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Flashcards in Final Exam Deck (108):

What are the two types of financial markets?

Public financial markets
>> markets for the creation, sale, and trade of liquid securities having standardized features

Private financial markets
>> markets for the creation, sale, and trade of liquid securities having les standardized negotiated features.


What are the different types of risk?

Default risk
>> risk that a borrower will not pay the interest and/or principal on a loan

Interest rate risk

Market risk


What is nominal interest rate ?

Observed or stated interest rate


What is the real interest rate (RR)?

Interest one would face in the absence of inflation, risk, illiquidity, and any other factors to determine the interest rate.

R debt (Rd) = RR + IP +DRP +LP + MP


What is risk-free interest rate?

Interest rate on debt that is virtually free of all default risk.


What is inflation?

Rising prices not offset by increasing quality of the goods or services being purchased.


What is inflation premium (IP)?

Average expected inflation rate over the life of a risk-free loan.

Risk-free rate (Rf) = RR +IP


What is default risk premium (DRP)?

Additional interest rate premium required to compensate the lender for the probability that a borrower will default on a loan.


What is prime rate?

Interest rate charged by banks to their highest-quality (lowest default risk) business customers.


What are bond ratings?

>> An assessment that reflects the default risk of a firm’s bonds as judged by a bond-rating agency
Ex. Standard&poor’s or moody’s

***for larger mature corps, differences in DRPs are often captured by bond ratings

***Liquidity and maturity horizon may influence the nominal interest rate on a ventures’ bond


What are the two different types of premiums?

Liquidity premium (LP)
>> Premium charged when a debt instrument cannot be converted to cash quickly as its’ existing value

Maturity Premium (MP)
>>premium that reflects increased uncertainty associated with long-term debt


What is the term structure of interest rates?

Relationship between nominal interest rates and time to maturity when default risk is held constant.

Also known as YIELD CURVE
>> Graph of the term structure of interest rates


Describe debt.

Debt issues may be SECURED or UNSECURED.

Senior debt: debt secured by a venture’s assets

Subordinated debt: Debt with inferior claim (relative to senior debt) to venture’s assets

There is an investment risk of loss:
>> chance or probability of financial loss from a venture investment


Describe rate of return

Probability -weighted average of all possible rates of return

%Rate of return = (cash flow+(ending value-beginning value))/(beginning balue)*100


Standard deviation.

Coefficient of variation

Measure of a the dispersion of possible outcomes and the expected return of an investment

Measure of the dispersion risk per unit of expected rate of return


What are the different type of investors?

Private equity investors
>>owners of proprietorships, partners in partnerships, and owners in closely held corporations

Closely held corporations
>>corporations whose stock is not publicly traded

Publicly traded stock investors
>>equity investors of firms whose stocks trade in public markets such as the over-the-counter market or an organized securities exchange


What are two different type of markets?

Over-the-counter (OTC)
>>network of brokers and dealers that interact electronically without having a formal location

Organized securities exchange
>>a formally organized exchanged typically having a physical location with a trading floor where trades take place under rules set by the exchange


What is market capitalization (aka CAP)?

A firm’s current stock price multiplied by the number of shares that are outstanding


What is the investment risk premium (IRP)?

Additional return that investors can expect to earn when investing in a risky publicly traded common stock


Market risk premium (MRP)

Excess average annual return of common stocks over long-term government bonds


Venture Hubris

Optimism expressed in business plan projections that ignore the possibility of failure or underperformance


Weighted average cost of capital (WACC)

Weighted average of the cost of the individual components of interest bearing debt and common equity capital

***most early stage financing is equity capital


Business planning.

***Business plan must allow the time and money necessary to secure proper legal advice from attorneys who specialize in tracking, interpreting, and apply the every-changing securities law

***during the development and startup stages, entrepreneur is likely to focus on identifying, developing, and bringing to market a product, service, or process


Business angels

Investors who typically invest in the equity of an LLV or a nonpublic (subchapter S or C) corporation


Venture capitalists

Investors who prefer equity investments in nonpublic corporations with the contractual agreements (spelled out in “term sheets”)


Heart of securities law

1. Prospective investors should have all relevant information necessary to make informed investment decisions

2. Investors in securities available to the general public should not be permitted to benefit from nonpublic or inside information

