ENTR6053-Entrepreneurial Finance

Background and Environment

Part I: Background and Environment

Chapter 1&2

Week 1 / Session 2
 Background and
Environment
Introduction and Overview
• The Entrepreneurial Process
• Entrepreneurship Fundamental
• Sources of Entrepreneurial Opportunities
• Principles of Entrepreneurial Finance
• Role of Entrepreneurial Finance
• The Successful Venture Life Cycle
• Financing Through the Venture Life Cycle
From Idea to the Business Plan
• Process for Identifying Business Opportunities
• To be Successful, You Must Have a Sound Business Model
• Learn from the Best Practises of Successful Entrepreneurial Ventures
• Time to Market and Other Timing Implications
• Initial “Litmus Test” for Evaluating the Business Feasibility of an Idea
• Screening Venture Opportunities
• Key Elements of a Business Plan
INTRODUCTION AND OVERVIEW
 The Entrepreneurial
Process
• Process:
– Developing
opportunities
– Gathering resources
– Managing and
building operations
• Goal:
– Creating value
 Entrepreneurship
Fundamental
• Entrepreneurship:
process of changing ideas into commercial
opportunities and creating value
• Entrepreneur:
individual who thinks, reasons, and acts to
convert ideas into commercial opportunities
and to create value
 Entrepreneurship
Fundamental
• Entrepreneurial Traits or Characteristics:
A successful entrepreneur
– Sees and seizes a commercial opportunity
– Tends to be doggedly optimistic (perhaps even to a fault)
– Plans to obtain the physical, financial, and human resources needed
for the venture to succeed
• Non-Entrepreneurial Traits or Characteristics :
Success is unlikely if you
– “are seldom able to see an opportunity, until it ceases to be one”
(Mark Twain)
– “view the glass as being half empty instead of half-full” (unknown)
– are paralyzed by a fear of failure
 Opportunities Exist but
Not Without Risks
Opportunities:
• New U.S. business formations in the millions annually
• Firms with less than 500 employees
– represent over 99 percent of all employers
– account for about one-half of the annual gross private domestic product
Risks:
• Annual employer firm births (~659,093 in 2005-07) slightly exceeds births
(~578,793 in 2005-07)
• Note, however, that bankruptcies are only a fraction (~29,073) of terminations -
terminations not all “bad”
• For new firms, a representative study (Head) found
a. one-third of new employer firms endure < 2 years
b. one-half endure < 4 years
c. 60 percent endure < 6 years
d. but, about one-third were “successful” at closing
 Sources of Entrepreneurial
Opportunities
• Research (J. Case) suggests
– 12% of Inc. 500 success is due to extraordinary idea
– 88% due to exceptional execution of ordinary idea
• Trends suggesting possible entrepreneurial
innovations
– Societal changes
– Demographic changes
– Technological changes
– Crises and “bubbles”
 Societal Changes

• Naisbitt’s reflections still relevant!

(Megatrends,1982)
1. “Industrial Society” to “Information Society”-
Suggested focus on human response to
information
2. Global economy - Awareness of international
innovation and sourcing

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 Demographic Changes

• Dent’s Generations – The Baby Boom

1. Spending wave (1990’s) - Behind the stock and
bond market booms
2. Power wave (to peak in the 2020’s)
– Aging baby boomers with great business
influence
– Aging baby boomers provide business
opportunities - creating them, financing
them, using them
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 Technological Changes

• Information Age
• Internet
• Wireless
• Cross-functionality
• Truly global in reach and competition

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 Crises and Bubbles

• 2007-09 Financial crisis changed the game

• Cloudy time almost always have silver linings
– Cost containment innovations
– Alternative energy
– Government stimulus

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 Entrepreneurial Finance
Principle
• Seven principles of entrepreneurial finance:
1. Real, human, and financial capital must be rented from owners.
2. Risk and expected reward go hand in hand.
3. While accounting is the language of business, cash is the
currency.
4. New venture financing involves search, negotiation, and privacy.
5. A venture’s financial objective is to increase value.
6. It is dangerous to assume that people act against their own self-
interests.
7. Venture character and reputation can be assets or liabilities.
 Entrepreneurial Finance
Principle
1. Real, Human, and Financial Capital Must be
Rented from Owners
– Money has owners and therefore costs
• Time value
• Risk
– Expect to provide a return or the venture will not
survive in a market economy

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 Entrepreneurial Finance
Principle
2. Risk and Expected Reward Go Hand in Hand
– Time value is not the only cost when using
others’ funds
– More risk => More expected reward
– How much more? Market-determined!

