Chapter 1 Introduction

Overview
The goal of this chapter is to discuss the earliest financial events in a new business venture. Choices made at the outset of a new business have the potential to affect (limit) options in the future, so every decision, from where money comes from to organizational form, should be made carefully with an eye to future growth and strategic goals. This chapter explores bootstrapping as a source of funds and relates the choice of organizational form to future growth aspirations.

Major Points
The difference between entrepreneurial ventures and other forms of small business is significant. It is important to distinguish between these two types of business at the outset because their structure and financing are impacted by growth aspirations. Entrepreneurial ventures are typically associated with high growth aspirations while life style businesses are more concerned with control. While the focus of the majority of this book is on the high growth entrepreneurial venture, we do provide data and statistics for lifestyle ventures as well. There is an important connection between entrepreneurship and the health of the overall economy. Statistics show that virtually all innovation and job growth in the United States is supplied by the entrepreneurial sector of the economy. This makes it important to foster this sector at a policy level and take steps to increase the odds of success at a firm level. A major part of increasing the odds of success for a new business is an understanding of why new businesses fail. Since failure rates are so high for business start-ups it is very important to study the reasons for business failure in the hopes of avoiding common pitfalls. Several reasons for business failure are listed in the chapter. Bootstrapping is defined as the financing options most commonly available in the very earliest stages of a companys life. Bootstrapping is simply doing more with less. It is critical to explore low cost ways to start and leverage a new business to increase the chances for success. There is a relationship between the organizational form chosen and future business and financial strategic options. Raising capital is inextricably tied to certain organizational forms. To avoid violating securitys laws and to expedite future financing, it is important to choose the organizational form at start-up that is best for the long run growth of the company.

Teaching Tip
Stress the various aspects of bootstrapping. Money is much harder to come by today than it was five years ago so it is crucial that students think about maximizing the use of personal resources at their disposal and organizing the business to get cash flow positive in the shortest time possible. Inc. Magazines web site has many stories of successful bootstrappers that can provide interesting examples for classroom discussion.

Discussion Questions:
1. Many professional investors demand that the business be organized as a C corporation. To attempt to raise external money in any other form is probably doomed to failure. Also to untangle a partnership and convert to a C Corp at the time of capital raising may add unwanted delay and complexity at a very stressful future time. 2. They are generally quite different. Motivations for a lifestyle business are usually control of ones time, freedom, following a passion, or creating something of value to be left to family heirs. Creating wealth via a high growth company with large sales prospects motivates most entrepreneurs. Whereas the lifestyle entrepreneur may be looking for a job until retirement, the entrepreneur may be looking for a challenge for the next few years with an intention of moving on at the end of that time. 3. It has been demonstrated time and again that more money at start up often leads to inefficiencies and waste. The dot-com era is replete with cases of venture capital spent on luxurious office space, high-end furniture and equipment and first class travel expenses. Less money forces creativity, frugality and efficiency for survival. These skills will benefit the company throughout its life. 4. C-Corporation Pros: expands access to capital, allows for faster growth, spreads risk to other investors. Cons: entrepreneur must share ownership, more owners may complicate future decision making, more owners complicates capital structure, which may inhibit future capital raising from professional investors. Accepting money from friends and family may also lead to destroyed relationships if the business fails. 5. The main cost of limited growth is the ability of competition to enter and capture market share. There may also be some economies of scale that are unable to be realized at lower volumes. 6. The three main reasons for business failure are: 1. Financial: under capitalization, negative cash flow and excessive debt. Obviously these three are interrelated. 2. Poor management: most businesses are started by persons with technical or product knowledge. Managerial skills may be nonexistent or underdeveloped. Likewise, good entrepreneurs seldom make good managers since the skill sets

differ. Relating to the first item, lack of financial knowledge by management also contributes to the firms inability to manage cash flow and budget. 3. Marketing: poor or inadequate market research, failure to listen to customers and adapt to actual needs. In all of these cases, problems can be reduced by complementing the entrepreneurs skills by adding people to an advisory board that have the skills and knowledge that the entrepreneur lacks. Under capitalization can be avoided by researching the financial demands of starting the business and drawing on all available personal resources to line up adequate capital in advance.

Case 1-1 New Tech

1. Stuart should organize as a C-corporation if he anticipates raising much external capital for the business. Professional investors demand the C-corporation form to allow new investors to enter and exit easily and to offer protection to investors from corporate liabilities. While other organizational forms could be used at startup this would involve a restructuring down the road, with possible complicating ownership issues. 2. Since New Tech has been in operation since 2005, they probably have enough operating history to qualify for at least some bank debt. New Techs inventory could serve as collateral for a loan. Some financing is also available from New Techs suppliers in the form of trade credit. New Tech should investigate the possibility of those same suppliers investing in the company, either through equity or perhaps subordinated debt. Finally, additional outside equity is possible in the form of angel investors. New Tech is probably too small at this point to seek venture capital. 3. New Tech should use as much free trade credit as they can. Which capital to seek second depends on New Techs cash flow situation. If their cash flow will allow they should seek bank debt, since debt is the lowest cost source of capital and ownership need not be diluted to obtain it. Supplier investment in the company is probably the next logical step. Suppliers are already familiar with New Tech and their business so the sales pitch to obtain financing should be much easier with suppliers than with seeking fresh external equity. 4. Some milestones that New Tech has already achieved are: having a salable product, reaching sales of $3 million, entering the U.S. market and having a management team in place. 5. Future milestones which could be tied to financing would be specific dollar sales increases, for example to $5 million, successful launch of the new power module product, and further penetration into the home market.

Chapter 2 Alternatives in Venture Financing Debt Capital

Overview
In this chapter we discuss the various alternatives in debt financing available to the new venture. While debt is typically not a major source of start-up capital there are sources of debt capital available outside of the realm of mainstream banking that should be explored. Entrepreneurs must be able to forecast sales, profits and asset requirements to determine their financial need. While incorporating the business offers the entrepreneur some legal protection, the entrepreneur and the company are more likely to be treated as one in a new venture. A personal loan guarantee will usually be required to reduce the lenders exposure to risk. A new ventures limited access to equity capital inherently limits the use of debt capital. For a new firm, cash flow is king and should be a primary determinant of capital structure.

Major Points
Debt is always cheaper than equity for a given firm and should be included in the firms capital structure. Bank debt is not a major source of capital for new firms. In general to qualify for a bank loan, a firm will need a three to five year operating history to demonstrate credit worthiness. This effectively removes bank debt as a viable source of capital for the first years of a new ventures life. Entrepreneurs should look beyond traditional banks for other sources of debt capital. o Equipment manufacturers provide loans directly and indirectly through leasing. o Finance companies provide loans as well as factoring of accounts receivable. o Vendors may be a source of financing, either through trade credit or direct investment in the business. o The Small Business Administration increases the entrepreneurs odds of obtaining bank debt by guaranteeing traditional bank loans. o Customer prepayments can also be a source of capital to the cash strapped firm. If a customer prepays for goods or service a liability is created for the firm to supply the goods or service, but the cash is provided to carry through on the fulfillment of the order. New ventures typically use less debt than would be considered optimal in a capital structure theory sense due to their limited access to equity and the necessity of focusing on cash flow above all else. This point provides an opportunity to discuss the assumptions implicit in optimal capital structure theory and to demonstrate that when the assumptions underlying a theory do not hold neither does the theory.

Personal guarantees are usually required for an entrepreneurial venture to obtain bank financing. This point is worth stressing since students may think that the incorporation of a business completely separates the owner from the business in a legal sense. When the credit history of a firm is insufficient, the bank will draw no distinction between the firm and its owner, and the owners personal assets may be placed at risk. Lines of credit are a good source of debt financing for young firms. The credit line is drawn down as needed and thus the entrepreneur does not pay interest for money that they are not using. To obtain a bank LOC the entrepreneur must be able to show the ability, usually annually, to pay down the LOC. Sometimes banks will charge a standby fee for making the LOC available. Entrepreneurs should shop around until they find a bank that is willing to offer the line without a standby fee. Historically, standby fees have been associated with very large LOCs. For some types of businesses asset based financing may be appropriate. When inventory is distinct, easily tractable, and with a ready secondary market, each item of inventory may serve as collateral for the loan used to purchase the item. Likewise, if accounts receivable are individually large and of good quality they can provide financing either through pledging or selling (factoring) of the receivables. For the majority of firms, however, asset based financing will not be an option. To obtain any type of debt capital the firm must be able to forecast their financial needs. This includes a sales and profits forecast as well as a forecast of investment in assets, which will allow for the calculation of the cash flow forecast. It is important to emphasize the difference between cash flows and profits and that cash flow is king for all firms but especially new ventures. Breakeven analysis is a useful planning tool but should be used with caution. Breakeven quantities are only valid over narrow ranges of output. Beyond those narrow ranges fixed costs usually increase in a stepwise fashion invalidating the breakeven calculation. Very few costs are truly fixed. As output increases virtually all assets will have to be increased to support increased production.

Teaching Tip
The three cases within the body of the chapter can be used as the basis for class discussion about the relevant points in the chapter. This will help to make more concrete some of the abstract concepts in the chapter. The Superior Plumbing Supply case allows for a discussion on some of the behavioral consequences of financing an expansion with debt. Students should discuss the financial advantages and disadvantages of using debt and then explore some of the non-financial issues raised in the case. What is the effect on growth of using debt versus internally generated equity?

The MDO case provides an opportunity to discuss the forecasting of fixed and variable costs. Students should think about how they would go about stratifying their costs and how they would forecast them without an operating history to draw on. They may be surprised to think of marketing costs as having a fixed component for example. Finally, the Cajun Yachts case demonstrates the steps in forecasting pro forma statements and the calculation of financial need, which will be the basis for the loan request.