3. Deceived investors should receive relief in the event of securities fraud


Securities act of 1933

>>main body of the federal law governing the creation and sale of securities


Securities exchange act of 1934

>> federal law that deals with the mechanisms and standards for public security trading


Securities crowd funding

JOBS act title III’s small offering registration exemption form SEC registration requirements involving crowdfunding for the sale of securities


Blue-sky laws

State laws designed to protect individuals from investing in fraudulent security offerings

offer — every attempt or offer to dispose of or solicitation

Sale — offer to buy


Expected value

Weighted average of a set of scenarios or possible outcomes


Internally generated funds

Net income or profits (after taxes) earned over an accounting period

— to calculate:
>>sustainable sales growth rate:
Rate at which a firm can grow sales based on the retention of profits in the business


Financial capital needed (FCN)

Funds needed to acquire assets necessary to support a firm’s sales growth


Spontaneously generated funds

Increases in accounts payables and accruals (wages and taxes) that accompany sale increases


Additional funds needed (AFN)

Gap remaining between the financial capital needed and that funded by spontaneously generated funds and retained earnings

AFN = required increase in assets - spontaneously generated funds - increase in R/E


Percent of sales forecasting method

Forecasting method that makes projections based on the assumption that most expenses and balance sheet items can be expressed as a percentage of sales


Constant ration forecasting method

Variant of the percent-of-sales forecasting method that projects selected cost and balance sheet items at the same growth rate as sales

The financial forecasting method:
1. Forecasted sales
2. Project the income statement
3. Project the balance sheet
4. Project the statement of cash flow


Venture capitalists (VC’s)

- Having personal stakes and have raised funds
- Individuals who join in formal, organized firms to raise and distribute venture capital to new and fast-growing ventures


American research and development (ARD) —1946

1st investment : high voltage engineering corporation, a venture organized by MIT physicists and engineers


Small business administration (SBA) in 1953

- tax advantages
- borrow 4 x the SBIC equity base


Professional venture investing cycle

1. Determine (next) fund objectives and policies
3 common
- industry
- stage and size of investment
- geographic area

2. Organize new fund (usually a partnership)
3. Solicit investments in new fund
4. Obtain commitment for series of capital calls
5. Conduct due diligence and actively invest
6. Arrange harvest or liquidation
7. Distribute cash and securities proceeds (as available)
8. Determine (next) fund objectives and policies


Business incubators

- organization that helps startup companies develop by providing management, operating, and financial services

- usually formed as a nonprofit

- length of time a co. Can stay in the program depends:
—complexity of the business model, predetermined revenue, or other benchmark targets


Seed Accelerator
(Startup accelerator)

- organization that usually provides both an equity investment and a mentoring and educational, fixed-term , cohort program to help startup co. succeed

Business incubators and seed accelerators offer mentoring, networking, and business educational skills to startup firms accepted into their programs. These benefits, along with obtaining loan funds by business incubators and the injection of seed equity by business accelerators, providing important assistance and support for entrepreneurs who are successful applicants.


Business crowd sourcing

- process of obtaining business ideas, development support, and operating services from a large network of non-employees

- lower development and opportunity costs at a faster speed


Crowd funding

- process of financing ideas, ventures, and projects by gathering funds from a large network of people

Reward-based crowdfunding
- involves soliciting non-equity funds to finance specific business products and services or to request donations form a specific purpose
- keep what is raised or all-or-nothing

Equity crowdfunding
- involves soliciting funds from a large number of small investors in exchange for an equity position in the venture requesting the funding.


The five C’s of credit analysis

Capacity - an indicator of future payment performance

Capital - personally invested

Collateral - “guarantees”

Conditions - purpose of loan

Character - general impression


Primary criterion

—- Firm’s ability to pay off loan + interest


Commercial loan restrictions

Maintenance of accurate records and financial statements

Limits on total debt

Restrictions on dividends or other payments to owners and/or investors

Restriction on additional capital expenditures

Restrictions on sale of fixed assets

Performance standards of financial ratios

Current tax and insurance payments


Small business administration programs

- provide contract assistance and counseling

-7(a) loans
- 504 loans
- micro loans
- venture capital



-selling receivables to a third party at a discount from their fv
- could be with recourse or without recourse


Receivables lending

Use of receivables as collateral for a loan


Venture leasing

Leasing contracts where one component of the return to the lessor is a type of ownership in the venture, usually through warrants


Direct public offerings

Security offering made directly to a large number of investors



Process of exiting the privately held business ventures to unlock the owner’s investment value.

