Gygax EF-09 Semester 1, 2024
Entrepreneurial Finance
Lecture 9
Structuring Deals
André Gygax
Bibliography:
Da Rin & Hellmann (2020) Chapter 7
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Gygax EF-09 Semester 1, 2024
Course Outline 2
Week Date Topic Required
Reading
DRH (2020)
Further
Reading
S&S (2003)
1 February 28 Introduction to Entrepreneurial Finance 1,10,13
2 March 6 Evaluating Venture Opportunities 2
3 March 13 The Financial Plan 3
4 March 20 Ownership and Returns 4
5 March 27 New Venture Valuation Methods 5
March 29 –
April 7
Easter Non-teaching period / Mid-
Semester Break
6 April 10 Entrepreneur versus Investor’s Perspective 5 11
7 April 17 Venture Capital 12
8 April 24 Term Sheets 6
9 May 1 Structuring Deals 7
10 May 8 Corporate Governance 8
11 May 15 Staged Financing 9
12 May 22 Exit 11
Gygax EF-09 Semester 1, 2024
New Venture Life Cycle 3
The Financial
Plan &
Ownership and
Returns
Venture
Capital, Term
Sheets & Deal
Structure
New Venture
Valuation
Methods &
Perspectives
Exit
Corporate
Governance &
Staged
Financing
Evaluating
Venture
Opportunities
1
2
4
3
5
6
Gygax EF-09 Semester 1, 2024
Agenda
n Last week, we discussed the important role term sheets play in
setting the incentives between the entrepreneur and the venture
capitalist.
n In this lecture
q We begin with the pre-contractual perspective and highlight how
contracting could address information problems.
q We learn how venture capital deals are structured.
q We discuss the process of structuring a deal, including pitching,
screening, syndicating, negotiating and closing.
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Gygax EF-09 Semester 1, 2024
Information Problems and Contracting
n Entrepreneur might face the
following problems
q How to raise capital without losing
control of critical intellectual
property?
q How to convey a message of
capability and commitment to
venture success?
5
n Investor might be concerned
about the following issues
q How to attract projects and gain
access to information critical to
assessing project merits?
q How to determine whether
projections in a business plan
reflect what the entrepreneur
truly expects?
n To address information and incentive problems, the parties relay on
contracting.
n Often, it is difficult to draw a clear distinction between the two types of
problems.
Gygax EF-09 Semester 1, 2024
Two Contractual Perspectives
n Pre-Contractual
q Adverse selection: One party has an informational advantage.
q Before two parties sign a contract, they have limited information
about each other.
n Post-Contractual
q Moral hazard: After two parties have signed a contract they
might choose not to perform as promised.
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Gygax EF-09 Semester 1, 2024
Pre-Contractual Information Problems
n Why do pre-contractual
information problems occur?
q Future is uncertain.
q Neither party knows what the other
knows.
q Parties have incentives to distort
what they know.
n We could try to use contracts to
overcome the pre-contractual
information problems. However,
we will face the problem of
bounded rationality.
q The parties cannot anticipate all the
contingencies a new venture will
face.
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n The cost of complete contracting is
prohibitive.
n Consequently, information
asymmetry, i.e., differences in the
information held, matter.
n Since parties have an incentive to
conceal negative information,
private information is impacted.
n The result is adverse selection ⏤
bad projects tend to drive out good
ones.
q An often-cited example is the used
car market. This example was first
studied by Akerlof (1970).
Akerlof, George (1970). “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” Quarterly Journal of Economics 84, 488-500.
Gygax EF-09 Semester 1, 2024
How Adverse Selection Works
n Entrepreneurs with good and bad opportunities both seek
investment capital.
n Each knows whether their project is good or bad, but investors
cannot distinguish between them.
n Investors compensate for bad projects
q Value business plan projections of all projects at high discount (hurdle)
rates (as in the Venture Capital Method).
n Projects with truthful projections
q Undervalued
q May not be pursued
n The ultimate result is market failure (only the most overvalued
projects are funded).
