 18412.2 Choosing Comparable Companies 18712.3 Using Comparable Companies to Estimate the Cost of Capital 192Summary 194Key Terms 194Reference 194Exercises 194Appendix 12.A: Potential Comparables for Healthco 195PART III Partial Valuation13 Option Pricing 19613.1 European Options 19613.2 Pricing Options Using a Replicating Portfolio 19813.3 The Black–Scholes Solution 20213.4 American Options 20513.5 Random-Expiration Options 20613.6 Reading Exit Diagrams 20713.7 Carried Interest as an Option 209Summary 211Key Terms 211References 211Exercises 211Appendix 13.A: RE Options: Technical Details 21214 The Valuation of Preferred Stock 21314.1 Base-Case Option-Pricing Assumptions 21314.2 RP Valuation 21414.3 Excess Liquidation Preferences 21714.4 Dividends 21914.5 CP Valuation 22114.6 CP with Excess Liquidation Preferences or Dividends 22314.7 Combining RP and CP 22514.8 Comparing RP and CP 227Summary 228Key Terms 228Reference 228Exercises 22915 Later-Round Investments 23015.1 Series B 23015.2 A Conversion Shortcut 23415.3 Series C 23515.4 Dividends in Later Rounds 23915.5 Beyond Series C 241Summary 243Key Terms 243Exercises 24316 Participating Convertible Preferred Stock 24516.1 Binary Options 24616.2 The Valuation of PCP 24716.3 The Valuation of PCPC 24816.4 Series B and Beyond 250Summary 257Key Terms 257References 257Exercises 25717 Implied Valuation 25817.1 Post-Money Valuation Revisited 25817.2 Measurement of Portfolio Value 26217.3 Down Rounds? 26617.4 How to Avoid Valuation Confusion 268Summary 269Key Terms 269References 270Exercises 27018 Complex Structures 27118.1 Management Carve-Outs 27118.2 Dealing with Partners 27718.3 A Complex Example 279Summary 283Key Term 283Exercises 284Part IV The Finance of Innovation19 R&D Finance 28519.1 R&D Around the World 28519.2 Two Touchstones 29019.2.1 Drug Development 29019.2.2 Energy Innovation 29319.3 How is R&D Financed? 29319.4 Where Do We Go from Here? 298Summary 299Key Terms 299References 29920 Monte Carlo Simulation 30020.1 Event Trees 30020.2 Simulation with Continuous Probability Distributions 30420.3 Simulation with Multiple Sources of Uncertainty 313Summary 315Key Terms 316Exercises 31621 Real Options 31721.1 Decision Trees 31721.2 Real Options in R&D 31921.3 The Valuation of Real Options 32021.4 Risk-Neutral Probabilities 32521.5 Drugco Revisited 331Summary 333Key Terms 333Exercises 33422 Binomial Trees 33522.1 The Black–Scholes Equation, Revisited 33522.2 Multiple Strike Prices and Early Exercise 34222.3 Dividends 345Summary 350Key Terms 350References 350Exercises 35023 Game Theory 35123.1 What is Game Theory? 35123.2 Simultaneous Games 35423.3 Sequential Games 36223.4 Game Theory and Real Options 366Summary 370Key Terms 370Exercises 37124 R&D Valuation 37224.1 Drug Development 37224.2 Energy 38124.3 The Forest and the Trees 388Summary 389Reference 389Exercises 389Appendix A Sample Term Sheet A-1Appendix B The VCFI Spreadsheets A-14Appendix C Guide To Oracle Crystal Ball A-16Glossary G-1Index I-1

"This third edition of Venture Capital and the Finance of Innovation is an excellent successor to Andrew Metrick and Ayako Yasuda's previous edition, which was the gold standard in the area. The book provides many unique features including valuation tools for high-growth firms, and option-pricing based tools for valuing the preferred stock used in venture capital. I highly recommend it to students and scholars alike."— Franklin Allen, Professor of Finance and Economics, Imperial College London"Metrick and Yasuda continue to provide the most comprehensive reference for venture capital. Their treatment of valuation, contracts, and returns is both rigorous and accessible. Every student of the industry should have this book on their shelves."—Paul Gompers, Eugene Holman Professor of Business Administration, Harvard Business School"A new and improved version of my go to book for students, GPs and LPs to learn and understand the fundamentals and nuances of VC investing."—Steven N. Kaplan, Neubauer Family Professor of Entrepreneurship and Finance, University of Chicago Booth School of Business“If you want to understand the venture capital industry, this is the book.”-Jay R. Ritter, Joseph B. Cordell Eminent Scholar, Warrington College of Business, University of Florida