Discussion Questions:
1. Creating the sales forecast is a crucial but difficult task. Future sales depend not only on the quality of your product, but also on customers willingness to adopt or switch to your product. This involves some thought as to switching and adoption costs the customer may have to incur before the product is operational. Thought must also be given to competitors response to your entry into the market. It is important to think hard about potential competitors not just those currently in the market. If anything entrepreneurs tend to err on the side of too grand in sales forecasting. Define the market tightly and narrowly and think in terms of a large share of a small market rather than 2% of China. 2. Bank covenants can impose real costs on a firm. While the costs may not seem onerous at loan inception, future growth may be prohibited by trying to comply with bank imposed ratios. Typical covenants a bank might impose would be to maintain a working capital ratio of X, a times interest earned ratio of Y or a total debt ratio of Z. A bank may specify that any future borrowing be subordinated to the current loan, which renders it more expensive. Dividend restrictions are also common covenants as are changes in ownership structure. Sometimes banks will even constrain capital investment, which may severely hamper future growth. 3. Debt financing imposes a cash flow constraint on the firm. For most startups cash flow is the primary concern, and debt may exacerbate an already difficult problem. On the other hand debt is cheaper than equity and preserves ownership within the existing management group. Equity does not impose a cash flow cost on the firm, but it does dilute ownership of the original management team. Equity investors are more likely to become involved in management decisions and dayto-day operations, which may or may not be a benefit. The optimal source of financing depends largely on the firms forecast of time to positive cash flow. A firm cannot sustain a long period of negative cash flow with debt financing. 4. Terms of 3/10 net 60 have a periodic cost of .03/(1-.03) = .0309. There are 365/(60-10) = 7.3 compounding periods in the year, thus the cost of trade credit is: (1+.0309)7.3 1 = 24.88%.

24.9% seems to be a very high price to pay for credit. If the firm can borrow from a bank, on any basis, for less than 24.9% they should pursue the bank loan and pay on day 10. If other lending options are not available the firm will have to bite the bullet and pay the high cost of trade credit. Depending on the firms operating cycle 50 days financing may be sufficient to get them through the business cycle and preserve the business.

Case 2-1 New Tech

This case gives students the opportunity to experiment with creating an actual forecast of pro forma financial statements. The case provides good practice in forecasting since even though several assumptions are given in the case several others must be made to complete the forecast. Many assumption sets would be reasonable and consequently there is no right solution for the case. To complete the forecast students must be fairly proficient in EXCEL and utilize EXCELs Goal seek function to balance the balance sheets. To use goal seek it is imperative that the financial statements be populated with formulas and that relevant accounts (e.g. accumulated depreciation and retained earnings) are linked across the years. One possible solution with a set of reasonable assumptions is shown below. Insert EXCEL file Case 2 here (Sheets 1 &2) Assumptions: 1. Sales growth is given in the case assumptions in Appendix 2.3. Beyond 2012 it is assumed to hold steady at 15%. 2. The percent of sales method is used to forecast most items. Percentage of sales in 2010 is used. 3. Actual total depreciation amounts for 2010, 2011 and 2012 are given. Depreciation is broken into 3 line items in the forecast. The percentage of total depreciation that each line represents in 2010 is used to break the total down in 2011 and 2012. Beyond 2012 depreciation expense is assumed to hold steady. 4. Administrative Salaries and Leasing are forecast for 2011 and 2012. Starting in 2013 the percentage of sales in 2012 is used to forecast Salaries and Leasing for 2013-2015. 5. R&D is assumed to hold steady throughout the forecast. 6. Interest income is modeled as 4% * Marketable Securities. 7. Interest on the working capital loan, the term loan and long-term debt are given in Appendix 2.3. 8. Some assumption about dividends must be made and this provides an opportunity to discuss dividend policy and the signaling effect dividend changes may have. We assumed a constant 3% annual increase in the dividend. 9. Increases in Gross Fixed Assets were given for 2011 and 2012. Fixed assets were assumed to hold steady beyond 2012. It is imperative that the accumulated depreciation account be linked to the depreciation expense in the income statement to have the forecast flow accurately. Obviously, if students assume some growth in capital assets beyond 2012, the need for external financing will increase. 10. In 2011, with our assumptions, New Tech suffers a net loss. The tax is shown as a tax credit, which assumes there are prior income taxes that can be recouped through a tax credit.

11. The outstanding amount of long-term debt is reduced by the amount in Current Portion of LTD each year. Using the Goal Seek function in EXCEL, the balancing item for years in which assets are greater than liabilities is the term loan. When assets are less than liabilities the balancing item is Marketable securities.

Analysis:
According to our assumptions, $1, 575,000 will not be a large enough loan. In 2012 the Term Loan reaches $1,628,000, however it falls rapidly after that point and is paid off by 2015. If the $1,575,000 is the maximum that New Tech can borrow changes could be made to the assumptions (e.g. delete the financial cushion and cut thee dividend growth) to comply with the maximum loan amount. The ratio analysis shows a heavy reliance on short-term debt during the first years of the forecast. The high short-term debt causes Current Liabilities to be larger than Current Assets which makes the Current, Quick and Sales/Working Capital ratios much below industry averages. The TIE ratio does not reach industry average until 2015. Long-term debt declines over the forecast, so it is clearly the term loan driving the high debt level. The profitability ratios are generally in line with 2010 levels and overall profitability is low due to the high level of interest. New Tech does exceed the industry average ROA and ROE by 2013-14 however. Overall, New Tech does not present a bad picture to the bank. In the short run the reliance on debt is very high, but New Tech demonstrates the ability to pay the debt down over time and exceed average profitability ratios.

Chapter 3 - Alternatives in Venture Financing Early Stage Equity Capital

Overview
This chapter focuses on the alternatives available to entrepreneurs to raise equity prior to or in lieu of formal venture capital. Many people speak of a capital gap, that range of financial need between a few thousand and two or three million dollars. The alternatives discussed in this chapter partially close this capital gap by providing smaller amounts of equity financing to growing businesses. Angel investors are covered in detail as are the many programs offered by the Small Business Administration.

Major Points
It is important to draw a distinction between public and private equity. The focus of this chapter is on private equity ownership shares without a ready market for secondary trading. Private equity is not usually the end of the story for equity. Private equity is often issued to employees, directly or through stock options. It is also sold to angel investors and other individuals with ties to the company. In all cases, for the equity to have value, it must be tradable. This means that at some point the stock must be available for sale most commonly through acquisition of the company by another company. This fact means that the entrepreneur must come to terms with the ultimate exit strategy before issuing any shares of stock in the company. The whole concept of a capital gap provides the basis for an interesting class discussion. Why is there a capital gap? What solutions are possible to minimize the informational asymmetries surrounding firms in this category? Is the capital gap a barrier to mid size firms achieving financial stability? Is there an impact on the economy of having a capital gap? Is government intervention a solution? Angel investors provide far more capital to new ventures than venture capitalists, although their number and impact are difficult to quantify. Angels come in many guises, and invest individually or through formal and informal networks. They are best located through networking in your local community. Angels typically invest amounts of $10,000 - $500,000 in a single company, but by aggregating the investments of several angels up to $2 million may be made available to the company.

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Angels tend to invest near their homes, in technologies with which they are familiar. Many angels invest for the mentoring role that the investment opportunity provides them. Angels are usually willing to wait 5-7 years for a return on their investment. Required returns for angel investors appear to be somewhat lower than for venture capitalists, perhaps due to the psychic income angels receive by becoming involved in an early stage venture. The Small Business Administration is a source of much help for entrepreneurs although the SBA does not invest funds directly in any business. It is a worthwhile exercise to have the students go the SBA website to investigate the many programs available. The SBAs SBIC program allows investors to form venture capital funds using SBA loan guarantees to leverage the funds invested. Borrowed money, backed by SBA loan guarantees, can be used to leverage equity investment in a 4 to 1 ratio. This is a good time to introduce the concept of post money valuation the value of the business assuming it receives the desired investment and achieves the projections in the business plan. The size of the share of the business given up in exchange for an investment is completely dependent on the post money valuation of the company. Since few investors want to own more than 40-50% of a business this places a cap on the size of investment given a post money valuation. The variables that should be the focus in a negotiation with a prospective investor are, the growth rate in sales or earnings, net income and the multiple used to establish the value of the business in the future. Investors tend to rely on established rules of thumb for the multiple, so the first two variables are likely to be more fruitful sources for negotiation. Have the students link the stages of growth that a company goes through to the sources of financing most likely available at each stage of growth. Have the students discuss the need for capital in the first place. Capital required is directly related to the type of business, with service businesses requiring the least invested capital. For this reason many capital intensive businesses are probably impossible to launch as new ventures. Inc Magazine provides many entertaining stories of businesses launched on very little capital that can be used in class to illustrate the point that large sums of money are not required to start all businesses. The two New Tech cases in this chapter are included to demonstrate how to put together a financing package and to provide some examples of how to conduct the market research necessary for a funding package.

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Discussion Questions:
1. Possible milestones for a technology start up include: Completion of software design Hiring of key personnel Pilot program installed First sale First $XXX in revenue Achieving a market share goal 2. Completion of software design could probably be achieved with personal resources and friends and family investment. Hiring of key personnel may take angel investment or venture capital. Pilot program installation should be achievable without much additional investment given that the program is complete. Sales goals require a sales staff and possibly a VP of marketing, which would likely require angel investment or venture capital. Achieving a market share goal may require venture capital or even sale of the business through IPO or sale to a larger company. 3. Research can be done on the internet. 4. To answer this question the student must assume a multiple to be applied to earnings in time three to establish a value as well as a required rate of return for the investor. Fifteen percent for $500,000 equates to a company value today of: $500,000 = $3,333,333. .15 Assuming investors require a 40% return on investment this would equate to a time three value of: $3,333,333 (1.40)3 = $9,146,666. Assuming a six times earnings multiple is used this results in time 3 earnings for the company of: $9,146,666 = $1,524,444. 6

Case 3-1: EcoTurista

1. The opportunity facing EcoTurista is an unfilled need within the adventure travel industry. Currently this is a rapidly growing, highly fragmented industry. Travel agents and travelers alike must research destinations with no centralized source of information or quality monitoring system available. If EcoTurista can aggregate

