[MUSIC] Hi everybody. During our last lecture, we insisted on the fact that growth required a lot of capital. The problem is that entrepreneurs do not have the required money. Banks will not lend because there is generally no collateral to offer. And anyway, initial capital is there to finance ongoing environments. So you need capital, not debt, in the first place. Would large companies be willing to provide capital to startups? It is increasingly the case. This can be useful, but there are pitfalls. Conflict of interest may arise over time. Your partner at the large company may change. This is why venture capital is the standard solution if you look for capital. How does this work? The venture capital firm is the general partner. It employs venture capital professionals to select and make decisions on investments. They also secure investors who will provide funding. They are long-term investors who accept to commit funds for a period of up to ten years. Pension funds, insurance companies, sovereign funds, university endowment funds, family offices, etc. In venture capital jargon, they are called limited partners. The general and limited partners invest in the venture capital fund. This is the investment vehicle for defining the amount and duration, typically from several hundred millions to several billions of dollars in 14 years. Then the fund invests in companies. The general partner collects management fees, generally around 2% of funds of the management. General partner and limited partners share realized capital gains. The general partner incentive component of remuneration is called carried interest. It is typically set at 20% of the capital gain, above a minimum threshold. One of the characteristics of the industry is that very large capital gains are extracted out of very small portion of the investment part for you. It is understood that certain investments will go bust. The investment policy is to target extraordinary returns and to take extraordinary risks. Let's now consider the situation of the entrepreneur vis-a-vis the investment cycle. Remember that the entrepreneur does not have the capital required to finance the growth of the firm. Ambitious starters, this much famed unicorns valued over $1 billion, will be funded for several tens of millions if not for several hundred million dollars. If this money was going to the one goal, providers of capital would take an enormous risk, while the entrepreneur would be diluted at a very low level. She would lose her motivation. As a result, it is joint interest of the entrepreneur and the financier to provide funds when specific development steps are reached. Why? The interest of the entrepreneur is to call for new capital as the company develops and attracts a high evaluation at the time when she really needs the money. In the mean time, the interest of the venture capitalist is to find other company at times when risk is easier to analyze and understand. This is why it is so important to meet tangible objectives like the finalization of a prototype or the booking of the very first orders. Now, let's have a concrete look at the evolution of the entrepreneur's holding as VC's invest in her company. Jean is an entrepreneur. She sets new goal and hold 100% of the shares after having initially funded the company for $50,000. 1,000 shares have been created. Jean builds a prototype and needs capital to produce the first batch of products and tests the markets. So she meets investors. They agreed to value the company at $1 million in light of its prospects. The value of the company is then $1 million, still for 1,000 shares. This valuation is called pre-money valuation. It is the value before any new investment. Jean raises $1 million. As a reserve, the company creates 1,000 new shares. Accordingly, NewCo plus money value is $2 million. It is the enterprise value post investment. As a consequence, Jean now holds 1,000 shares out of the 2,000 existing shares. This now represents 50% of the capital of the company for paper value of $1 million, 50% of the post money value. The two following slides illustrate the entrepreneur's dilemma. If she restricts her funding to the bare minimum, she will maintain their holding at a higher level. But the risk is, sluggish growth, or even bankruptcy. If she asks for too frequent financing rounds, her stake will be diluted. She will be demotivated. It is not her interest and setting enough the interest of the finance here. The optimal solution is to raise the value of NewCo between founding rounds and to find a trade off between the size of the funding and the value of the company. Let's come back to the mechanics of NewCo. Jean raised $1 million. This helped to increase production capacity, sales, and also to make a profit on the next year. Jane now decides to set up a US subsidiary. She needs $5 million to complete this project. She needs investors. They agree to value NewCo at $10 million pre-money. Since there are 2,000 shares in circulation, the price of each share is $5,000. As a result, NewCo creates 1,000 shares to raise $5 million. After this, the post-money evaluation of the company is $15 million. Jean still holds 1,000 shares on the total of 3,000 shares, i.e., she holds one-third of the NewCo capital for paper worth of $5 million, one-third of the post-money evaluation. So let's recapitulate our understanding of the link between development cycle and the funding cycle. Sales develop, bankruptcy risk is accordingly reduced. Under this scenario, investments are recurring to finance roles. They will be all the more available because risk has been reduced. The enterprise value has increased. A new financial partners from the company until the IPO takes place. The entrepreneur is diluted at each stage of the process. The calculation of the holding of each stakeholder is computed in a spreadsheet called cap table in the industry jargon. We will look at this in an exercise. Good bye. [MUSIC]