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 Entrepreneurial Finance
Principle
3. While Accounting is the Language of Business, Cash
is the Currency
– Two important reasons to employ accounting
• Tracking and accountability for actions taken
• Quantifying different visions of the future
– But, remember cash flow is a new venture’s lifeblood
• “Get enough accounting to see through the accruals to the cash
account”
• Cash burn: gap between cash being spent and that being
collected
• Cash build: excess of cash receipts over cash distributions
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 Entrepreneurial Finance
Principle
4. New Venture Financing Involves Search,
Negotiation, and Privacy
– Public Financial Markets: standard contracts
traded on organized exchanges
– Private Financial Markets: customized contracts
bought and infrequently sold in inefficient
private negotiations

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 Entrepreneurial Finance
Principle
5. A Venture’s Financial Objective is to Increase
Value
– Many objectives including personal ones
– But, the unifying financial objective is to increase
value
• rather than price, margin or sales
• rather than profit, return or net worth
– (Market) Value derives from the ability to generate
cash to pay capital providers for their capital
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 Entrepreneurial Finance
Principle
6. It is Dangerous to Assume that People Act Against Their
Own Self-Interest
– Aligning incentives (investors, founders, employees, spouses,
etc.) is critical
– As situations change, incentives diverge and renegotiation is
important
– Owner-manager conflicts: differences between a manager’s
self-interest and that of the owners who hired him/her
– Owner-debt holder agency conflict: divergence of the owners’
and lenders’ self-interests as the firm gets close to bankruptcy

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 Entrepreneurial Finance
Principle
7. Venture Character and Reputation Can be Assets or
Liabilities
– Ventures have character that can be different from the
individuals who founded or manage it
– Many entrepreneurs state that high ethical standards are
one of a venture’s most important assets and are critical to
long-term success and value
– Ventures can - and do - make meaningful societal
contributions
– Many successful entrepreneurs are financially and personally
involved in charitable endeavors
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 Role of Entrepreneurial
Finance
• Entrepreneurial Finance
– application and adaptation of financial tools and
techniques to the planning, funding, operation,
and valuation of an entrepreneurial venture
– focuses on the financial management of a
venture as it moves through its life cycle,
beginning with its development stage &
continuing through to when the entrepreneur
exists or harvests the venture
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 The Successful Venture
Life Cycle
• Venture Life Cycle:
stages of a successful
venture’s life from
development through
various stages of revenue
growth)
– Development Stage:
period involving the
progression from an idea to a
promising business
opportunity
– Startup Stage:
period when the venture is
organized, developed, and an
initial revenue model is put in
place
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 Successful Venture Life
Cycle
– Survival Stage:
period when revenues start to grow and help pay some, but typically not all, of the expenses
– Rapid-Growth Stage:
period of very rapid revenue and cash flow growth
– Early-Maturity Stage:
period when the growth of revenue and cash flow continues but at a much slower rate than
in the rapid-growth stage

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 Financing Through the
Successful Venture Life Cycle
• Development Stage  Developing opportunities and seed
financing
• Startup Stage  Gathering resources and startup financing
• Survival Stage  Gathering resources, managing and
building operations and first-round financing
• Rapid-Growth Stage  Managing and building operations
and second-round mezzanine, & liquidity stage financing
• Early Maturity Stage  Managing and building operations
and obtaining bank loans, issuing bonds, & issuing stock

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Financing
Through
the
Venture
Life Cycle
 Selected Financing
Definitions
• Seed Financing:
funds needed to determine whether the idea can be
converted into a viable business opportunity
• Startup Financing:
funds needed to take the venture from having
established a viable business opportunity to initial
production and sales
• Venture Capital:
early-stage financial capital often involving substantial
risk of total loss
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 Selected Financing
Definitions
• Venture Capitalists:
individuals who join in formal, organized firms to raise and
distribute venture capital to new and fast-growing ventures
• Business Angels:
wealthy individuals operating as informal or private investors
who provide venture financing for small businesses
• Investment Banker:
individual working for an investment bank who advises and
assists corporations in their security financing decisions and
regarding mergers and acquisitions

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 Selected Financing
Definitions
• First Round Financing:
equity funds provided during the survival stage to cover
the cash shortfall when expenses and investments exceed
revenues
• Second Round Financing:
financing for ventures in their rapid-growth stage to
support investments in working capital
• Mezzanine Financing:
funds for plant expansion, marketing expenditures,
working capital, and product or service improvements
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 Selected Financing
Definitions
• Bridge Financing:
temporary financing needed to keep the venture
afloat until the next offering
• Initial Public Offering (IPO):
a corporation’s first sale of common stock to the
investing public
• Seasoned Securities Offering:
the offering of securities by a firm that has previously
offered the same or substantially similar securities
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 Life Cycle Approach to Teaching
Entrepreneurial Finance

• Background & Environment

• Organizing & Operating the Venture
• Planning for the Future
• Creating & Recognizing Venture Value
• Structuring Financing for the Growing
Venture
• Exit and Turnaround Strategies

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Life Cycle
Approach to
Teaching
Entrepreneurial
Finance
FROM IDEA TO THE BUSINESS PLAN
 Process for Identifying
Business Opportunities
Various Types of Firms
• Salary-replacement firms: firms that provide their owners with
income levels comparable to what they could have earned working
for much larger firms
• Lifestyle firms: firms that allow owners to pursue specific lifestyles
while being paid for doing what they like to do
• Entrepreneurial ventures: entrepreneurial firms that are flows- and
performance-oriented as reflected in rapid value creation over time

