Hi everyone, David Hsu here. The session is on venture capital and the financing of innovation. One big motivation for this session is that many startups, particularly the more successful ones, end up receiving venture capitol. Think about companies like Google, Facebook, etc, etc. And so, the goal of this session is to give you an overview of one reason why we might think about having a specialized institution for financing start ups and some information about why we have the venture capital industry. Now before I get into the details, I think it is important to take one step back. And recognize that venture capitol is only one form of financing that you may be able to choose from. So if you think about the alternatives to receiving venture capitol financing, you might think about things like having a commercial bank loan regular debt type financing. You might think about sourcing or tapping into wealthy individuals. So think about Google millionaires and receiving financing from such individuals. Those are known as angel investors. You might think about crowdfunding, so if you have more of a product orientation and are able to leverage into a platform, crowd based financing might be an option for you. Government grants are another source. So, here, there's a small business innovative research grants from the US Federal Government. Or governments around the world will be interested in subsidizing research and development. Those have their own particular rules. And then, of course, there's the old stand by entrepreneurial bootstrapping. So getting hustling, getting revenue from ongoing sales to financing ongoing operations and the like. So that's the background and there will be other sessions that will cover some or all of those alternatives. The goal of today is to really talk about this institution of venture capital. And just to give two very specific examples on the table to really motivate this session. Here two companies which received venture capital. So, the first Apple and the second, Genetech. What I'm showing you here is the rounds of financing that each of these companies received over time. Take a look at Apple. First few rounds of financing were from the founders themselves. And you can see that in the next to last column, they're paying between one and nine cents per share. And as the venture capitalists come in more uncertainty is being resolved, the company is being developed, they're developing their products, they're really scaling the company, and the venture capitalists come in at successfully higher prices per share. And then the company ultimately conducts an initial public offering in December of 1980, valuing the company, as a whole, at $1.4 billion. And of course, investors at that round have to pay $22 a share. And so this is the natural progression of a successful venture that there's uncertainties being resolved, the business is being developed, investors that come in late have to pay higher dollar per share. And Genentech exhibits the exact same sequence. And what's interesting to note about these two companies, is that these are the companies that worked well. The point about venture capital financing is to try to design a set of mechanisms. So that you can guard against the downside while giving incentives for both the investors and the entrepreneurs to succeed on the upside. And so let me take one step back and conceptualize this in a broader type of framing. The framing that I have here is one in which there are two parties, the entrepreneur and the investor. And the big problem here is what's known as asymmetric information. So the entrepreneur likely has much better information about the likelihood of success relative to the investor. And so think about two periods of time, before an investment is made and after. So let's focus on the first period in which the venture capitalist and the entrepreneur meet. There is negotiation, there is a process of due diligence, in which the investor is trying to find out about the quality of the entrepreneurial company and in fact the entrepreneur has very little incentive to disclose all the problems that might be associated with an opportunity to the investor. And so we can think about that problem as one of hidden information. And the analogy I would like to make is the used car market. If you are the entrepreneur trying to sell a used car to an outside marketplace, say the investor, you're not going to be incentivized to tell the buyer, the investor, about all the problems that you have as a used car. It runs fine unless it's raining or unless it's colder than 230 degrees fahrenheit. All those things should be discovered by the investor or potential buyer, and so this asymmetry in information can breakdown the market for funding start-ups. And that's one problem that we have to confront. A second problem arises after a contract has been signed. And the problem is quoted definitely different, here the problem is that the investor cannot perfectly monitor what the entrepreneurs doing with the money and the problem is one of hidden action, and here the analogy is the insurance market, say that you have you car insured, you may not be? Incentivized to always lock your car, always take the best care to make sure that no damage arises. Because after all, you're only going to be out your deductible, and that's not 100% of the losses. And so as a consequence with this type of insurance type situation, the investor has to be quite careful, because the investor's not a member or party to the company on a day to day basis, not making the micro-decisions. And so as a consequence it's very common for the venture capitalist to come on the board of the company and to disperse funds in rounds of financing. So, in other words, if as the entrepreneur, you need $100 million to successfully roll out a product, venture capitalists, or investors not going to give you all $100 million up front. Instead, what's going to happen, usually, is that the venture capitalist will give you. $1 million, $5 million to show proof of concept, a prototype, and should you meet those milestones as the entrepreneur, you will then get the next round of financing etc, etc. And so these two problems of hidden information and hidden action are some of the conceptual problems that plague the financing of startups type of market. And if these problems are too severe, that can really break down the financing type of relationship, and in fact gives rise to something that we're not going to talk about too much. But the terms that govern the financing between the investor, the metro-capitalist, and the entrepreneurs are typically very, very complex. Because it has to reach some covenants in the legal contract which allocate the rights to one party or the other, depending on the different states of the world. And because there's so many different eventualities and potential contingencies, as to the states of the world that contract that governs investing relationship is often quite complex. Now let me get very practical in terms of telling you about what venture capitalist actually do to earn their compensation. So they do a number of activities so first state raise money for their funds from institutional investors, wealthy families and individuals, pension funds. So think about the endowment of Yale University, the pension fund of the state of California. These institutions will allocate a certain percentage of their portfolio to investing in an asset class like venture capital. So, venture capitalists first and foremost, raise money for their funds. They also source the investment opportunities. They identify the entrepreneurs and entrepreneurial companies that may offer outsides