by Andrew Metrick and Ayako Yasuda
PREFACE TO 2ND EDITION—A READER’S GUIDE vii
CHAPTER 1 THE VC INDUSTRY 3
CHAPTER 2 VC PLAYERS 21
CHAPTER 3 VC RETURNS 46
CHAPTER 4 THE COST OF CAPITAL FOR VC 65
CHAPTER 5 THE BEST VCs 83
CHAPTER 6 VC AROUND THE WORLD 99
CHAPTER 7 THE ANALYSIS OF VC INVESTMENTS 123
CHAPTER 8 TERM SHEETS 146
CHAPTER 9 PREFERRED STOCK 163
CHAPTER 10 THE VC METHOD 178
CHAPTER 11 DCF ANALYSIS OF GROWTH COMPANIES 195
CHAPTER 12 COMPARABLES ANALYSIS 214
CHAPTER 13 OPTION PRICING 231
CHAPTER 14 THE VALUATION OF PREFERRED STOCK 252
CHAPTER 15 LATER-ROUND INVESTMENTS 272
CHAPTER 16 PARTICIPATING CONVERTIBLE PREFERRED STOCK 290
CHAPTER 17 IMPLIED VALUATION 305
CHAPTER 18 COMPLEX STRUCTURES 320
THE FINANCE OF INNOVATION
CHAPTER 19 R&D FINANCE 339
CHAPTER 20 MONTE CARLO SIMULATION 357
CHAPTER 21 REAL OPTIONS 378
CHAPTER 22 BINOMIAL TREES 400
CHAPTER 23 GAME THEORY 419
CHAPTER 24 R&D VALUATION 445
APPENDIX A SAMPLE TERM SHEET 466
APPENDIX B THE VCFI SPREADSHEETS 484
APPENDIX C GUIDE TO CRYSTAL BALLs
THE ORGANIZATION OF THIS BOOK
The book is divided into four parts, with six chapters each. Each of these four parts has a major finance theme: the theme of Part I is the relationship between risk and return; the theme of Part II is the valuation of high-growth companies; the theme of Part III is the analysis of capital structure; and the theme of Part IV is the relationship between strategy and finance. Overall, Parts I and II are heavy on data and definitions and are intended to provide students with the vocabulary of VC and knowledge of the key industry facts. Although these two parts contain some new definitions and approaches, most of the material should seem familiar to a VC practitioner. In contrast, Parts III and IV are more theory based and provide a new perspective on the evaluation of VC and other high-technology investments.
Although these latter two parts might seem experimental to a practicing VC, financial economists will recognize the material as a straightforward translation of well-known methods.
In Part I, “An Introduction to VC”, we provide an overview of the VC industry, with discussions of history (Chapter 1), major players (Chapters 2 and 5), performance measurement (Chapters 3 and 4), and global patterns (Chapter 6). The discussion of risk and return in Chapters 3 and 4 provide a key translation between the language of VC and the language of financial economics—a translation that we rely on heavily throughout the book.
In Part II, “Total Valuation”, we provide data and methods used to value a high-growth company. We first review the investment process used by VCs and provide data on their historical performance (Chapter 7). We next describe the structure of VC transactions (Chapters 8 and 9) and then demonstrate the industrystandard technique for the valuation of VC investments (Chapter 10). This technique, known loosely as “the venture capital method”, requires that analysts estimate company values far into the future. Although such estimates will always contain a fair amount of guesswork, we show how to use a “reality-check” model to frame these estimates (Chapter 11) and how to use evidence from comparable companies to provide an additional input for the investment decision (Chapter 12).
In Part III, “Partial Valuation”, we take the total valuation (Part II) as given and analyze the special features of VC transactions. In most VC transactions, the investors receive preferred stock with several special features. When there are many VC investors, the capital structure of the company grows quite complex, with each investor holding a unique place in the capital-structure hierarchy of the company. In Part III, we show how to divide the total valuation of the company into its component parts (partial valuation) for each investor. The key step in this analysis is the recognition that all flavors of preferred stock can be represented as a portfolio of options. In Chapter 13, we show how the classic option-pricing analysis of Black and Scholes can be extended to VC settings. We then apply this extended analysis to the valuation of preferred stock (Chapters 14, 15, and 16). The techniques used in these chapters can also be used to refine some industry-standard measures of company valuation (Chapter 17) and to estimate the partial valuation of complex nonstandard transaction structures (Chapter 18).
Parts II and III of the book take the perspective of a venture capitalist making an investment in a high-technology company. In Part IV, we take the perspective of the company deciding what to do with VC money or other capital. Specifically, we develop a framework for modeling investment in “research and development” (R&D). Since VC-backed companies typically spend a significant fraction of their capital on R&D, an understanding of R&D finance is crucial for both VCs and for financial decision-makers at technology companies of all sizes. After introducing typical kinds of R&D investment problems (Chapter 19), we study several of the most interesting and cutting-edge techniques in finance, including Monte Carlo analysis (Chapter 20), real options (Chapter 21), binomial trees (Chapter 22), and game theory (Chapter 23). In Chapter 24, we pull all of these tools together and solve the investment problems originally posed in Chapter 19.
Several appendices supplement the text. Appendix A provides an example “term sheet” VC contract developed by the National Venture Capital Association. Appendix B provides some basic documentation for the companion spreadsheets and the web-based valuation model used in the book. Appendix C is a brief primer on Crystal Balls software, a commercial product from Oracle that is useful for solving some of the models in Part IV. Finally, a glossary at the end of the book gives definitions for all key terms used in the book.