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Chapter 7 (Finance) - Final Exam Material BU121

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Igor Ivkovic

Text Chapter 7: Financing New Ventures Why it is so difficult to raise money and solutions Information asymmetry problems: entrepreneurs have information that investors don’t have or can’t recognize; creates 3 problems for raising money - entrepreneurs reluctant to disclose information to investors (otherwise people would purse same opportunities, or investor could exploit) à result, investor gets limited information for decision making - information edge that entrepreneurs have make it possible for them to take advantage of investors and use it for own gain/benefit (eg. Need special expense account) - adverse selection: when a person is unable to distinguish between 2 options (basically, entrepreneurs pretend to possess desirable skills) and so investor asks for risk premium which entrepreneurs don’t want to pay and they withdraw from financing market leaving only entrepreneurs that investors don’t want to back – hence creating adverse selection Uncertainty Problems: - Investors have to make decisions about value of company based on very limited data that is only known after – financing decision becomes very risky for investor - entrepreneurs and investors often disagree about value of ventures; so investors make their financing decisions based on their own perceptions - investor seeks collateral if venture fails: problem is entrepreneurs don’t have anything of value to give up so don’t get funding Solution to New Venture Finance Problems - Self financing – reduces entrepreneurs incentive to act against interest of investors - Contract provisions – o Covenants – restrictions on someone’s actions o Mandatory redemption rights – require entrepreneur to return investors capital when requested o Convertible securities – convert preferred stock o Forfeiture – entrepreneurs lose a portion of ownership if they fail to meet agreed upon milestones o Antidiluation – entrepreneur provide investors with additional shares so investors percentage of ownership is not reduced in later rounds of financing o Control rights – discretion to determine how to use venture assets o Vesting periods – time when entrepreneur cannot cause out their investments (difficult for entrepreneur to leave company) - Specialization (overcome asymmetry, and uncertainty problems because investor learns about processes) - geographically localized investing (investor can be involved with company and easier to build networks) – protects against opportunistic entrepreneurs - Syndicate – don’t by venture capitalists and business angels who attract other investors to join them; allows to diversify risks, and easier to gather information from different people with different experiences Hazards of raising too little money - Running out of cash, need to know your burn rate (the rate at which you use funds), circumstances can arise later on that make it hard to raise cash Types of Capital - debt financing: obligation to return capital+scheduled amount of interest payments at fixed rate of IR (uncommon for entrepreneurs to use because can’t make IR payments until cash flow positive, and with loans they start taking risky decisions which scares investor) - equity financing: portion of ownership given to investor for money provided - asset-based financing: debt that is secured by the equi
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