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information and suppliers of travel experiences they can dramatically lower search costs for travelers and agents. Threats to successful implementation of the business model are plentiful. If EcoTurista experiences much success with their plan, it will undoubtedly draw interest and perhaps entrance from major online travel aggregators (Travelocity, Expedia, Orbitz), the major airlines or large travel agencies. Part of the revenue generation model relies on travel agents willingness to adopt the technologybased system in an industry that has traditionally been characterized by relationship building. Success with the business model will depend on the quality of the travel experiences the EcoTurista is able to provide. This means that monitoring of the destination providers is essential and quality standards must be upheld and maintained often difficult in this part of the world. EcoTuristas major strength is its first mover advantage. It is not clear from the Executive Summary what individual strengths, if any, the founders bring to the project. Finally, a major weakness is that the founders do not mention any travel agency experience or connections to the industry in Latin America. The model will be fairly labor intensive, to develop and maintain the catalog, monitor quality and create a network in an industry where they do not appear to have a reputation to build on. 2. This business does not appear to be terribly capital intensive. It will be labor intensive to build the network, the catalog, the relationships with service providers and travel agents and to grow the business. Major capital needs are a computer network and software development costs. 3. EcoTuristas revenue forecast assumes 339% annual growth over the three years of the forecast. Year 3 revenue of $15.6 million is a small fraction of the total online travel market of $28 billion forecast. While the growth rate is high, the forecast starts from a relatively low base, which makes the ultimate number seem achievable. The companys costs will largely be fixed as the computer costs and personnel needed will be necessary over a wide range of volume. It is hard to judge based on the information in the case but costs are likely to be slightly more heavily weighted toward fixed costs. 4. EcoTuristas forecasted profit margin in Year 3 is 15%. This is based on EBITA, which means that the actual profit margin will be lower. This is a fairly average profit margin which should not attract competition but if costs are higher than forecast the profit margin may be too low to interest investors. Likewise, EcoTurista may have to price the product low to gain market acceptance which will lower their profit margins further. 5. EcoTuristas EBITA in Year 3 are forecast to be $2,375,237. Assuming a multiple of 5, this results in a time three value for the company of $11,876,185. Assuming

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a 40% required rate of return by investors this results in a post money valuation for the company at time zero of $4,328,056. $11,876,185 = $4,328,056 (1 + .4)3 A $495,000 investment would represent an 11% ownership share in the business which seems fundable. 6. Possible milestones to achieve before receiving subsequent funding would be: Development of software and reservation system Signing on X number of travel experience providers in Latin America Development of at least a preliminary catalog of travel opportunities A contract with an on line travel retailer Identification of a test market of travel agents

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Chapter 4 - Determining the Amount Needed

Overview
This chapter focuses on the business plan. All sections of the plan are discussed with special attention paid to the financial portion of the plan. Market research is discussed with emphasis on competition existing and potential. The importance of the management team in attracting investment is stressed. The business plan is also discussed from the viewpoint of investors. What are investors looking for in a plan? In addition to the financial statements required in a plan, breakeven analysis and scenario analysis are covered.

Major Points
The role of the business plan as a tool to focus and sharpen thinking about the business should be stressed. Even if the entrepreneur is not seeking external funding, creation of a business plan forces the entrepreneur to think hard about the business model. Additionally, it can and should be used to create milestones for monitoring progress in the future. Some time should be spent in class discussing the apparently contradictory statements regarding the importance of the business plan and the fact that most plans are not read past the Executive Summary. As the first point above stresses, the real value of the business plan is to the entrepreneur. The fact that most readers of the plan will not read beyond the Executive Summary merely underscores the importance of the summary itself. Even though few readers of the plan will take the financial projections as fact, it is still a useful exercise for the entrepreneur to put together the financials to see if the business model is viable. The Executive Summary should be written last, and should clearly convey the need for the business and the owners passion for the idea. The sense of passion and excitement about the opportunity cannot be stressed enough. Investors are deluged with plans and passion about the idea is one of the key criteria they are seeking in entrepreneurs. Key points from the plan should be made in the two to three page summary to entice the reader to read on. The business plan is one area where a consultant should not be hired. No one should understand the business better than the entrepreneur and no one should possess the entrepreneurs passion for the idea of the business therefore no one is better suited to write the plan than the entrepreneur. Consultants may be used for feedback or formatting tips but should never be hired to write the business plan. In the Vision Statement as well as the Executive Summary it is imperative to articulate what need the business is being created to fill. To be compelling, new

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ventures should be started to fill an unmet need or to resolve a market discontinuity. Beware the hot technology seeking a use! Time in class should be spent discussing who the competition is for a startup company. Using an example startup discuss who the competitors are currently and where future competition might come from. The latter is especially important to address in the market analysis section of the plan as it could prove to be the most damaging competition of all. Very often large firms will wait to assess the demand for a product or service before entering the market. The management team is the key variable to the reader of a plan. Past experience with a similar business inspires confidence in plan readers. Plan writers should take particular care to fill in holes in the management team, and compensate for managerial weaknesses through the board of directors. While investors do not expect all of the team to be in place they are looking for experienced managers with track records for at least the CEO and CTO positions. The exit strategy section of the plan should be written thoughtfully, recognizing that IPO is the exit strategy for only a very small number of businesses. Thinking about potential acquirers early on may help to fine tune the business plan in the early stages. Likewise, thoughtful identification of likely suitors will inspire confidence in investors that a return on their investment is likely. When discussing the financial section of the business plan, much discussion needs to center on sources of information for creating the financial forecasts. The Small Business Administration has some data, organized by industry, and industry trade associations may provide data. Market research firms collect and sell market data that may be helpful. Robert Morris and Associates or Dunn and Bradstreet can provide ratio information that is helpful in creating the income statement and balance sheet, but information for the sales forecast itself will result from the market research carried out by the entrepreneur. The level of detail that underlies the business plan is critical. The entrepreneur must think about the number of people in each position and their salary level. The compensation structure for sales personnel must be addressed fixed vs. variable? Commission tied to what? Pricing issues must be resolved to create the revenue stream. While none of this detail is shown in the actual pro forma, it should be tied to the financial statements through a series of linked assumption pages. When forecasting the balance sheet it is important to distinguish between fixed and variable line items. The most likely relationship to sales for the variable components must be decided upon and modeled. Thought must be given to over what range fixed assets (and costs) are truly fixed.

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The Amazon.com example in the chapter can be used to illustrate the creation of the Cash Flow Statement and to demonstrate how this statement provides crucial information that is not readily seen on the other financial statements. The New Tech case deals with the assessment of managerial talent and could provide the basis for a class discussion of the methods used to assess talent, the weaknesses in New Techs team and what hires need to be done immediately to round out the team.

Discussion Questions
1. This is a good exercise to familiarize students with the resources available and to familiarize them with the basic format of a business plan. While there are differences across sites, the basic structure of all business plans is essentially the same. 2. To forecast sales you must have a specific estimate of the market niche you are targeting. If there is competition what share does each have and how will you wrest share away from the competition? How long will market acceptance take? When forecasting a growth rate in sales, what is the likelihood of new competition entering to slow your growth rate? If there are competitors, at what rate have their sales grown? 3. A capitalization table with many owners potentially complicates things for new investors. Since each share of stock is entitled to one vote, a block of minority shareholders could band together against the new owners, to block progress or otherwise slow down the companys growth plans. For shareholder votes all owners must be contacted, which increases the transaction costs of running the corporation. 4. Amazons options are very limited. They have basically used up their borrowing capacity and a huge debt payment is looming in the very near future putting an imminent large drain on cash flow. Amazon has two choices: raise prices or cut costs. Since Amazons contribution margin is so small, simply increasing sales will not be sufficient to solve the cash flow problem. Amazon has chosen to follow the cost cutting approach to date, reducing the number of distribution centers and trying to do more with less. Since their business model is built on low prices, cost cutting may be their only viable strategy.

Case 4-2: Web Wired

1. The market for Web Wired is very large manufacturing organizations that outsource production. The market is currently estimated at $1.7 billion and expected to grow to $50 billion over the next few years. Web Wireds niche is

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supply chain management for the 700,000 companies that fit that description. The niche is well defined and not currently served by any comprehensive technology. 2. Web Wireds revenue projections grow from $500,000 to $172,000,000 over four years, a 331% compounded annual growth rate. $172 million represents 10% of the current market for e-collaboration applications and a much smaller fraction of the 2012 total market. Given that Web Wired has already signed on Lucent and BP as clients, their revenue projections seem attainable. 3. Web Wireds profit margin in 2017 is forecast to be 23%. 23% margin for a software company is not out of line. (Students should use published ratios to verify the typical margin in the software industry).Web Wired will be a people centered service business, which is characterized by higher margins than a more asset intensive business. 4. The barriers to entry are twofold. Web Wired appears to have a first mover advantage, which is significant if they can grab market share and establish their technology as the standard for e-collaboration. The second barrier would seem to be their hub and spoke model. As client companies become reliant on Web Wired for their outsourcing process management, the path of least resistance is to continue with the known service provider. Also, as their marketing strategy states, as clients become linked as spokes in the model they are more likely to become hubs with their own suppliers. 5. Web Wired is proposing a viral marketing strategy. If the service delivery is error free and easily implemented their strategy could work well. By signing clients up as spokes they are essentially entering into pilot programs for the software with many potential clients. This approach minimizes the use of sales people and essentially rules out cold calling. If the system does not work well the hub and spoke model could prove disastrous. 6. The management team collectively has many years of experience (actually much more experience than was typical of most startups during this period). They have identified their missing link (marketing VP) and are planning to fill the position during the next round of financing. Based on the limited information in the case this team would seem to inspire confidence in investors. 7. The financials presented in this abridged version of the case are clearly not sufficient. To acquire funding much more information would have to be provided. Web Wired has gone through nearly $5 million in two years and is not predicting profitability for another couple of years. An accounting of their spending to date as well as detailed pro forma statements would be required. Capital spending should be detailed, as should the current ownership structure of the company. 8. My investment in Web Wired would be contingent upon a full accounting of the first $5 million. I would probably stage the investment and tie further funding to

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the acquisition of another major account and the transference of at least some spokes into hubs to demonstrate the viability of the marketing strategy.

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Chapter 5 Valuation Survey of Methods

Overview
This chapter focuses on the various methods of valuation used to establish a business value. The intent is to expose the students to the major techniques of analysis commonly used, making them aware of the strengths and weaknesses of each method. By better understanding the various methods the students will be equipped to employ a variety of techniques, thereby strengthening their ultimate estimate of firm value. It is assumed that students have had at least one finance course prior to taking this class. This assumes they are familiar with discounted cash flow analysis and with ratio analysis, which are both discussed in the chapter. The appendix includes a review of ratio analysis for those students who may need to refresh their knowledge a bit.