1. Through a systematic distribution of assets directly to the owners

2. Through an outright sale of the going concern to others.



High-expected growth companies with valuations in excess of $1 billion


Systematic liquidation

>> a venture liquidated by distributing the venture’s assets to the owners

-the entrepreneur and other owners maintain control throughout the harvest period

-the harvesting of the investment value can be spread out over a number of years

- the time, effort, and cost of finding a buyer for the venture can be avoided

-The treatment and taxation of liquidation proceeds as ordinary income (rather than capital gains)

-the commitment of the entrepreneur’s wealth, abilities, and focus to a dying venture, rather than other venture pursuits that might be more lucrative.

- the acceleration of the rates of decline in the going concerns’ value as other industry participants respond to the reduction in the investment


Outright sale

>> venture sold to others, including family members, managers, employees, or external buyers


Family members

Can transfer through



>> have limited personal resources for an outright buy

*leveraged buyout (LBO)
*Management buyout (MBO)

***LBO/MBO exit strategy requires a tight plan for streaming operations and cutting costs


Leveraged buyout (LBO)

>> Purchase price of a firm is financed largely with debt financial capital
~ existing investors equity is retired from an aggressive debt issue


Management buyout

>>special type of LBO where the firm’s top management continues to run the firm and has a substantial equity position in the reorganized firm



-employee stock ownership plans (ESOPS)
-available in leveraged (harvest all at once) and un-leveraged securities


Outside buyers

Valuation analysis for an acquisition

- control premium: “value of controlling the venture”
~related to the value

-illiquidity discount : “compensate for the resale of disadvantages”


Initial public offering (IPO)

- a venture’s first offering of SEC registered securities to the public

Primary shares offering: the sale of new shares (securities)

Secondary shares offering: the sale of used shares (securities)


Investment banking

>> an intermediary assisting in the creation, sale, and distribution of financial assets.
>>experts; initiate markets

Underwriting spread (typically 7 to 10 percent)
-difference between what the investment bank gets from selling securities to public investors and what it pays to the issuing firms


Red herring disclaimer

Obligatory disclaimer disavowing any intent to act as an offer to sell, or solicit an offer to buy securities


Investment banking due diligence

The process of ascertaining, to the extent possible, an issuing firm’s financial condition and investment intent


Firm commitment

Type of agreement with investment bank involving the investment banks’ underwritten purchase and resale of securities


Best efforts

Type of agreement with investment bank involving only marketing and distribution efforts


Seasoned offering

A firm that has already had publicly traded shares


Unseasoned offering

When the issuer has not previously issued that type of security


Financial distress

When cash flow is insufficient to meet current debt obligations


Loan default

Occurs when there is a failure to meet interest or principal payments when due on a loan


Acceleration provision

Provides that all future interest and principal obligations on a loan become immediately due when default occurs


Cross-default provision

Provides that defaulting loan places all loans in default



Legal process used by creditors to try to collect amounts owed on loans in default



>> when a venture has a negative book equity or net worth position and /or when its cash flow is insufficient to meet current debt obligations

A) balance sheet insolvency
B) cash flow insolvency


Balance sheet insolvency

- exists when a venture has negative book equity or net worth because total debt exceeds total assets

- common during early stages


Cash flow insolvency

Exists when a venture’s cash flow is insufficient to meet its current contractual debt obligations



>> turnaround a financially distressed venture

-operations restructuring
-asset restructuring
-financial restructuring


Operations restructuring

Involves growing revenues relative to costs and/or cutting costs relative to the venture’s revenues


Asset restructuring

Involves improving the working capital to sales relationships and/or selling off fixed assets


Financial restructuring

Involves changing the contractual terms of the existing debt obligations and/or the composition of the existing the venture

-debt payment extension
-debt composition change


Debt payments extension

Involves postponing due dates for interest and principal payments on credit purchases


Debt composition change

Occurs when creditors reduce their contractual claims against the venture


Federal bankruptcy reform act of 1978

Ch. 11 - business reorganizations

Ch.7 - procedures for liquidating a ventures assets



When a petition for bankruptcy is filed with a federal bankruptcy court.

