Week 4 Flashcards
Financial accounting
it deals with allocating risks and rewards/returns between entrepreneurs and investors
Modigliani-Miller theorem
It states that the market value of a company is calculated as the present value of its future earnings and underlying assets
It would hold if
1. capital structures were irrelevant
2. Only NPV of project matters
3. Financing easily available for positive NPV projects
Real life implication of Perfect market
Investment and financing decisions are interlinked
External financing is scarce
Asymmetric information between entrepreneur&investors
Contracts are incomplete
Why do entrepreneur keep ownership?
- information asymmetries: keeping ownership signals confidence in venture
- Agency problems: incentive alignment requires entrepreneur ownership
- private benefits: non-financial utility from controling the company
Risk allocation
The process of distributing or assigning risks among different parties or stakeholders
Tools for risk allocation
- Security design (debt vs equity)
- Contractual provisions
- Staging of investments
Return allocation
refers to process of distributing the returns (or profits) generated by an investment or portfolio among various stakeholders, entities, or components based on predefined rules
Factors affecting return allocation
Market competition for sales
Value added by investors
Information asymmetry
Need for incentive alignment
Tools for return allocation
- Ownership stakes
- Performance-based compensation
- Control rights
- Exit rights
Trade off of active investors for entrepreneurs
The value added by the active investor and the investor’s higher ownership claim. In essence, the entrepreneur must weigh the benefits of the investor’s contribution against the cost of diluting ownership
What is investor’s concern regarding moral hazard?
Debt holders are afraid that entrepreneur takes excessive risk
Equity holders are afriad that entrepreneur pursue private benefits rather than joint
What is entrepreneurs concern regarding moral hazard?
The investors will use its experience with the venture to hold up the entrepreneur in subsequent rounds of financing
The investors will seek to control the venture
Core of Principal and Agent problems
i. Separation of ownership (principal) and control (agent)
ii. Information asymmetry
iii. Different incentives and objectives
iv. Cost of monitoring
Possible solutions for agent and principal problems
Signaling – it allows entrepreneur to convince financiers that the company has potential without giving up proprietary information. (e.g. contract provision)
Screening – the investors offer the entrepreneur the choice of alternative financing terms such that the entrepreneur reveals his private information through choosing among the alternatives
Monitoring – board of directors overseeing the management of the company, staged financing where funds are provided as the business meets predetermined milestones, and restrictions placed on a borrower as part of a loan agreement.
Anti-dilution rights and earn-ups – anti-dilution rights ensures if the company issues more shares at lower price in the future, the investor’s ownership percentage will be adjusted to maintain its original value. Earn-ups refers so entrepreneurs receiving upfront payment, but a portion of the final price depends on the company meeting specific requirements.
Termination and control rights – investors have the rights to appoint directors and fire founder as CEO and have to approve issuance of securities, sale of assets or sale of entire company.
Features of VC contracts
- If the company performs poorly, the venture capitalist obtains full control
- As company performance improves, the entrepreneur retains /obtains more control rights
- If the company performs very well, the venture capitalists retain their cash flow rights, but relinquish most of their control and liquidation rights