Major Points
In the world of entrepreneurial finance valuation tends towards the simple simple rules of thumb and simple methods. The more sophisticated methodologies are not generally relied upon simply because the information available for valuing a new venture is so speculative and so subject to estimation error that the more involved techniques are not viewed as being worth the effort involved. For the entrepreneur, however, the exercise of creating a well thought out discounted cash flow valuation for the firm is time well spent. As with the business plan itself, the exercise of forecasting future cash flows forces the entrepreneur to think through the assumptions and relationships underlying the business model. It is important to stress to students that there is nothing wrong with the DCF model itself. The problem lies with the cash flow estimates and there is nothing but the passage of time that can render the cash flow estimates more reliable. The first technique covered in the chapter, asset based valuation, is not typically used to value a going concern. All three of the methods in this section would be used to set a lower bound for the valuation or used when the purchaser is buying the assets of the business as opposed to the business as an ongoing entity. Of the asset-based approaches, modified book value is definitely the most thorough. Many items not considered assets under generally accepted accounting principles are added to the balance sheet to determine firm value. Obviously this method is time-consuming and expensive to employ due to the need to hire a variety of specialized appraisers. This expense results in the method not being used much in practice. Market multiples are the methodology of choice among practitioners. There are several reasons that practitioners have a preference for multiples. One reason is

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that the multiples are market determined, typically based on recent transactions. Second, the multiples are simple to use. Investors will argue that that simplicity is justified since firms tend to be more alike than different at various stages of their growth. Third, investors argue against using DCF stating that the cash flow estimates would simply result in garbage in garbage out. On the negative side, multiples tend to be used across the board and for long periods of time, not always reflecting the current market. When using multiples it is incumbent upon the entrepreneur to make the case for why his business is different than the norm and thus subject to a higher multiple. If more discussion in class is desired around determining comparable firms to establish multiples, any of Shannon Pratts valuation texts contain several interesting case studies of court cases where various, not always obvious, firm attributes were used to establish a comparable company. When using the market multiple method the question of what the multiple will be applied to arises. The best answer is forecasted earnings that have been normalized to remove unusual and nonrecurring items. The relationship between the market multiple, which is essentially a PE ratio, and the standard dividend discount model should be stressed. When the equality between the two equations is demonstrated it becomes clear that risk and growth are the driving forces behind the multiple. Time in class should be spent going through the Superior Plumbing example in the chapter to illustrate how ratio analysis can be used to justify a multiple different from the standard. In the case Superiors superior ratios seem to justify a multiple on the high end of the range of multiples. Multiple information is available at various sites on the internet. A quick search should uncover several sources of information. While the cap rate tends to be most commonly used in the real estate industry, it is important for students to recognize that the cap rate is simply the inverse of the market multiple and therefore essentially the same method. As with the market multiple, the cap rate assumes a zero growth rate in earnings. As the example in the chapter illustrates this assumption could be potentially costly for the entrepreneur if it is incorrect. The Excess Earnings Approach was developed by the IRS as a tool to value goodwill in valuations for tax purposes. The method has been promulgated as a technique for general firm valuation, although the IRS strongly discourages its use for such purposes. The major problem with using the Excess Earnings Approach is that it necessitates the use of two discount rates, both of which are somewhat arbitrary. This introduces more opportunity for error and disagreement between negotiating parties.

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When discussing discounted cash flow analysis students should be aware that there are two methods for carrying out a DCF analysis the direct and the indirect methods. The direct method discounts equity cash flows (after subtracting debt servicing costs) at the firms cost of equity. The resulting value is the present value of the equity on the firm. The indirect method discounts pre debt cash flows at the companys weighted average cost of capital. The indirect method is more commonly used because it allows for direct estimation of total firm value (indirect estimation of the value of the equity). The value of the debt is then subtracted from total firm value to arrive indirectly at the value of the equity. One of the main reasons that a DCF analysis should always be done is that this is the only method that allows for a sensitivity analysis. Since DCF values tend to be sensitive to the assumptions employed in generating them it is very important to examine the effect of changes in the assumptions on firm value. The importance of creating scenarios of related assumptions cannot be overemphasized. It is not terribly helpful to simply vary the inputs to the model plus or minus a few percent. A definition of the best case and worst-case scenarios should be arrived at with all of the interlocking assumptions that those cases imply. A discussion of DCF leads directly to a discussion of estimating the discount rate for privately held firms. The key point here is that there is no accepted methodology to do this. For all of the words written about employing proxy betas to estimate the cost of equity, the fact remains that the entrepreneur is typically undiversified, bearing the total risk of the business, and thus in violation of the fundamental underlying assumption of the CAPM. Perhaps the best advise that can be given for estimating the cost of equity is to try and assess the entrepreneurs true opportunity cost of remaining in the business at what return does it become economically undesirable to retain the firm? That is the entrepreneurs cost of equity.

Discussion Questions
1. This is a somewhat challenging question. Students must forecast EBIT and Total Operating Capital for the five years of the explicit forecast period. Using EBIT(1T) = NOPAT and the change in Total Operating Cash Flows students can calculate the Free Cash Flow each year. Using the long-term growth rate the terminal value can be found. The present value of the total FCF discounted at the cost of capital = the value of operations. Adding in the non-operating assets we get the Value of the Firm. Subtracting the interest bearing debt we arrive at the value of the equity.

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INPUTS Cost of Capital Sales0 Non-operating assets Interst-bearing debt Operating Profit Margin Working Capital/Sales Fixed Assets/Sales Tax rate Forecasted sales growth: Years 1-2 Years 3-5 6 on

12% $1,000 $100 $250 12% 35% 20% 40% 12% 8% 4%

Sales Operating Profit NOPAT Working Capital Fixed Assets Total Operating Capital Change in Total operating Capital Free Cash Flow Terminal Value Total FCF PV Of FCF Add: non-operating Assets Value of Firm Subtract: Interest bearing debt Value of Equity

0 1 2 $1,000 $ 1,120 $ 1,254 $ 134 $ 151 $ 81 $ 90 $350 $ 392 $ 439 $200 $ 224 $ 251 $550 $616 $690 $66 $74 $ 15 $ 16 $ $477.75 $100 $577.75 $250 $327.75 15 $

3 4 5 $ 1,355 $ 1,463 $ 1,580 $ 163 $ 176 $ 190 $ 98 $ 105 $ 114 $ 474 $ 512 $ 553 $ 271 $ 293 $ 316 $745 $805 $869 $55 $60 $64 $ 42 $ 46 $ 49 $ 642 16 $ 42 $ 46 $ 692

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Case 5-1: New Tech (F) Whats the Company Worth?

The current value of New Tech is just over $4.6 million based on the DCF analysis below.

New Tech's Financial Forecast (000's) Actual Sales Cost of Good Sold Gross Margin OPERATING EXPENSES Selling expense Administrative expense Total Operating cost Operating Income Taxes (34%) NET INCOME Working Capital: Accounts Receivable Inventory Accounts payable Net Working Capital Capital Spending
1 1

2010

2011 Forecast 3,900 $ 1,560 2,340 $ 1,326 702 2,028 312 $ 106 206 $

2012

2013

2014

2015

$ $

3,000 $ 1,185 1,815 $ 857 555 1,412 403 $ 137 266 $

4,700 $ 1,645 3,055 $ 1,316 752 2,068 987 $ 336 651 $

5,640 $ 1,805 3,835 $ 1,410 846 2,256 1,579 $ 537 1,042 $

6,700 $ 2,077 4,623 $ 1,474 1,005 2,479 2,144 $ 729 1,415 $

8,040 2,412 5,628 1,528 1,206 2,734 2,894 984 1,910

$ $

450 350 550 250 $ $

546 429 585 390 $ 1,100 $ 325

658 470 658 470 $ 740 $ 375 987 $ 651 $ 820 $ (169) $ (169) $

733 564 620 677 $ 500 $ 400 1,579 $ 1,042 $ 707 $ 335 $ 335 $

871 670 737 804 $ 500 $ 430 2,144 $ 1,415 $ 627 $ 788 $ $ 788 $

1,045 804 884 965 500 490 2,894 1,910 661 1,249 11,241 12,490

Includes depreciation of $ $ $ $ $ $4,615

Operating Income NOPAT Change in Total Operating Capital Free Cash Flow Terminal Value Total FCF PV at 20%

312 $ 206 $ 1,240 $ (1,034) $ (1,034) $

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The Investors Perspective: Assuming that the 2015 value of the firm is 3 times 2015 EBITA of $3,384 (2,894 +490) the value would be $10,152,000. The investors 30% share would equal $3,045,600. To calculate the return on investment the time zero cash flow is $1,000,000, the future value in five years is $3,045,600 so the return is approximately 25%. This does not meet the investors desired 30% rate of return. At this point Grant can reexamine the assumptions in the cash flow forecast or play with the initial investment. To achieve a 30% return on a $1,000,000 investment the investors share must be worth $3,712,930 at 2015. This equates to 36.6% share of the 2015 value.

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Chapter 6 Venture Capital

Overview
This chapter takes an in depth look at the venture capital industry. Where capital comes from, how firms are organized and what VCs are looking for in investment opportunities are all covered. Changes in the industry in recent times are examined by looking at data on investment by venture capitalists over the last several years. The venture capital method of valuation is covered as are common terms found in term sheets.

Teaching Suggestion
If one is available this is the ideal class to invite a venture capitalist as guest speaker. The venture capitalist can provide up to the minute data on trends in the industry, provide insight as to thought processes used when investing and generally provide an insiders look at the industry. They are usually willing to share details of their career paths, which may be helpful to aspiring VCs.