returns. They perform due diligence, as we just discussed, on these potential investees. They price and structure an investment so that it tries to give the right incentive to the different parties to take the right action that will raise value for all the participants. They then have to monitor and hopefully add other or extra financial value to the portfolio companies, they do so through their corporate governance, sitting on the board of directors, trying to connect these companies with the labor markets, with the capital market, with strategic alliance relationships and the like. And then ultimately, the venture capitalists are charged with exiting the investment, trying to find some liquidity for the investors. We can conceptualize this flow of funds and process in the following chart. These limited partners, the investors like the Yale University or California Pension Fund allocate a certain percentage of their portfolio to the venture capital fund. That venture capitalist is called the general partner. The general partner disperses cash to the entrepreneurial ventures. The portfolio companies who in turn give up equity stakes in the company to the venture capital fund. And if all goes well after seven or ten years or so, venture capital fund offers returns to the investors, these things are often gauged by metric known as internal rate of return. Now, just to give you a snapshot of how large of an asset class venture capital is over time, what I'm showing you here is data from 1995 through 2015 as to the amount of money that venture capitalists in the United States have collectively dispersed to start up companies. And you can see in the bubble period there, there's a huge spike up. But this is a industry that's stabilized in the $30 to $50 billion figure. And if you looked at the, if you instead graph the number of deals that these companies, these venture capitalists are doing, the profile would look very, very similar. Now you might also wonder, how well have these venture capitalist investments done. And the study that I'm citing here is actually quite revealing. These authors publishing in the American Economic Review studied over 22,000 investments made by US venture capitalists between 1987 and 2008. And they found that the average investment by venture capitalists returned about $5.8 million, that would seem pretty high, but the shrinking figure here is that 75% of those 22,000 investments return zero. And what is happening is that there's a very long right tail. So you have some outlier exits. So, for example Google conducts initial public offering that's really exceeding the bounds in the multi billions of dollars as an exit. And that lifts the average quite high. So what I want you to take away from this statistic is that the venture capitalist business is actually not an easy one. And as consequence, it's important to assemble a portfolio of investments so that you can hedge your bets. Because many of those bets will actually not pay off. And this has corresponding implications for startup entrepreneurs like yourself, in that you may want to design or look into mechanisms that will allow you to experiment or test an idea rather than regarding the entrepreneurial idea itself as an experiment. I want to end with one research study that I actually published in The Journal of Finance in the year 2004. And what I did was I collected a sample of start-up companies. Raising the very early stage round of investment, the Series A. And whats unique about this sample is that each of these startup companies received multiple offers for financing for the Series A round of financing. And I studied two outcomes. First, what is the likelihood that the entrepreneur accepts a given offer by a venture capitalist, and secondly, I studied what was the price per equity units sold that's being offered to the startup company? And in this, in the study I controled for a wide spectrum of variables that had to do characteristics of the venture capitalists, all of the characteristics of the startup company, as well as many other variables that differ in the sample. And let me quickly summarize the results here. So the first striking result Is that the entrepreneurs did not always take their best financial offer. And in fact, they left 12 and half percent of the collective value on the table, that means that instead of always taking their highest financial evaluation offer, they were willing to accept a discount. And that discount in terms of the offers that were accepted, correlated very highly with the reputation of the venture capitalist. In fact, venture capitalists who had a high reputation were three times more likely to have their offers accepted. And those high reputation venture capitalists acquired start up equity at a 10% to 14% discount. What are the implications of the study? It means essentially that entrepreneurs themselves perceive venture capitalists to be stratified in the value added that they are able to bring and in the value added type of services and as a consequence entrepreneurs themselves are willing to take a discount on their valuation in order to be affiliated with more reputable venture capitalist. So what I like to do is to summarize this session, and leave you with the take-away that the venture capital industry is a very specialized one. It's fraught with many difficulties, not the least of which are information asymmetry problems. As a consequence it's evolved to something that's become very specialized. An institution that tries to be very tailored in what it does. It can lead to outsiders performance but it's not a given that venture capitalist investments are always successful. Finally, I want to introduce a few other studies, which suggest that there's a tight correlation, or even causal relationship between venture capitalists, especially highly prominent venture capitalists and startup success. So one group of studies suggests that as measured through business development and strategic alliances, as well as professionalization of human resource management practices at startups, more prominent venture capitalists are certainly correlated with these measures of startup success. Another set of studies suggests that there may even be a causal relationship between prominent venture capitalists and innovative success or outcomes of portfolio companies as measured through patent based innovation as well as successful exit events as measured by initial public offerings and successful acquisitions. And what's intriguing about this second set of studies is that the authors took a look at events that were really unrelated to what the venture capitalists were doing themselves and what they did is they compared the success of startup companies before and after the introduction of direct flights between venture capitalist and portfolio companies. And what's nice about this setting is that venture capitalists have no direct control as to the introduction direct airline flights between their portfolio companies and their own headquarters. But after the airlines have decided to exogeneously place direct flights in, you see a lift In terms of the innovation rates and the rates of success of these portfolio companies after the introduction of those airline flights. Suggesting a more causal relationship between the prominent venture capitalists and startup success. Let me conclude by suggesting that the venture capital landscape is a complex one. It's fraught with many information asymmetries and the industry has evolved to one that has tried to really add value to startup companies in the need for both startup financing and extra financial services brought to those portfolio companies thank you.
