Question 1

Admati and Pfleiderer (1994) argued that by having both inside and outside investors contribute to a venture, ____________, and thus a rational continuation/termination decision would be made at each stage of development.

A)both information asymmetry and principal-agent problems are resolved
B)taxes and risk are both minimized
C)the overinvestment and underinvestment problems are balanced out
D)perception biases cancel out

Accepted Answer

Admati and Pfleiderer (1994) suggested that having both inside and outside investors helps balance overinvestment and underinvestment problems, leading to more rational decisions at each development stage.

Question 2

VCs are rarely involved in the governance and management of a venture that they finance.

Accepted Answer

VCs often take an active role in the governance and management of a venture they finance, typically through board participation and strategic guidance, to protect their investment and help the venture succeed.

Question 3

Suppose a venture requires $7 mn.in equity financing to move to the next stage of development.The firm's management is negotiating with a venture capital firm (VC) for the funding.Assuming that the firm's business goals are achieved, it will generate earnings of $21 mn.per year into perpetuity starting beginning on the harvest date, four years from now, when the firm will go public.At that time, the firm will be valued in the market according to a P/E ratio of 18.Thus, the harvest -date value of the firm, assuming that it is successful, will be $378 mn.(=18[$21 mn.]).However, the probability that the firm will be successful is only 25%, while the probability of total failure of the venture is 75%.Therefore, the expected harvest-date value of the firm is $94.5 mn.(=0.25[$378]).A discount rate of 33% is applied to this value to determine the present value of the venture, yielding a value of V=$30.2 mn.(=$94.5 mn./[1.33]⁴).Based on this value and the VC's contribution of $7 mn., what fraction of the firm's equity shares should the VC receive?

A)13.2%
B)23.2%
C)33.2%
D)43.2%

Accepted Answer

The VC's contribution of $7 million is divided by the present value of the venture, $30.2 million, to determine the fraction of equity shares the VC should receive. This calculation results in 0.232 or 23.2%.

Question 4

VCs generally take the form of a&#10;A)limited partnership.&#10;B)corporation.&#10;C)proprietorship.&#10;D)joint venture.

Accepted Answer

Venture capitalists (VCs) typically organize as limited partnerships where the general partners manage the VC firm and the limited partners invest in the fund. This structure allows for professional management of the investments while limiting the liability of the investors.

Question 5

Which of the following is the least likely source of funding for a venture that is in the seed stage of development?&#10;A)angel financiers&#10;B)bootstrapping&#10;C)banks

Accepted Answer

Banks are typically the least likely source of funding for a venture in the seed stage due to the high risk associated with early-stage startups and the lack of collateral or a proven track record to secure the loan.

Question 6

Gompers' (1995) theoretical model of venture financing focused on mitigating principal-agent conflicts between the entrepreneur and an outside financier.His model explains why ventures are developed in stages: the end of each stage is

A)a cash-out opportunity.
B)an opportunity to harvest parts of the venture.
C)a time for management to rest and recuperate.
D)a monitoring opportunity.

Accepted Answer

Gompers' model emphasizes the importance of staged financing as a mechanism for mitigating principal-agent conflicts by allowing investors to monitor progress and make subsequent funding contingent on performance, thus the end of each stage serves as a monitoring opportunity.

Question 7

Joe Ogden, the Chairman and CEO of Ogdenergy, Inc., a promising venture in the natural gas industry, is negotiating with Summer Street Capital Partners, a Buffalo, NY-based venture capital firm (VC), for funding of $15 mn., which will be used for building PP&E.Summer Street is impressed with the venture, and is considering providing the funding in exchange for equity shares.However, Summer Street is concerned that if they demand an equity ownership percentage that is too high, Ogdenergy's entrepreneurs may be less inclined to work hard to ensure the venture's success.They determine that if they demand a 40% equity percentage, the firm will be worth $44 mn., but if they demand a 60% ownership percentage, the firm's value will be only $26 mn.Which equity ownership percentage should Summer Street take? (i.e., which maximizes Summer Street's NPV?)

A)Summer Street should take a 40% equity percentage.
B)Summer Street should take a 60% equity percentage.

Accepted Answer

At a 40% equity stake, the firm's value is projected to be $44 million, making Summer Street's share worth $17.6 million (40% of $44 million). At a 60% equity stake, the firm's value drops to $26 million, making Summer Street's share worth $15.6 million (60% of $26 million). Therefore, a 40% equity stake maximizes Summer Street's NPV.

Question 8

The VC industry did not become a major force in financing ventures until which TWO problems were solved?&#10;A)informational asymmetry and principal-agent problems&#10;B)legislation allowed institutional investors to provide significant capital backing, and an effective legal-liability arrangement for contributing parties was devised&#10;C)contracting problems with the venture and compensation for executives&#10;D)financing problems (i.e., debt vs.equity) and the underinvestment problem

Accepted Answer

The VC industry became a major force when legislation allowed institutional investors to provide significant capital and when an effective legal-liability arrangement was devised, enabling more secure and substantial investments.

Deck 11: Private Equity and Venture Capital