Major Points
The most important point to stress in this chapter is the very small number of firms for which venture capital is a viable option. In the current environment that number is even smaller than it has been. Venture capitalists are looking for firms with huge market potential (in the billion dollar range) and very high growth prospects. The vast majority of entrepreneurial firms do not fit these criteria and are therefore not likely candidates for venture capital. It is very important to stress the connection between the venture capital market and the stock market. Even though sale to another firm is a far more common exit strategy than IPO, if the stock market is unreceptive to IPOs the effect on the venture capital market will be to essentially shut off most new investment. Venture capital funds focus on what they know and what is hot at the time. In industries change over time and the flow of venture capital moves towards whats hot at the moment. Venture capitalists focus on what they know. They invest in industries in which they have expertise to make the due diligence process more efficient and more effective. Firms also look to leverage synergies between their portfolio firms. This all means that the entrepreneur needs to do substantial due diligence of their own before approaching any venture capital firm to increase their odds of success. Some time in class should be spent discussing venture capital compensation. The fixed portion of VC compensation is based on committed capital, which differs 26

from invested capital. Currently firms are sitting on large piles of committed funds and hesitant to invest them. Obviously the committed portion increases their compensation and explains why firms do not just pay a dividend to return uninvested capital to investors (the general partners in the fund). This strategy cannot go on indefinitely, however, as investors will eventually demand a return on their investment. The variable portion of VC compensation, the carried interest, is the profit sharing arrangement that occurs when the firm is sold. Many large corporations have venture capital divisions or subsidiaries. Usually the motivation for corporate venture capitalists is different than it is for commercial VCs. Most corporate VCs invest primarily for strategic reasons. How would this effect the likely exit strategy for the recipient of corporate venture capital, if at all? A look at Table II reveals that required rates of return on venture capital are very high. It is important to distinguish between required rates of return and realized rates of return. Precisely because the failure rate for target firms is so high, the required rate of return must be of the magnitude in Table II in order to realize rates of return in the mid twenty percent range. Realized rates of return are much more in line with the risk return trade-offs we see for other investments. The Venture Capital Method of valuation is covered for the first round of valuation. More complicated formulas are available when the investor chooses not to invest in subsequent rounds but wishes to maintain a certain percentage of the business. These formulae are not included here because most VCs will invest in subsequent rounds if they are concerned about maintaining a specific percentage of the business. The key variable in the Venture Capital Method of valuation is the future value of the firm which depends on the net income in the future and the market multiple applied to that net income. VCs tend to hold firm on the multiples and required rates of return used in the valuation, so any negotiation must center on the ultimate net income. This of course depends on assumptions made about sales and expense growth over the forecast period. Some time is spent in the chapter on how to get before a VC firm. Unsolicited plans are almost never read so a strategy of blanketing various firms with a business plan will typically lead nowhere. The best strategy is to find a contact that can provide an introduction or recommendation that increases the likelihood that a business plan will get read. It is important to know that once negotiations with a venture capitalist are underway, the entrepreneur must stop shopping for alternative funding. Failure to do so could result in the negotiations being cancelled.

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It would be instructive for students to spend time in class going through an actual term sheet such as the term sheet in the appendix to the chapter, from an agency cost perspective. For each term we can ask, what agency cost is the VC trying to mitigate and how does this term do so? The terms in the term sheet will clearly demonstrate that term sheets are written by VCs for VCs.

Discussion Questions
1. All of the clauses below have the intent to reduce the VCs risk by increasing the expected return on the investment. Dividends: This is a typical feature of preferred stock the dividend preference. It is unlikely that a venture-backed firm would be paying dividends but if it should the holders of the preferred are entitled to an 8% dividend prior to the common stockholders receiving anything. Obviously the VC is protecting themselves from the risk that cash would be divested to the common shareholders, weakening the financial strength of the company. Liquidation Preference: This term is to ensure some return on investment to VCs at the time of any liquidation of the company. This increases the odds of the VC achieving their desired rate of return. At a minimum, if there is any value in the liquidating company, the VC will get their investment back before the founders receive anything. Note that liquidation does not imply bankruptcy but rather a change in majority ownership of the company. Conversion: This term allows the preferred stockholders to convert to common stock when the stock goes public. This gives them the benefit of the upside potential of the stock in the marketplace. This particular term guarantees the VC at least a 3X return on their investment in an IPO but also allows them to convert at their discretion. This allows them to become common stockholders if the liquidity event is other than an IPO. Anti-dilution Provisions: This is an example of a partial ratchet clause. This reduces the conversion price for the VC to reflect shares issued at lower valuations than the VC paid. The lower conversion price increases the number of shares the VC will receive thus preventing any dilution due to lower priced rounds. Voting Rights: Typically preferred stock is non-voting stock. This provision confers on the preferred stockholders the voting rights of the common stockholders. This reduces the risk that the common shareholders could vote on issues displeasing to the VC.

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Protective Provisions: this provision essentially gives the holders of the preferred stock more voting rights than the common shareholders. As long as two thirds of the originally issued preferred remains outstanding the majority of the preferred stock holders have ultimate control over change in ownership or other major change in assets or cash flow for the company. Like the last provision this reduces the risk that the founders could take action displeasing to the VC. Registration Rights: Registration rights come in two varieties, demand and piggyback, and this company is seeking both. Piggyback rights simply say that the holders of the preferred stock can convert their shares to common and piggyback onto an offering of stock that the company is already making. The cost to the company of piggyback rights is small and allows the VC to liquidate their investment. Demand rights on the other hand, allow the VC to demand that their shares be converted to common and sold in a public offering even if the company is not doing a stock offering. This clause also says the company will pay all the costs of the offering. This allows the VC to liquidate their investment after 5 years if they choose, or subsequent to an IPO. In this case the investors are demanding two demand registrations, which could prove very expensive and disruptive for the company. The purpose of registration rights is to reduce the liquidity risk to the VC. This allows them to realize a return on their investment after five years. Right of Participation to Significant Holders: this clause allows the VC to maintain their percentage ownership in the company by purchasing a pro rata share of any future offerings. Terms of the Right of First Refusal and Co-Sale: Should the founders desire to sell any of their share in the company the VC has the right of first refusal to purchase those shares. Should the VC not wish to purchase the shares they have the right to sell their shares alongside the founders on a pro rate basis. The Other Matters terms are self-explanatory. 2. A strong candidate for venture capital has a product with huge market potential, some sort of barrier to entry that would preserve market share and a strong management team that is capable of executing on very high growth projections. Another criteria is that the product can be brought to market relatively quickly. 3. An entrepreneur should look for more than money from a VC. The VC should provide value added. They should have knowledge and the time to guide and mentor the entrepreneur. Ideally, they would have industry contacts that could be helpful to the entrepreneur. They should also have an investment time frame that matches the entrepreneurs and the life cycle of the product.

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Case 6-1: New Tech (G) Getting Investors Attention

1. New Techs proposal for funding is fairly strong although for venture capital funding it is not so strong. New Tech has the advantage that the company is up and running, has experienced strong growth (30% per year over the past five years) and is already producing the high margin PowerSelect line that is the basis of their future growth. Growth is actually forecast to taper off as the growth in the PowerSelect line is offset by much slower growth in their current business, however. 2. While growth is slowing the shift to higher margin units should enable the net income to continue to grow more rapidly. NewTech forecasts a 20% share of the growing market for specialized high-end laptops but does not mention existing or potential competition. This weakens their pitch. NewTechs proposal is stronger than a start-ups due to an existing customer base which may be leveraged into purchasing their new product. Also, they have a proven track record of a successful business. 3. The management team is not venture capital strong. The CFO is still a weak link, with no prior CFO experience. The Sales Manager does not have prior management experience although he appears to have been New Techs Sales Manager through their rapid growth period. The Production Manager also does not seem to have prior experience managing production processes. 4. A 40% share for a $600,000 investment translates into a present value of the company of $1,500,000. $600,000 = $1,500,000 .4 A present value of $1,500,000, future value of $10,400,000 ($1.3 million X 8), 5 year time frame equals an IRR of 47.3%. Given the stage of the business that New Tech is at, a 47% return is probably sufficient. 5. New Tech does not have the characteristics of a standard venture capital candidate. Their potential market is too small, their management team too weak and their growth prospects too low. Additionally, the size of the investment they are requesting may be too small for most venture capitalists. Even though their forecasted return seems in line with venture capital required returns, they are probably too small to be interesting to most VCs.

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Chapter 7 Exit Strategies

Overview
The goal of this chapter is to thoroughly explain the IPO process, while at the same time introducing other more (and less) common methods of exit for early stage companies. Entrepreneurial ventures have far more exit opportunities than the IPO and for the majority of them some other strategy will be the optimal strategy to pursue.

Major Points
The importance for the entrepreneur of considering, and planning for, the optimal exit strategy cannot be overemphasized. This consideration must occur before the entrepreneur accepts any outside equity investment. No outside investor invests with an unlimited investment horizon. Since dividends are likely to be nonexistent in a start-up, the exit is the only means of providing any return to the investor and must be explicitly stated at the time of investment. Most equity investors have a three to seven year investment horizon. This means that the entrepreneur must think hard about where the company will be in 3-7 years and what the most likely liquidity opportunity will be at that time. For the vast majority of firms the most likely exit strategy is exit through acquisition by another firm. In thinking about an exit via acquisition, the entrepreneur should think specifically. Which firms are likely acquirers? Name names. What potential synergies would motivate such an acquisition? Look for acquirers where there is a complementarity of process, of product, or a significant source of added value by joining the two companies. With the recent decline in activity in the market for IPOs, what has always been the most common exit strategy, acquisition, is now even more important as a method of achieving liquidity for investors. In both acquisitions and mergers the tender offered for the stock of the target company is often stock in the acquiring firm. These stock for stock exchanges have the advantage of being nontaxable as well as doing away with the need for the acquirer to raise or use cash in the transaction. The disadvantage of a stock for stock exchange, in the context of this chapter, is that it does not necessarily provide liquidity for investors. Only if the acquirer is public will liquidity be provided in an exchange of stock. Even if the company is public, a protracted vesting schedule may not provide the entrepreneur with the liquidity they desire if they truly are looking to exit the business. If the company is profitable, an earn-out may be an effective way to provide liquidity for outside investors while allowing the entrepreneur to regain control of

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the business. In an earn-out company profits are used to repurchase outside equity at a price that provides an acceptable return to the outside investor. An earn-out has the obvious benefit of allowing the entrepreneur to buy back the company without borrowing money or using personal resources. The danger lies in allocating too much of the companys profits to the earn-out at the expense of the future growth of the company. Likewise the investor must be amenable to receiving a return on their investment over a protracted period of time. The management led earn-out differs from a non-management buyer earn-out arrangement in one fundamental way. In a management led earn-out, managers are exerting their own effort to generate the profits that will allow them to buy the business from outside investors. In a non-management led purchase with an earnout management is working to generate the profits for a third party to buy the business from them. In the first case management will own the business as a result of their hard labor at the end of the earn-out. In the second case the third party will own the business. The debt for equity swap covered in the chapter is not technically an exit strategy since lenders are not owners. It does provide lenders with an opportunity to exit their positions as lenders, but liquidity, and return, will not be provided until a true liquidity event takes place. As the example in the chapter illustrates excessive debt can endanger the firms viability and the debt for equity swap may be more of a survival strategy than a true liquidity event. Exit via merger may or may not provide a true means of exit for the entrepreneur. Typically mergers are motivated by synergies and both management teams remain in place to realize those synergies. Liquidity will be provided if one of the parties to the merger is public and shares are allowed to be sold subsequent to the acquisition. The biggest risk in a merger is the inability to realize the synergies forecast due to a clash of cultures of the merging parties. The business press is full of examples of clashing cultures undermining the success of the merger. Examples include the Boeing McDonnell Douglas merger, General Motors with ETS, and the Safeco American States merger. In a class of MBAs it is our experience that a majority of them work in companies that have survived a merger and can speak to the issue of culture clash only too well. For smaller businesses, especially service businesses, liquidation is a common strategy for exit. When a business has few tangible assets and most of the business value derives from the relationships the owner has with customers, there may be little perceived value in the business as a going concern without the owner. In this case the entrepreneurs best option for exit is to sell what assets there are and simply close the business. In general the highest valuations and most liquidity are provided by an initial public offering of the firms stock. These facts may make the IPO the most desirable form of exit, but as the $78 million average offer size indicates the IPO

