Chapter 13 - Chapter 13: 1. Why does staging reduce the...

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Chapter 13: 1. Why does staging reduce the outside ownership share of ventures that ultimately are successful? Answer: Staging of outside investment reduces the ownership interest of the investor. For a single- stage investment, once made, the investor’s commitment is sunk. The investment is valued at a discount rate that reflects the uncertainty associated with the project as of time 0. If the financing is staged, the investor commits to provide first-stage funds but will fund later stages only if the venture continues to be an attractive investment. At a later stage, some of the uncertainty of the venture will be resolved causing a decrease of the discount rate used by the investor to value the venture. Lower discount rates and shorter time to harvest yield higher valuation and ultimately, lower required ownership share in exchange for the funds. 2. Suppose a first round investor requires an ultimate ownership fraction of 20 percent, and that if the venture is successful a second round investment will be needed. The second round investor is expected to require 10 percent of final equity. Using the Venture Capital Method of valuation, determine the first round investor’s initial required ownership fraction: A nswer: Use equation 13.1 Ending Fraction of Equity Required Fraction of Equity Required = (1 – Sum of Fractions Required in Future Rounds) = .2/.9 = 22.22% 3. Acknowledging that the overall value of the venture is maximized if all nonmarket risk is borne by a well-diversified investor, why is it that contracts between the entrepreneur and the investor do not transfer all the nonmarket risk to the well-diversified outside investor? Answer: Information and incentive problems operate against the proposition that the investor should bear all risk. The investor is likely to be skeptical of a proposal that allows the entrepreneur to extract most of the venture’s value up front. Such an arrangement would raise concerns that the entrepreneur might not devote as much effort to the venture as the investor would desire. Moreover, the investor may question whether the entrepreneur has not revealed relevant private information, and that financial projections are too optimistic. Hence, without an allocation of some risk to the entrepreneur, the deal may be worth less to both the investor and entrepreneur.
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4. Sometimes the outside investor’s claim in the venture is in the form of hybrid equity, such as, convertible preferred stock that has a liquidation preference compared to common stock. Why might an entrepreneur want the investor to receive convertible preferred instead of common equity or debt. Answer: Convertible preferred stock would enable an entrepreneur who is confident about venture success to retain more of the ownership than if straight equity were issued to the investor. Convertible preferred stock aligns the interests of the entrepreneur and the investor better
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Chapter 13 - Chapter 13: 1. Why does staging reduce the...

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