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Chapter 2

Management and Organizational Studies 1023A/B Chapter Notes - Chapter 2: Venture Capital, Initial Public Offering, Leveraged Buyout

Management and Organizational Studies
Course Code
MOS 1023A/B
Maria Ferraro

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Chapter 7- How Firms Raise Capital
How New Businesses Get Started
most businesses are started by an entrepreneur who has a vision for a new business
or product and a passionate belief in the concept’s viability
new businesses are seldom started in large corporations
the entrepreneur often fleshes out his or her ideas and makes them operational
through informal discussions with people whom the entrepreneur respects and trusts
Initial Funding of the Firm
the process by which many entrepreneurs raise “seed” money and obtain other
resources necessary to start their businesses is often called bootstrapping
initial “seed” money usually comes from the entrepreneur or other founders
other cash may come from personal savings, the sale of assets such as cars and
boats, borrowing against the family home, loans from family members and friends
it is spent on developing a prototype of the product or service and a business plan
Venture Capital
bootstrapping period usually lasts no more than one or two years
the founders will have developed a prototype, which they can “take on the road” to
seek venture capital funding to growth the business
venture capitalists are individuals or firms that help new businesses get started and
provide much of their early-stage financing
individual venture capitalists, so-called angels (or angel investors), are typically
wealthy individuals who invest their own money in emerging businesses at the very
early stages in small deals
venture capital firms typically pool money from various sources to invest it in new
The Venture Capital Industry
venture capital industry as we know it today emerged in the late 1960s with the
formation of the first venture capital limited partnerships
approximately $25 billion was invested in venture capital funds in both 2005 and 2006
biggest concentrations of firms in California and Massachusetts
modern venture capital firms tend to specialize in a specific line of business
Why Venture Capital Funding is Different
three reasons why traditional sources of funding do not work for new or emerging

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1. The high degree of risk involved- most new businesses fail, and it is difficult to
identify which firms will be successful, most suppliers of capital are averse to
undertaking high-risk investments
2. Types of productive assets- new firms who primary assets are often intangibles,
such as patents or trade secrets, find it difficult to secure financing from traditional
lending sources
3. Informational asymmetry problems- information asymmetry arises when one party to
a transaction has knowledge that the other party does not, an entrepreneur knows more
about his or her company’s prospects than a lender does. Most investors do not have
the expertise to distinguish between competent and incompetent entrepreneurs
for these reasons, many investors find it difficult to participate directly in the venture
capital market
The Venture Capital Lending Cycle
the business plan describes what you want the business to become, why consumers
will find your business attractive (the value proposition), how you are going to
accomplish your objectives and what resources you will need
venture capital firms receive many unsolicited business plans and respond to very few
Staged Funding
each funding stage gives the venture capitalist an opportunity to reassess the
management team and the firm’s financial performance
if the performance does not meet expectations, the venture capitalists can bail out and
cut their losses, or if they still have confidence in the project, they can help management
make some corrections so that the project can proceed
companies typically go through three to seven funding stages
latter stages of financing are sometimes called mezzanine financing
the venture capitalists’ investments give them an equity interest in the company
typically, this is in the form of preferred stock that is convertible into common stock at
the discretion of the venture capitalists
preferred stock ensures that the venture capitalists have the most senior claim among
the stockholders if the firm fails and the conversion feature enables the venture
capitalists to share in the gains if the business is successful
Personal Investment
venture capitalists often require an entrepreneur to make a substantial personal
investment in the business
it is also unlikely that the venture capitalists will allow you to pay yourself a large salary
as manager of the business

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syndication occurs when the originating venture capitalist sells a percentage of a deal
to other venture capitalists
syndication reduces risk in two ways
first, it increases the diversification of the originating venture capitalist’s investment
portfolio, since other venture capitalists now own a portion of the deal
second, the willingness of other venture capitalists to share in the investment provides
independent corroboration that the investment is a reasonable decision
In-Depth Knowledge
a high degree of specialization gives the venture capitalist a comparative advantage
over other investors or lenders that are generalists
venture capitalists are not long-term investors in the companies they back
they stay with a new firm until it is a successful gong concern, which usually takes
three to seven years; then they exit by selling their equity position
every venture capital agreement includes provisions identifying who has the authority
to make critical decisions concerning the exit process
usually include the following: (1) timing, (2) the method of exit, and (3) what price is
exit strategies can be controversial
Strategic Buyer
a common way for venture capitalists to exit is to sell the firm’s equity to a strategic
buyer in the private market
the strategic buyer is looking to create value through synergies between the
acquisition and the firm’s existing productive assets
Financial Buyer
this type of sale occurs when a financial group- often a private equity (leveraged
buyout) firm- buys the new firm with the intention of holding it for a period of time,
usually three to five years, and then selling it for a higher price
difference between a strategic and a financial buyout is that a financial buyer does not
expect to gain from operating or marketing synergies
in a financial buyout, the firm operates independently and the buyer focuses on
creating value by improving operations as much as possible
Initial Public Offering
a venture capitalist may also exit an investment by taking the company public through
an initial public offering (IPO)
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