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is not feasible for the majority of entrepreneurial firms. Without significant market share and high growth prospects the IPO is simply not an option. While liquidity is provided by an IPO many entrepreneurs are surprised by the restrictions on that liquidity. After the IPO the original investors are typically prohibited from selling their shares for a period of six to twelve months (sometimes longer). Subsequent to the end of the lock-up period, management can sell only within strictly defined windows of time during the year. The record keeping and reporting requirements of a public company are substantial. In addition to the formal reporting requirements, many CEOs find it necessary to hire an investor relations specialist to prevent the CEO from spending all of his or her time with analysts. Like the average offering size, this too makes the public form of organization prohibitively expensive for all except the largest firms. IPO underpricing should lead to a protracted class discussion of the actual IPO process. Students should be aware of who the parties to the IPO are, what their expertise is and whose interest they are serving during the process. The underwriter has strong reasons to underprice new issues and has a potential conflict of interest in serving both the entrepreneurial venture and the clients on the buy side of the transaction. Much of what students read from investment bankers on this subject, is in our opinion, spin to justify IPO underpricing. The Open IPO is a direct response to the issue of IPO underpricing. The example in the chapter provides a good illustration of how the process works. What is less clear is why the process has been slow to be embraced by investors (or perhaps by issuing firms). For Open IPOs to replace the standard method as the method of choice, entrepreneurs must be aware of the option and cognizant of the true motivations of the parties to a traditional IPO. Perhaps this understanding is simply a matter of time in coming. Certainly there has been press portraying the Open IPO as the option for firms unable to secure traditional investment bank interest. Without a good understanding of the issues, this may be enough to scare potential issuers away. The Direct Public offering, SCOR offerings and the Regulation A and D offerings discussed in the chapter may all be answers to the capital gap problem discussed earlier in the book. None of them are answers to the desire for liquidity by exiting investors, however. While each of them provides the entrepreneur with the opportunity to raise relatively small sums of capital from outside investors, none of the resulting stock is truly liquid and is best seen as a step along the road to true liquidity.

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Discussion Questions
1. The first place to look for a strategic buyer is up and down the supply chain. Suppliers, customers and competitors are all potential buyers. For a strategic acquisition to add value synergy must be created between the parties. Look for companies that complement what you do either through marketing, distribution channels or technology or other specialized expertise. 2. The best discussion will result from personal experiences of mergers that the students have been through. As mentioned in the teaching notes culture clash is probably the single biggest obstacle to success in a merger. The ATT acquisition of McCaw Cellular, the General Motors merger with ETS, and the AOL Time Warner merger were all plagued by a failure to integrate a large bureaucratic organization with a more entrepreneurial growth oriented organization. The Daimler Chrysler merger has struggled due to a true clash of cultures. The Safeco American States merger and a series of Bank of American acquisitions have been hampered by a failure to integrate (or severely underestimating the cost of integrating) computer systems. 3. Some of the most common barriers to success in a merger and acquisition are: Failure to act quickly. If downsizing or reorganization is to be done it needs to be done quickly to prevent speculation and fear from consuming all of employees time and energy. Too often the expectations of the merger are inflated. The merger may have been motivated by top management arrogance or greed without sufficient due diligence. Failure to integrate cultures Failure to define the new business model and unify the direction of all involved Failure to communicate about everything related to the acquisition 4. Pros of an IPO are that it: Provides liquidity for investors Establishes a market value for the company and the stock Provides for ease of ownership transfer Provides unlimited access to capital Cons of an IPO are: Expense of execution and ongoing compliance Exposure to takeover Vulnerability to shareholders, who may not be informed 5. In addition to all of the pros listed above the main reason for an open IPO is to secure the highest price for the shares in an underwriting. No money is left on the table from the investors standpoint. The major con is the perception that the Open IPO is for second rate firms that cant attract reputable underwriters.

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6. The pros of a DPO are that it can be done at substantially less cost than an IPO, that it can be done for smaller issue amounts and there is less regulation and reporting than with an IPO. The major con is that it does not provide liquidity or establish a true market value for the stock. In addition, the burden of due diligence falls on the shareholder since an underwriter is typically not involved.

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Chapter 8 Anatomy of a Venture Funding

Overview
This entire chapter is a case study that pulls together all of the material to date on financing and looks in detail at the process of successfully negotiating a term sheet and subsequent deal. The case is a wrap up of the New Tech case that has been running throughout the text.

Teaching Tips
This case can most fruitfully be used as an in-class exercise without the students having read the material before class. By going through the case in class it can provide the basis for a class discussion of the issues, hurdles and solutions at each step of the way. Have the students go through the deliberations that Stuart and Elizabeth went through before reading on to discover what happened. This case represents the ideal scenario in searching for external funding. Ideally, entrepreneurs would proceed as New Tech does, listing their criteria in an investor and examining several prospects before approaching the investor most in tune with their criteria. Unfortunately, too often entrepreneurs are completely focused on the money without any thought given to the best fit and most value added by an investor. Have the students rate all of the potential investors against the criteria established by the New Tech management team. Have them choose the top three candidates according to the stated criteria. Do they match New Techs ranking? New Tech pursues further meetings with two potential investors, Walter Buffet and Chinook Ventures. What company valuations are implied by the ownership shares offered by each investor? Do either of them appear sufficient? Buffet: $600,000 = $1,363,636 .44

Chinook: $600,000 = $1,224,490 .49 In preliminary negotiations, Stuart had implied that $2,500,000 was in the ballpark of a valuation. If so, then both offers appear to be demanding too much of the company for the money offered.

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Discuss Buffets original term sheet and New Techs counter offer. What seems like a reasonable position, fair to both parties, in each case? o Clearly, if the Board size is to remain at three, Buffets request to nominate three members is going to be unsatisfactory to Stuart. Two possible solutions are to increase the board size to retain Stuarts majority position, or to reduce the number of directors Buffet can nominate. Stuarts mother and brother most likely have little to offer as mentors and probably should be replaced with more professional directors. o The 44% ownership seems too large given the desired valuation. o New Tech does not currently seem like a likely candidate to go public. Perhaps the terms should be expanded to consider other exit strategies such as acquisition or management buyout. o Items 4 and 5 together place quite a constraint on managerial flexibility, especially the 30-day approval period. Given that many of new Techs expenditures are in the $25,000-$50,000 range, perhaps a $50,000 minimum for approval is more appropriate. Thirty days seems unworkably long and should be reduced to ten days. o An employee stock option plan is reasonable and desirable, however if the establishment of such a plan is to delay closing for several weeks the implementation of the plan should be later, post closing.

Go through the terms of the agreed upon term sheet to make sure the students understand them and to see the results of the compromise. o The non-dilutive term means that Buffets purchase of stock will not cause the value per share to fall for the existing stockholders in New Tech. If shares are subsequently sold to new investors at a higher price or the firm does an IPO with gross proceeds of $4.5 million all current investors may suffer some dilution of their ownership in the company. o The second term ensures that Buffets investment is used for its intended purpose and not to fund management perqs or some other less desirable end. o The Board configuration allows Stuart to maintain control while giving Buffet substantial input. o The right of first refusal is a right to retain Buffets percentage ownership in the company. Given that Buffets intention to participate must be stated within 10 days this should not provide a hardship for the company. o Buffets approval period was decreased to 10 days and the issues over which he has a say are reasonable. o Item (f) reiterates that Buffet wants to be the majority shareholder and a new shareholder can only acquire 45% of the outstanding shares if he agrees to buy Buffet out. This is a protection for Buffets position as a majority shareholder. o The ESOP must be in place within six months, which seems a good compromise.

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o The IPO is now contingent upon the market being receptive and New Tech being ready, which should allay New Techs fears from the initial term sheet. Students may be surprised to see that signing the term sheet merely begins the in-depth due diligence process. At this point, if something is uncovered in the due diligence that the investor finds unacceptable, the whole deal could be declared null and void. Buffet appears to be an ideal angel investor, providing guidance to help the company grow to the next stage of IPO within three years.

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Chapter 9 Franchising

Overview
This chapter provides a fairly in depth review of franchising as an entre into entrepreneurship. Common terms, requirements, costs and benefits are all covered. Three examples of actual franchises are presented to expose students to the range of franchising options available and also to allow them to study franchising in the real world. Buying into a franchise lies somewhere between starting a business and employment with a company. Where it lies on this continuum is a function of the franchisers philosophy. This means that there are many different options available to the potential franchisee in terms of franchiser involvement and control. While the investment in monetary terms may be less than starting a similar business from scratch, the investment in time most likely will not be less.