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 To be Successful, You Must
Have a Sound Business Model
Components of a Sound Business Model
• Generate Revenues (You must have customers and
sell them something)
• Make Profits (You must eventually have revenues
that exceed the expenses of generating those
revenues)
• Produce Free Cash Flows (You must generate cash
inflows that exceed net working capital and capital
expenditures)
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 Learn from the Best Practises of
Successful Entrepreneurial Ventures

• Three Areas:
– Marketing Practices
– Financial Practices
– Management Practices
[Note: While Operations/Production practices
are not listed separately, they go hand-in-hand
with high quality products and services, as well
as on-time delivery]

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 Time-to-Market and Other
Timing Implications
• Business opportunities exist in real time
• Most ideas have a relatively narrow window
of opportunity to become a successful
business venture
• Sometimes ideas are ahead of their time
• Of course, being “first to market” does not
necessarily ensure success

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 Initial “Litmus Test” for
Evaluating the Business
Feasibility of an Idea
• A viable venture opportunity:
creates or meets a customer need, provides an initial competitive
advantage, is timely in terms of time-to-market, and offers the
expectation of added value to investors
• SWOT analysis should consider the following areas as potential
strengths or weaknesses:
– Unfilled customer need
– Intellectual property rights
– First mover
– Lower costs and/or higher quality
– Experience/expertise
– Reputation value

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 Initial “Litmus Test” for
Evaluating the Business
Feasibility of an Idea
• The SWOT analysis should, at a minimum,
consider the following areas as potential
opportunities or threats:
– Existing competition
– Market size/market share potential
– Substitute products or services
– Possibility of new technologies
– Recent or potential regulatory changes
– International market possibilities
 Screening Venture
Opportunities
• Venture opportunity screening:
assessment of an idea’s commercial potential
to produce revenue growth, financial
performance, and value
• Our approach:
– Qualitative screening: Interview with the
Founder
– Quantitative screening: VOS Indicator
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 Qualitative Screening:
Interview
• Four Factor Categories Initially Evaluating a
Potential Venture’s Attractiveness:
1. The Big Picture
2. Know Thy Customer
3. Production and Development Challenges
4. Financial Fortune-Telling

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 Quantitative Screening:
VOSTM Indicator
• VOS Indicator™: checklist of selected criteria and metrics used to
screen venture opportunities for potential attractiveness as
business opportunities.
• Attempt to quantify the following areas
– Industry/Market (market size potential, industry barriers to entry)
– Pricing/Profitability (size of expected profit margins, accounting-based
rates of returns)
– Financial/Harvest (expected investment returns, potential for an initial
public offering [IPO])
– Management Team (quality of management team)
• Supplement to, rather than replacement of, basic qualitative Q&A
approach
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Metrics or
verbal labels
to be used
for judging
each item in
the
VOS
Indicator™
 Selected Accounting Terms

• Cost of Goods Sold:

direct costs of producing a product or providing a service
• Gross Profit:
revenues less the cost of goods sold
• Gross Profit Margin:
gross profit divided by revenues
• Net Profit:
dollar profit left after all expenses, including financing costs
and taxes, have been deducted from the firm’s revenues

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 Return on Assets (ROA)
Model
• Net Profit Margin (NPM):
net profit divided by revenues
• Asset Intensity:
total assets divided by revenues, the reciprocal of
asset turnover (so ATO = Revenues/Total Assets)
• Return on Assets (ROA):
net after-tax profit divided by total assets
• ROA Model:
ROA = NPM x ATO
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 ROA Model Considerations

• Case 1: High Profit Margins & Low Asset Turnovers

– Examples: products and services based on technological innovations
• Case 2: Low Profit Margins & High Asset Turnovers
– Examples: commodity-type products and services
 More Selected Financial
Terms
• Operating Cash Flow:
cash flow from producing and selling a product or
providing a service
• Free Cash Flow to Equity:
cash remaining after operating cash outflows, financing
and tax cash flows, investment in assets needed to sustain
the venture’s growth, and net increases in debt capital
• Internal Rate of Return (IRR):
compound rate of return that equates the present value of
the cash inflows received with the initial investment
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 VOS Indicator™ Average
Scores
• High Potential (average scores of 2.34-3.00)
– ideas that have the potential to become high-
growth, high-performance ventures or “home
runs”
• Average Potential (average scores of 1.67-
2.33)
• Low Potential (average scores of 1.00-1.66)

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 Key Elements of a
Business Plan
• Business Plan:
written document that describes the proposed product or service
opportunity, current resources, and financial projections
• Cover Page:
should identify the venture and provide the name, address, and phone
number of the entrepreneur or other contact person
• Confidentiality Statement:
Example: “This business plan contains information that (the firm)
considers proprietary. By accepting this business plan the recipient
acknowledges the proprietary nature of this information contained
herein and agrees to keep confidential all such information.”

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Business Plan Outline
 Source

• J. Chris Leach. (2012). Entrepreneurial

finance. 04. South-Western College
Publishing. Mason, OH USA. ISBN:
9780538478151 (Chapter 1&2)
Thank You