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Gygax EF-09 Semester 1, 2024
Example 1
n This example illustrates the underinvestment problem, first
discussed by Myers & Majluf (1984).
n Assume that
q There are two equally likely states of nature: State 1 and State 2.
q The entrepreneur learns the true state at time 0.
q The venture capital investor learns the true state at time 1.
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Gygax EF-09 Semester 1, 2024
Example 1
n Asset Values
q The venture has no financial slack (S = 0).
q The opportunity requires investment (I = $600).
q Hence, the entrepreneur must raise equity from a venture
capitalist E = $600.
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Item (in $ ‘000) State 1 State 2
Venture assets-in-place
NPV of first-round outside financing
a=$300
g=$80
a=$100
g=$20
See Smith, Smith & Bliss (2011), “The new venture underinvestment problem”, p. 500
Gygax EF-09 Semester 1, 2024
Example 1
n Suppose the entrepreneur states at time zero that she is
seeking outside financing and undertakes the expansion no
matter which state occurs.
n What is the resulting total value of the venture?

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Gygax EF-09 Semester 1, 2024
Example 1
n What are the values of the entrepreneur’s (ENT) shares and venture
capitalist’s (VC) shares when the true state is realized?
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Gygax EF-09 Semester 1, 2024
Example 1
n What are the values of the entrepreneur’s (ENT) shares and venture
capitalist’s (VC) shares when the true state is realized?
12
State Party Calculation Result
1
VENT
VVC
= V x V’/(V’ + E)
= $980 x $250/$850
= V x E/(V’ + E)
= $980 x $600/$850
$288
$692
2
VENT
VVC
= V x V’/(V’ + E)
= $720 x $250/$850
= V x E/(V’ + E)
= $720 x $600/$850
$212
$508
Gygax EF-09 Semester 1, 2024
Example 1
n ENT’s shares and the VC’s shares are correctly priced at the
outset.
V’ = ($288 + $212)/2 = $250

E = ($692 + $508)/2 = $600
n In this case, the ENT’s decision to raise capital tells the VC
nothing about what the ENT knows the true state to be.
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Gygax EF-09 Semester 1, 2024
Example 1
n Why is raising capital in both states not the best deal for the
ENT?
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Gygax EF-09 Semester 1, 2024
Example 2
n The problem for the ENT is that the VC will recognize that
seeking financing signals that the ENT knows that State 2 will
occur.
n What will the VC do?
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Gygax EF-09 Semester 1, 2024
Example 2
n In the new equilibrium, how much will the ENT’s shares now
be worth in State 2?
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Gygax EF-09 Semester 1, 2024
The Art of Structuring Deals
n Both the entrepreneur and the
investor contribute to
structuring the deal.
q Entrepreneur: gets the process
started
q Investor: designs the term
sheet and performs a valuation
n Deal structuring is more art
than science:
q Yet, art is not easier than
science!
n Deals are made of ‘hard’
elements (valuation, term
sheet).
q Quantitative relationships
(e.g., pricing)
q Hard legal constraints
17
n Some ‘soft’ elements are
necessary: they provide a
buffer to sustain the deal and
allow the parties to work
productively.
n Buffers go into effect when
(contingent) contracts are not
enough for effective solutions.
q How do you elicit interest into
the venture?
q How do you choose a
commercial partner?
q How do you react if a key
employee leaves? A
competitor appears? A key
supplier goes bankrupt?
Gygax EF-09 Semester 1, 2024
Pitching
Fundraising/
Pitching (to
investors)
Screening
(business
opportunities)
Syndicating
(with other
investors)
Negotiating
(between
parties)
Closing
Pitching Screening Syndicating Negotiating Closing
18
Gygax EF-09 Semester 1, 2024
The Fundraising Process
n Fundraising is a long process
that requires preparation:
q Using the venture evaluation
matrix (VEM) to prepare a
strong business case
q Building a financial plan
q Negotiating share splits among
founders
q Preparing to negotiate valuation
19
n Fundraising also requires
engaging potential investors:
q Early contact facilitates
interaction and trust building
q Later stage companies want to
keep good relations with
investors and attract competing
bids
q Timing the fundraising campaign
matters because it affects
Ø Funding risk

Ø Company growth
Ø Dilution
Gygax EF-09 Semester 1, 2024
The Fundraising Process (continued)
n Executing the fundraising campaign has its own challenges:
q Cold-calling vs. introductions
q Need to involve many investors to get one offer (‘right investor at
the right time’)
q Prepare a good pitch: domain knowledge and confidence. Key
relevant dimension change with stage.