Major Points
It may be enlightening to begin this class session with a discussion about whether franchising even qualifies as entrepreneurship. To focus the discussion you could start by listing the typical risks and rewards of a start up as well as the characteristics of a successful entrepreneur. Now go back through the list and see how the typical franchise and franchisee match up. Does franchising qualify as entrepreneurship? The most important benefit of buying into a franchise is that the franchisee is buying a proven business model. If the business model is not proven the dreaded ground floor opportunity then there most likely is not much value in the franchise opportunity. In addition to the business model, the franchiser and other franchisees should provide a wealth of experience and resources for the franchisee to draw upon. The probability of success for the franchise depends to a large extent on the franchiser. This means that due diligence by the franchisee, prior to signing an agreement, is imperative. Interview as many current franchisees of the company as possible. Also track down former franchisees that have left the organization. Make sure the franchiser is familiar with your geographic area, especially the local real estate costs. Costs to acquire and develop real estate vary greatly across the country and can affect ultimate profitability if projections are based on a low cost environment and the new franchise is opening in a high cost area. Students will most likely be surprised at the cost to open a franchise. In virtually all cases the franchise fee is a rather small part of the total cost of opening the business. One of the questions at the end of this chapter asks students to research various franchising opportunities. A discussion of costs would be a good time to

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compare notes on costs to open for the various opportunities the students have researched. Franchises are most commonly divided into product/trade name franchises and business format franchises. Most franchises with which students will be familiar are of the later type. Independent Coca-Cola bottlers would provide an example of the former and may help the students better understand what the product/trade name format involves. Some explanation of the risk sharing function of franchises may be in order. The franchise arrangement allows the franchisee to share risk by spreading the costs that result in benefits to the entire franchise over the larger organization. Examples would be advertising and marketing costs as well as any research and development expenditures. This means that the benefit per dollar invested should be higher for a franchise than a stand-alone business and thus the risk of that expenditure is less. A very important part of the due diligence process should be a thorough understanding of how area development rights are granted. Much of the entrepreneurs upside lies in expanding to more than one franchise. If new area development rights are allocated on the basis of seniority it may take years for the aspiring franchisee to expand into the profitable locations. The allocation of area development rights also obviously affects the value of the initial franchise as well. If area development rights are allocated on the basis of seniority, is the available franchise the one no one wanted? To illustrate the spectrum of franchising opportunities available spend some class time comparing and contrasting McDonalds and the Great Harvest Bread Company. How can such vastly different approaches both result in successful business models? Is there likely a difference in the franchisee attracted to Great Harvest rather than McDonalds? What would be the profile of a successful franchisee in each of the companies? The Torrefazione example provides an interesting case study in risk taking. Would students invest in a Torrefazione franchise based on the information available to them? An interesting side note to this article is that within a year of the articles publication, AFC Enterprises sold both its Torrefazione and SBC franchises to Starbucks. Perhaps there were not enough risk takers out there after all! To wrap up the discussion it may be helpful to have the students summarize together the pros and cons of the franchising arrangement. This may help clarify for them whether franchising is an appealing entre to entrepreneurship after all.

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Discussion Questions
1. The obvious benefit to becoming a franchiser is to grow quickly without bearing the cost of the growth. In most franchises the franchisee is responsible for the set up costs of the new business so this allows the franchiser to grow the business without the investment of growing a standalone business. The benefits of quick growth are market penetration and name recognition as more units of the business are opened. The franchise allows the franchiser to share the investment risk as well as the cash outflow of opening new locations, although obviously the franchiser relinquishes control, which increases the franchisers business risk. 2. There is a wealth of information on the internet available for students to research various franchises. This could easily turn into a manor project or a short paper. 3. The biggest risk to the franchisee is that the franchiser provides no assistance after collecting the franchise fee. Another risk is that the franchisee is required to purchase materials from the franchiser at above market prices. The franchiser essentially maximizes his income at the expense of the franchisee. A third potential problem was illustrated with the hotel example in the chapter. Competition from other brand names owned by the franchiser but not covered by the specific area rights of the franchise. All of these problems should be anticipated and dealt with before the franchise agreement is signed. The contract should specify exactly what the franchisers responsibilities and duties vis a vis the franchisee are. The pre signing due diligence by the franchisee should uncover potential problems in these areas and others and if the problems can not be dealt with satisfactorily in the franchise agreement the franchisee should move on the next opportunity.

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Case 9-1: Franchising the Neighborhood Restaurant

The franchise looks like a decent investment. Several assumptions must be made to solve this case and depending on the assumptions value may vary drastically. Assuming the $400,000 initial investment is all that is required to set up the franchise this represents the franchisees total investment in plant and equipment. Since this type of asset is typically depreciated over a 7-year life that is the life we will use here. We use straight-line depreciation rather than MACRS for simplicity. There are no assets mentioned in the case that would need amortizing so depreciation expense of $400,000/7 = $57,143 is the total expense taken each year. It is assumed that no debt is taken out to finance the initial investment or subsequent operations. Since franchisers typically do not allow the initial investment to be debt financed this is a realistic assumption and an expense avoided. No additional non-operating expenses are included. Obviously the presence of either of these last two items would lower profits and cash flows. Data is given for only three years. Assuming that the franchise is a going concern it will continue beyond three years. To be conservative we assume revenues and earnings stabilize at the time 3 values and remain there in perpetuity. This provides a lower bound estimate of the value of the firm (assuming that is lasts beyond three years). If any growth at all is realized beyond year three it will dramatically increase the value of the investment. We assume that the franchise is organized as a sole proprietorship and is therefore not taxed at the entity level. The entrepreneur should know that they will have to pay personal taxes on their salary as well as the net income of the firm. If the firm is organized as a C Corporation all of our profit numbers would be reduced by the corporate tax rate. We use a 15% discount rate as the required return in determining firm value and NPV.

As the spreadsheet on the next page indicates, at the current projections the time to breakeven is 3.82 years. Adding back depreciation to net income and assuming that there is no additional investment in plant and equipment required, the free cash flows and continuing value can be calculated. To calculate the continuing value we assume that the cash flows hold steady at their time three value or that growth is zero. Assuming a 15% discount rate the

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present value of the cash flows is $1,269,810. Subtracting the $400,000 initial investment the
NPV of the investment is $869,810.

conservative assumptions the franchise looks like a fairly good investment. If the franchisee has to borrow any part of the purchase price debt service costs lower the forecasted cash flows but also the cost of capital.
Based on these Sales Product Costs Food Alcohol Total Gross Margin Labor Costs Wages Management Benefits Franchisee's Salary Total Operating Expenses General Operating Rent Royalty Advertising Depreciation Total Net Profit Net Investment Unrecovered Investment Free Cash Flows Continuing Value Total Free Cash Flow PV @ 15% NPV $ $ $ 1,100,000 100% $ 1,300,000 100% $ 1,500,000 100%

$ $ $

254,100 85,800 339,900 760,100

23.1% $ 7.8% 30.9% $ 69.1% $

300,300 101,400 401,700 898,300

23.1% $ 7.8% 30.9% $ 69.1% $

346,500 117,000 463,500 1,036,500

23.1% 7.8% 30.9% 69.1%

220,000 33,000 33,000 44,000 330,000

20.0% $ 3.0% 3.0% 4.0% 30.0% $

234,000 39,000 39,000 52,000 364,000

18.0% $ 3.0% 3.0% 4.0% 28.0% $

240,000 45,000 45,000 60,000 390,000

16.0% 3.0% 3.0% 4.0% 26.0%

$ $

71,500 71,500 85,500 44,000 77,000 57,143 406,643 23,457 400,000 376,543 80,600 80,600 $1,269,810 $869,810

6.5% $ 6.5% 7.8% 4.0% 7.0% 5.2% 37.0% $ 2.1% $

84,500 78,000 85,500 52,000 91,000 57,143 448,143 86,157

6.5% $ 6.0% 6.6% 4.0% 7.0% 4.4% 34.5% $ 6.6% $

97,500 82,000 85,500 60,000 105,000 57,143 487,143 159,357

6.5% 5.5% 5.7% 4.0% 7.0% 3.8% 32.5% 10.6% $ 159,357

290,386 $ $ 143,300 143,300 $ $

131,029 216,500 1,443,333 1,659,833

0* *3.82 years to breakeven

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Chapter 10 Internal Financial Management

Overview
This chapter examines the effective management of current assets and current liabilities as a source of funds for the entrepreneurial venture. Students will learn how, by controlling current assets, cash can be released for other uses in the firm and operating efficiency can be improved. The cash budget is covered in detail as both a planning and a control tool. Sources of short-term financing are introduced as well as methods for calculating the costs of these sources.

Major Points
While internal financial management is not technically fund raising, its importance in fundraising cannot be overemphasized. Prudent internal financial management will reduce the firms need for external capital and conserve the resources that the firm does have. Internal financial management is germane to all firms regardless of size, but it is perhaps most important for new and private companies with limited access to capital and high financing needs. Today, strong internal financial management is a prerequisite to securing external financing, as it should be. Large companies have well-developed accounting staffs, usually reporting to the Controller, and finance staffs, usually reporting to the Treasurer. This distinction is important because the accountants job is centered on reporting the results of operations and complying with Generally Accepted Accounting Principals. The finance staff should be more focused on the future of the business and planning for that future. In new firms both limited resources and external reporting requirements necessitate that the accounting function is typically filled first. It is important to emphasize that the finance function cannot be overlooked if the firm is to maintain fiscal health over the long run. Despite the differences in the magnitude of resources allocated to the finance function across firms, the financial planning and control functions are relatively more critical for new and smaller firms, particularly private firms with their limited access to capital and small margin for error in operations. While a GE or General Motors can tolerate excessive inventory or late paying customers, either of these situations could plunge the smaller firm into a cash flow crisis. The Cash Conversion Cycle (CCC) can be used to manage the firms current assets. By calculating the Days Sales Outstanding, DSO, and Inventory Conversion Period, ICP, the firm can spot opportunities to speed up collections and inventory turns. For every day decreased in these two items the need for external financing is reduced or, if external financing is not relied upon, cash is freed up for other uses in the company.

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Dell actually won an award from CFO Magazine for implementing the CCC to improve working capital management. As the example in the chapter illustrates Dell has been quite successful in using the CCC as a financial management tool. The story of Dells implementation of the CCC can be found at CFO.com and makes a nice case study for class discussion. Just as current assets need to be monitored constantly, Accounts Payable should also be monitored and utilized to maximize the firms use of free trade credit. Maximum use of free trade credit will reduce the firms need for costly external capital. Accounts Payable management can provide an opportunity for an ethics discussion in class. Many finance professionals advocate for pushing the limits of the DPO, especially when the purchaser has some sort of clout over the supplier. The idea is, if due to inefficiencies in the suppliers collection system the buyer can gain extra days of non-payment, the buyer should maximize his own companys wealth by taking advantage of the suppliers inefficiency and push the limits of the payment period. The ramifications on the supplier and the ripple effect through the supply chain should be discussed as the costs of such a strategy. The Cash Budget is probably the single most important planning and financial management tool. By focusing on cash flows the firm can chose to rearrange their operations in response to a cash shortfall before it happens. At a minimum, the cash budget will be required documentation if external financing is needed. When going through the cash budget it may be worthwhile to discuss additional sources of inflows and outflows not represented in the example and how they could be incorporated into a cash budget. A properly constructed cash budget is a powerful tool when used for sensitivity analysis. By varying the parameters to the model the analyst can readily see which parameters are major drivers of cash flow and how sensitive cash need is to changes in the parameters. Some discussion of small business acceptance of credit cards may prove enlightening for students. A fairly standard charge for accepting credit cards is 3% and on that basis, many small retail businesses refuse to accept credit cards. What are the costs of that strategy? Certainly lost sales are among them. What are the benefits of accepting credit cards? By expanding customer payment options the firm will increase sales. Is the cost of carrying its own receivables less than 3%? An analysis should be done to be sure but receivables necessitate having collection and processing personnel in addition to time spent waiting for collections. In addition, carrying your own receivables means that you will bear the cost of bad debts. Since uncollectable accounts can easily run 2% of sales, it seems likely that the total costs of a credit department would exceed 3% of sales.

