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Venture Capital and the Finance of Innovation
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Table of Contents

Part I VC Basics Chapter 1 The VC Industry 3 1.1 What Is Venture Capital? 3 1.2 What Do Venture Capitalists Do? 9 1.3 The History of Venture Capital 10 1.4 Patterns of VC Investments in the United States 14 Summary 19 Key Terns 20 References 20 Chapter 2 VC Players 21 2.1 Firms and Funds 21 2.2 The Limited Partners 27 2.3 VC Partnership Agreements 30 Summary 41 Key Terms 42 References 42 Exercises 42 Appendices: Key Terms and Conditions for Three VC Funds 43 Chapter 3 VC Returns 46 3.1 Industry Returns 46 3.2 Fund Returns 53 Summary 62 Key Terms 63 References 63 Exercises 63 Chapter 4 The Cost of Capital for VC 65 4.1 The Capital Asset Pricing Model 65 4.2 Beta and the Banana Birds 69 4.3 Estimating the Cost of Capital for VC 74 Summary 79 Key Terms 80 References 80 Exercises 80 Chapter 5 The Best VCs 83 5.1 The Economics of VC 83 5.2 The Best VCs: A Subjective List 86 5.3 VC Value Added and the Monitoring of Portfolio Firms 95 Summary 98 Key Terms 98 References 98 Chapter 6 VC Around the World 99 6.1 The Global Distribution of VC Investing 99 6.2 The Cost of Capital for International VC 111 Summary 119 Key Terms 199 References 119 Exercises 120 Chapter 7 The Analysis of VC Investments 123 7.1 VC Investments: The Historical Evidence 123 7.2 The Investment Process 135 Summary 144 Key Terms 145 References 145 Chapter 8 Term Sheets 146 8.1 The Basics 147 8.2 The Charter 151 8.3 Investor Rights Agreement 155 8.4 Other Items 159 Summary 161 Key Terms 161 References 162 Exercises 162 Chapter 9 Preferred Stock 163 9.1 Types of Preferred Stock 163 9.2 Antidilution Provision 173 Summary 176 Key Terms 177 References 177 Exercises 177 Chapter 10 The VC Method 178 10.1 The VC Method: Introduction 178 10.2 The Standard VC Method 184 10.3 The Modified VC Method 185 Summary 192 Key Terms 192 References 192 Exercises 192 Chapter 11 DCF Analysis of Growth Companies 195 11.1 DCF Analysis: Concepts 196 11.2 DCF Analysis: Mechanics 198 11.3 Graduation Value 204 11.4 DCF Analysis: The Reality-Check Model 207 Summary 212 Key Terms 212 References 213 Exercises 213 Chapter 12 Comparables Analysis 214 12.1 Introduction to Comparables Analysis 215 12.2 Choosing Comparable Companies 219 12.3 Using Comparable Companies to Estimate the Cost of Capital 224 Summary 226 Key Terms 227 References 227 Exercises 227 Appendix 12.A: Potential Comparables for Semico 228 Part III Partial Valuation Chapter 13 Option Pricing 231 13.1 European Options 232 13.2 Pricing Options Using a Replicating Portfolio 234 13.3 The Black-Scholes Solution 238 13.4 American Options 242 13.5 Random-Expiration Options 243 13.6 Reading Exit Diagrams 245 13.7 Carried Interest as an Option 247 Summary 248 Key Terms 249 References 249 Exercises 249 Appendix 13.A RE Options: Technical Details 250 Chapter 14 The Valuation of Preferred Stock 252 14.1 Base-Case Option-Pricing Assumptions 253 14.2 RP Valuation 254 14.3 Excess Liquidation Preferences 257 14.4 Dividends 259 14.5 CP Valuation 261 14.6 CP with Excess Liquidation Preferences or Dividends 263 14.7 Combining RP and CP 266 14.8 Comparing RP and CP 268 Summary 269 Key Terms 270 References 270 Exercises 270 Chapter 15 Later-Rounds Investments 272 15.1 Series B 272 15.2 A Conversion Shortcut 277 15.3 Series C 278 15.4 Dividends in Later Rounds 282 15.5 Beyond Series C 285 Summary 288 Key Terms 288 Exercises 288 Chapter 16 Participating Convertible Preferred Stock 290 16.1 Binary Options 291 16.2 The Valuation of PCP 292 16.3 The Valuation of PCPC 294 16.4 Series B and Beyond 296 Summary 303 Key Terms 303 References 303 Exercises 303 Chapter 17 Implied Valuation 305 17.1 Post-Money Valuation Revisited 306 17.2 Measurements of Portfolio Value 310 17.3 Down Rounds? 314 17.4 How to Avoid Valuation Confusion 317 Summary 318 Key Terms 318 Exercises 319 Chapter 18 Complex Structures 320 18.1 Management Carve-outs 320 18.2 Dealing with Partners 327 18.3 A Complex Example 329 Summary 334 Key Term 334 Exercises 34 Part IV The Finance of Innovation Chapter 19 R&D Finance 339 19.1 R&D Around the World 339 19.2 Two Touchstones 345 19.3 How is R&D Financed? 349 19.4 Where Do We Go From Here? 354 Summary 355 Key Terms 356 References 356 Chapter 20 Monte Carlo Simulation 357 21.1 Decision Trees 379 21.2 Real Options in R&D 381 21.3 The Valuation of Real Options 382 21.4 Risk-Neutral Probabilities 388 21.5 Drugco, Revisited 395 Summary 398 Key Terms 398 Exercises 398 Chapter 22 Binomial Trees 400 22.1 The Black-Scholes Equation, Revisited 400 22.2 Multiple Strike Prices and Early Exercise 409 22.3 Dividends 411 Summary 417 Key Terms 418 References 418 Exercises 418 Chapter 23 Game Theory 419 23.1 What Is Game Theory 419 23.2 Simultaneous Games 423 23.3 Sequential Games 433 23.4 Game Theory and Real Options 438 Summary 443 Key Terms 443 Exercises 444 Chapter 24 R&D Valuation 445 24.1 Drug Development 445 24.2 Energy 455 24.3 The Forest and the Trees 464 Summary 464 References 465 Exercises 465 Appendix A Sample Term Sheet 466 Appendix B The VCFI Spreadsheets 484 Appendix C Guide to Crystal Ball (R) 487 Glossary 512 Index 535

About the Author

Andrew Metrick is a Professor of Finance and the TheodoreNierenberg Professor of Corporate Governance at the Yale School ofManagement, where he teaches a course in Venture Capital and theFinance of Innovation. He was previously a faculty member in thefinance department at the Wharton School of the University ofPennsylvania, and in the economics department of HarvardUniversity. In 2010 he served as the Chief Economist for PresidentObama's Council of Economic Advisers. Dr. Metrick received a BA inEconomics and Mathematics from Yale and a Ph.D. in Economics fromHarvard. He has received numerous teaching awards and distinctions,including recognition by BusinessWeek as one of the bestteachers at Wharton. Ayako Yasuda is an Assistant Professor of Management atthe Graduate School of Management, University of California, Davis.She was previously a faculty member in the finance department atthe Wharton School of the University of Pennsylvania; prior to herPh.D. she worked at the Investment Banking Division of Goldman,Sachs & Co. Dr. Yasuda received a BA and Ph.D. in Economicsfrom Stanford University. She has won numerous research grants andhas been published in the Journal of Finance, Journal ofFinancial Economics, and the Review of FinancialStudies.

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