316 ENTREPRENEURSHIP
the entrepreneurs predict small variance in the expected cash flow of their venture. What
happens if the variance is increased? If the variance of outcomes is increased to $50 cash
flow in a bad year and $950 in a good year (the expected value is still $500), we increase
the importance of reevaluating the investment decision. In Table 8.4, with the spread
between $450 and $550, the investor is going to get paid in either case. With the wider
spread, however, the investor does not get paid at all in a bad year.
If the venture needs $500 in two stages, the investor must compare two options.
Venture capitalists may follow the rule that suggests that they have no choice but to
invest in the second round, even if the cash flow is only $50. Another rule, however, says
investors may choose not to invest in the second round and thereby abandon the proj-
ect. If the investor abandons the project, he or she forfeits any claim to an annual cash
flow and receives a reduced share of the terminal value, $750. Table 8.6 illustrates the
possibilities of these cash flow scenarios and rules.
The top portion of Table 8.6 shows a situation in which the investor is required to
invest in both years. Because the discount rate is still 40 percent and the expected value
of the annual cash flows have not changed from the original example in Table 8.4, the
PV of the venture is still $1,204. But because $500 of the investment is delayed one
period, the NPV for the entire project rises to $346 from $204.
The bottom portion of Table 8.6 is more complex and requires calculating the aver-
age of expected values of a good year and a bad year when the investor may abandon
the project after the first period. The good scenario shows a periodic cash flow of $950
and an NPV of $1,262. The bad scenario shows an initial investment of $500, no cash
flow, and a terminal value of $750. The NPV of this is ($361). The average of a posi-
tive $1,262 and a negative $361 is $451. So, the value of the difference between the
expected NPV of the situation at the top of table and the expected NPV of the situation
at the bottom is $105 ($451 minus $346). Therefore, the investor can gain up to $105
in expected value by choosing the option to abandon. If the option is granted for free,
the investor gains the full $105. Clearly, investors would be willing to pay up to $105
at the outset for the right to abandon. By changing the structure of the deal, the entre-
preneur has created value and can sell that value to the investor in the form of an option.
Of course, this is a simplified example. Calculating such options is generally more
complicated because there are more than two possible cash flows ($50 and $950) and
more than two possible investing stages. But it illustrates the principle that the deal struc-
ture can create value.
Other option types exist as well. For example, the option to revalue the project deter-
mines at what price new capital will come into the deal. A fixed-price option for future
financing is one possibility: If the value of the firm is above the exercise price, the
investor will invest. If the value is below the exercise price, the investor will allow the
option to expire or sell it to another investor who has a different risk/reward profile and
preference.Warrants
A warrant is the right to purchase equity and is usually attached to another financial in-
strument, such as a bond or debenture. Ordinarily, debt holders’ returns are limited to
interest and principal. The purpose of a warrant is to enable debt holders to add to their