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Gygax EF-09 Semester 1, 2024
The Fundraising Process (continued)
n The disclosure dilemma:
q Non-disclosure agreements (NDAs) are a largely useless tool –
information is largely common knowledge (idea execution is key)

q Arrow’s information paradox: you only pay if you can see the quality of
the idea, but that requires that this is disclosed!
n How to solve the dilemma?
q Use patenting to protect ideas even with disclosure

q NDAs suitable for objective, project-specific, non-patentable
information, often soft (e.g., client lists)
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Gygax EF-09 Semester 1, 2024
The Fundraising Process (continued)
n Do business ideas have a value?
q Is different from valuing a venture, because it reflects a more
basic level of option value
q Is only necessary if some financial transaction depends on it
n What is an idea’s theoretical value?
q Idea itself does not generate cash flows, so it can only be valued
together with the assets needed to make it profitable
q Can the idea improve the profitability of alternative uses of those
assets? How unique is the idea?
Ø Idea in isolation is not much worth
Ø Asking where the value of the venture lies is the key question
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Gygax EF-09 Semester 1, 2024
Screening
Fundraising/
Pitching (to
investors)
Screening
(business
opportunities)
Syndicating
(with other
investors)
Negotiating
(between
parties)
Closing
ScreeningPitching Syndicating Negotiating Closing
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Gygax EF-09 Semester 1, 2024
Screening
n Once the proposals are in, they need vetting by investors.
n Survey evidence (averages per year):
q 200 business plans (BPs) examined in depth
q 50 management teams met
q 20 BPs reviewed (12 with due diligence) by each partner
q 5.5 offers made – 4 accepted
q Probability of moving from screening to investment: 2%
q 83 days to deal closing, 118 hours of due diligence
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Gygax EF-09 Semester 1, 2024
Finding a Match
n The MATCH Questionnaire represents a way to assess the fit
between investor and entrepreneur.
q It sifts through several questions that can be adjusted to each
situation.
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Gygax EF-09 Semester 1, 2024
Syndicating
Fundraising/
Pitching (to
investors)
Screening
(business
opportunities)
Syndicating
(with other
investors)
Negotiating
(between
parties)
Closing
SyndicatingScreeningPitching Negotiating Closing
26
Gygax EF-09 Semester 1, 2024
Syndication 27
25%
35%
45%
55%
65%
75%
85%
95%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Angel/Seed Series A Series B+
Survey of VCs reports information
about the main reasons to syndicate:
1. Capital constraints (30%)
2. Complementary expertise (33%)
3. Risk sharing (24%)
4. Access to future deals (3%)
n Syndication is quite
common (50% to 80% of
deals).
n Investors syndicate the
deal to:
q Obtain second opinions
q Reduce commitment/
diversify/keep ‘dry
powder’
q Reciprocate invitations
(giving up cherry-picking)
q Involve investors with
complementary skill sets
& networks
Gygax EF-09 Semester 1, 2024
Syndication
n How are syndicates structured:
q Lead investor performs due diligence, negotiates, sits on board of
directors
q Followers provide capital, on-demand expertise and networks
n Does syndication affect performance?
q Studies show that syndicated deals tend to perform better
n VCs with better record tend to be better networked and syndicate
more
n Their past success breeds future success by accessing better deals
through others
q Syndication also allows to make better investment choices,
improve diversification, attract co-investors that are a good fit
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Gygax EF-09 Semester 1, 2024
Negotiating
Fundraising/
Pitching (to
investors)
Screening
(business
opportunities)
Syndicating
(with other
investors)
Negotiating
(between
parties)
Closing
NegotiatingScreening SyndicatingPitching Closing
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Gygax EF-09 Semester 1, 2024
Nobel Insights: Bargaining Theory 30
Gygax EF-09 Semester 1, 2024
Deal Negotiation
n Nash Bargaining theory can
be made operational by
using three concepts:
q Each party’s outside option of
walking out of the deal
q The Zone of Possible
Agreements (ZOPA)
q The actual final agreement
31
n Outside options are the
alternatives to the deal.
q They give each party the
power to threaten to walk
out, so they are very
important.
q They are often built over time
by cultivating alternative
employment/investment
possibilities.
q For later stage deals, the cash
flow situation is an important
factor in this respect.