- voluntary bankruptcy petition
- involuntary bankruptcy petition


Bankruptcy reorganizations

1. a successful reorganization and continuing of operations
2. Merging the venture with another firm
3. liquidating the venture under Ch. 7 of the bankruptcy law


Reasons for legal reorganizations

- Common Pool problem
- holdout problem


Common pool problem

When individual creditors have incentive to foreclose on the venture even though it is worth more as a going concern

Automatic Stay provision:
A restriction on the ability of an individual creditors to foreclose to try to recover their individual claims


Holdout problem

When one or more of the creditors refuses to agree tot eh reorganization term because of the potential for a larger individual recovery.

Cram-down procedure:
- Bankruptcy court accepts a reorganization plan for all creditors, including dissenting creditor classes

Debt-in-possession financing
-short-term financing, made all existing unsecured debt, to help meet liquidity needs during the reorganization process



1. restrict management from fraudulently transferring the ventures assets.
2. provides a court-decided "fair and equitable" basis for allocating the asset proceeds to all claimants
3. Allows the entrepreneur and other shareholders to "walk away" from the venture with no further obligations


Liquidity order of claims

1. administrative costs associated with the venture's liquidation
2. wages and other unpaid employee benefits (limited to amounts earned within the past three months with a maximum of $2,000 per employee)
3. specific consumer claims ($900 maximum per claim)
4. Tax claims (property and income taxes)
5. Secured creditors (entitled to the proceeds from sale of plan and equipment pledged as security for mortgage loans or bonds )
6. unfunded pension plan liabilities ( a portion may have prior claim over general creditors while the remainder has a claim equal to the general creditors)
7. General (unsecured) creditor claims (includes holders of trade credit, unsecured loans including debenture loans, and unpaid portions of secured loans)
8.preferred stock holder claims
9. common stock holder claims (differential priorities might exist if different classes of common stock had been previously issued)


Two types of cost


Difference between accounting perspective and finance perspectives
1. Cash flow is a new venture's lifeblood.
2. Finance perspective demands that, where possible, the cost of financial capital be explicitly incorporated in evaluations, projections, and strategy.


State securities regulations

- in addition to federal restrictions, issuers must also consider restrictions imposed by the various states
- state securities regulations are "blue sky" laws
- designed to protect individuals from investing in fraudulent security offerings


Role of federal securities law

- Federal laws frequently are predicated on some offending behavior's affecting more than one state
- This focus is due to "state-rights" traditions and the notion that an infraction confined to one state is a state, not a federal, matter.


Securities fraud

- It is unlawful for a person in the offer or sale of securities:
- to employ any device, scheme, or artifice to defraud
- to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact
- to engage in any transaction, practice, or course of business which operates as fraud or deceit upon the purchaser


Projected financial statements

Financial forecasting process to project financial statements
1. forecast sales
2. project income statement
3. project balance sheet
4. project statement of cash flows


Carried interest

portion of profits paid tot eh professional venture capitalist as an incentive compensation


two and twenty shops

investment management firms having a contract that gives them a 2% of assets annual management fee and 20 percent carried interest


Capital call

when the venture fund calls upon the investors to deliver their investment funds
- it is common to require subsequent investments consistent with the levels of investors' initial contributions


Deal flow

flow of business plans and term sheets involved in the venture capital investing process


due diligence (in venture investing context)

process of ascertaining the viability of a business plan


VC screening criteria

1. venture capital firm requirements
2. characteristics of the proposal
3. Characteristics of the entrepreneur/team
4. nature of the proposed industry
5. strategy of the proposed business


Term sheet

Summary of the investment terms and conditions accompanying an investment
-ongoing funding needs
- size and staging of financing
-preemptive rights on new issues
-commitments for future financing rounds and performance conditions
- form of security or investment
-redemption rights and responsibilities


Protective clauses in case of default

1. acceleration provision: provides all future interest and principal obligations on loan become due immediately upon default
2. cross-default provision: provides that defaulting on one loan places all others in default


Private workouts

voluntary agreement between a venture's owners and its creditors that provides for a financial restructuring of the venture's outstanding debt


Private liquidations

assignment: transfer of title to the ventures assets to a third-party assignee or trustee