Gygax EF-09 Semester 1, 2024
Deal Negotiation
n The ZOPA maps the respective sets of admissible deals,
those that are more attractive than the outside option(s).
n Below is a simple bi-dimensional example, trading off valuation and
downside protection.
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Gygax EF-09 Semester 1, 2024
Deal Negotiation
n Which specific deal is chosen within ZOPA depends on deal- specific
conditions, including any factors not accounted for in the diagram.
n Negotiation ability comes here into play!
n Let us introduce some equations:
SV = JV – OOE – OOI
BVE = OOE + BSE*SV
BVI = OOI + BSI*SV
where
SV=surplus, JV=joint value of cooperation, OO=outside option, BV=bargaining
value, BS=bargaining strength, E = entrepreneur, I = investor
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Gygax EF-09 Semester 1, 2024
Deal Negotiation
n Example 1: Entrepreneur (E), Buyer (B) who would pay X
dollars for V. Investor (I) could contribute Y dollars so that
value of V increases to Z dollars.
q Surplus Value (SV):
SV = JV – OOE –OOI = Z – X – Y
q E’s bargaining value with BSE = w :
BVE = OOE + BSE*SV = X + w*(Z–X–Y)
q I’s bargaining value:
BVI = OOI + BSI*SV = Y+(1-w)*(Z–X–Y)
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Gygax EF-09 Semester 1, 2024
Dynamic Strategies
Fundraising/
Pitching (to
investors)
Screening
(business
opportunities)
Syndicating
(with other
investors)
Negotiating
(between
parties)
Closing
Pitching Screening Syndicating Negotiating Closing
35
Gygax EF-09 Semester 1, 2024
Closing 36
n Closing the deal
requires coordinating
various activities, like
the interest of
different investors, so
that everything can
fall into place in the
right way.
q Entrepreneurs take
initiative. Founders
need to agree on a
common position on
bargaining
q Investors contribute
experience and a
balancing hand
n Both sides benefit
from creating
competition.
q Means building
better outside
options to reduce
ZOPA
q ‘No shop’ clauses
n Market conditions
also affect how ‘hot’
a certain deal is:
q When ‘money
chases deals’
getting better
conditions is easy.
n A constant threat
is to get
agreement/commi
tment by external
parties.
n Example: funding
is conditional on
hiring a senior
manager, who will
accept conditional
on funding …
n Here good
negotiators can
make a difference.
Gygax EF-09 Semester 1, 2024
Living with the Deal
n A deal is part of a set or repeated interactions, whose goal is
the success of the venture.
n Two ‘soft’ elements are particularly important as buffers:
q Trust = ‘firm belief in the reliability, truth of ability of someone’
Ø It allows one party to let the other take action without direct control or
limitations
Ø It allows parties to make decisions when a contract cannot help and
there is need to absorb bumps
q A long-term perspective allows to ‘compensate’ for intertemporal
imbalances. It can create future value-creating opportunities but
there may be trade-offs between short-term and long-term gains:
Ø Higher valuation now at the risk of down round later
Ø How to make room for future investors?
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Gygax EF-09 Semester 1, 2024
Key Points
n In this lecture
q We began with the pre-contractual perspective and highlight how
contracting could address information problems.
q We learnt how venture capital deals are structured.
q We discussed the process of structuring a deal, including pitching,
screening, syndicating, negotiating and closing.
38
Gygax EF-09 Semester 1, 2024
Practice
Now it is time for another round of practice
questions. Let’s test your knowledge of some of
the recently covered topics.