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In addition to trade credit, short-term sources of funds should usually include a line of credit, LOC, with the firms bank. The cash budget can be used as part of the LOC application to indicate to the lender when and why cash is likely to be needed and when the LOC can be repaid. The LOC is the preferred source of short-term debt due to its flexibility in terms of demand and repayment. Pledging assets as collateral for a loan lowers the cost of the credit and may be the only condition under which an entrepreneurial venture can obtain financing. While inventories and receivables can theoretically both be used as collateral, it is only specific classes of these assets that will be acceptable to a bank. Finished goods with an active secondary market are acceptable inventory collateral. High value accounts receivable with large credit worthy firms also make good collateral. Numerous, small accounts and work in progress inventory would never be accepted by a bank as collateral for a loan. The distinction between pledging and factoring accounts receivable should be made clear. Pledging involves posting accounts receivable as collateral for a loan. Factoring is actually selling the receivables to a third party. While the procedure and the risk born are different from the entrepreneurs standpoint, the receivables that would be acceptable are similar in either case. Customers and suppliers should be explored as sources of financing, probably before approaching a bank. Terms are likely to be more favorable from other companies in your supply chain and your firm will be a known quantity to them in a familiar industry. The key to securing supply chain financing is to be a unique or critical source of value added for the customer or supplier. The more critical your product or service is to the other firm the more it is in their self-interest to work with you. The physical management of cash flow is extremely important, timely billing and collection, sweep accounts to earn interest on cash balances and the legitimate use of float in paying your own bills all increase cash flow and reduce the need for external financing. A simple example may help illustrate the lockbox concept. Assume XYZ Company, located in Atlanta, estimates that it takes three days to receive checks from its west coast customers. XYZ averages 100 checks per day at $500 per check and their cost of short term financing averages 12%. The bank would charge a $7,500 flat fee plus $.35 per check processing to set up a lockbox on the west coast. Would it be cost effective to set up a west coast lockbox? Answer: Benefit 3 days X $50,000 X .12 Cost: = $18,000

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Flat fee Per check fee .35 X 100 X 260

$ 7,500 9,100 $16,600 $ 1,400 =======

Net Profit

On average, over the course of the year, the firms cash balance would increase by $150,000 as collections are sped up. Annually this would save the firm $18,000 in financing charges. The 260 days in the per check fee calculation is based on fifty-two weeks x 5 days per week.

The final point in the chapter is an important one. While current asset and liability management are important, the most effective working capital strategy is to minimize the levels of current assets and focus the firms resources on income producing fixed assets.

Discussion Questions
1. An example calculation from FYE 2011 statement would be: CCC = DSO + ICP - DPO = Accounts Receivable + Inventory - Accounts Payable Sales/365 COGS/365 COGS/365 = $ 616,900 + $ 965,800 + $ 1,626,500 $11,700,400/365 $4,949,300/365 $4,949,300/365 = 19 + 71 - 120 = <30> days

Starbucks DSO is low as would be expected for their business. Inventory levels seem high but are offset by the very long payables deferral period. This represents a strategic change in strategy from the first edition of our book when their CCC was a positive number. A discussion of the ethics of delaying payment for 4 months would be appropriate around this number.

2. 3/15 net 45 terms equate to a periodic cost of .03/(1 - .03) = .0309. Financing is being extended for a thirty-day period (45-15 = 30) and there are 12.17 30-day periods in a year (365/30), so the effective cost of the trade credit is: (1 + .0309)12.167 - 1 = 44.8%

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The firm can most likely borrow from a bank at a lower interest rate and use the funds to take the discount and pay on day 15. 3.

INPUTS: Pay in month of sale Pay one month after sale Pay 2 months after sale Bad Debts COGS percentage DPO Cost of credit Target cash balance

20% 70% 7% 3% 70% 30 12% $5,000 January February $50,000 $50,000 March $40,000 $8,000 35,000 3,500 $46,500 $46,500 $28,000 $3,000 $1,000 $400 April $60,000 $12,000 28,000 3,500 $43,500 $43,500 $42,000 $4,000 $1,000 $600 $8,000 0 $55,600 ($12,100) $19,100 $7,000 $5,000 0

Sales Collections: MOS t+1 t+2

Collections: Payments: Inventory Wages Rent Other Taxes Interest Total Payments Cash Surplus/Deficit Beginning Cash Cash Available Target Cash New Borrowing Repayment Net Borrowing Ending Cash Balance

$32,400 $14,100 5,000 $19,100 $5,000 0

$19,100

$7,000

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Case 10-1: New Tech Monthly Cash Budget 1. The spreadsheet shows that New Tech will incur large deficits in April and May that persist for the rest of the 12 month period due to the asset purchases in April and May. For the rest of the year they will be utilizing any cash surpluses to pay down the debt and will end the year with a zero cash balance and a large loan balance still outstanding. The case does not mention an interest rate on the borrowing. One can certainly be assumed and inserted into the cash disbursements as another cash outflow. Because the case does not assume a target cash balance, New Tech does not maintain any cash on hand and the ending cash balance is zero every month after March due to the outstanding loan. If a target cash balance is assumed the loan will be larger but the firm will have some financial slack. New Tech does not end the year with a positive cash balance unless sales exceed projections by at least 10%. Insert EXCEL file Case 10.1 here (Sheet 1) 2. The simplest way to perform the sensitivity analysis is to build the forecast based on the adjusted sales line. Adjusted Sales = Sales * (1+change in sales). This way the -10%, etc. can be entered in the Input box and the spreadsheet will recalculate. Students should copy the values from each iteration into a new area on the spreadsheet This makes it quick and easy to perform the sensitivity analysis provided the spreadsheet cells are linked properly! In the sensitivity analyses, some assumption must be made about purchases. In the initial months of the forecast it is reasonable to believe that purchases are held at their initial level, but over time purchases should adjust downward (or upward) to reflect the lower (higher) demand as a learning curve effect takes place. In the numbers that follow purchases were held steady at their initial level. Sales for November and December of the prior year are not adjusted as they are historical.

3. As shown on the spreadsheet the change in the payment patterns does not change the results Materially from the base case scenario. The 3% increase in bad debts is offset by customers Willingness to pay sooner.

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Chapter 11 Essentials of Risk Management

Overview
This chapter is similar to the previous chapter in the way that it fits into the theme of this book. Certainly, risk management is not a fund raising strategy, but like working capital management it is a cash conservation strategy. By learning and applying the fundamentals of risk management the entrepreneur can prevent, or at least mitigate, a major outflow of cash as a result of an unforeseen risk. Large companies are moving rapidly to implement risk management departments and small businesses would do well to follow their lead. As with working capital management, small and newer firms typically have smaller financial cushions and consequently less margin for error. These facts make risk management relatively more important for the entrepreneurial venture than for larger firms.

Major Points
Risk management involves anticipating all of the things that can go wrong in a business, deciding which are cost effective to mitigate and taking the necessary steps to do so. The process is ongoing and continuous. Risks should be constantly reevaluated as should mitigation strategies. Risk is inherent whenever there is uncertainty about the future, and at least one possible outcome for the future involves a monetary loss to the firm. Identification of risk is the first step in a risk management program. In purely financial terms, risk management lowers the risk of the company by reducing the effects of uncertainty. This lowers the companys cost of capital and increases the value of the firm. Thus, risk management is prudent financial management. Risk is divided into pure risk and speculative risk. Pure risks are unavoidable, but can be anticipated and prepared for. Speculative risks are caused by business decisions. They occur in the areas of financing, operations and strategy, and should also be anticipated and prepared for. Risk cannot be eliminated entirely and some risks cannot be dealt with in a pre-loss setting at acceptable cost to the company. In other words, it may be more cost effective to bear the risk than try and deal with it ex ante. The firm must establish, at a

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policy level, which risks should be mitigated pre loss, and which should be born. For those that are born it is common to establish a reserve fund or purchase insurance to lessen the impact in the case that the adverse event does occur. The most effective form of loss exposure identification, is periodic and repeated physical inspection of the business premises. This does not require a risk management department, or specialized personnel to carry out. The inspection process can be made part of all employees daily activities part of the culture. The key is to have it as part of an ongoing process. Loss control activities are the prevention measures taken before the fact to prevent losses from occurring. Loss prevention has two beneficial effects on the company. One is a reduction in the direct and indirect costs of losses, the second is a reduction in insurance premiums that result from lower loss occurrences. The World Trade Center disaster provides many examples of direct and consequential property losses. The direct loss of property is obvious. Less anticipated were all of the businesses that failed due to the removal of their clientele from the immediate area. From delis to day care centers businesses were forced to shut down due to lost revenue, even though they did not experience the direct loss of property. The business continuation exposure is an especially relevant exposure for closely held businesses to be dealt with ex ante. The death of a partner or owner could easily cause a business to cease if insurance is not carried by the firm, which allows the company to buy out the deceaseds estate and prevent liquidation of the company in order to divide up the business value. Risk financing deals with how the potential loss will be dealt with financially should it occur. Most potential losses can be insured or hedged with financial derivatives. In some cases the cost of the insurance is greater than the expected value of the loss and it makes sense to retain the loss exposure or self-insure. In some instances the most efficient retention strategy is to set up a captive insurance subsidiary. If a business believes they can control the frequency of loss, due to superior business practices and risk management strategies, they may actually represent less risk than average. This means that conventional insurance rates would be too high for their actual expected loss and the business can pay premiums to its captive to maintain a fund for self-insurance at less cost than it can buy conventional insurance. Most firms that self-insure carry insurance that kicks in should the actual losses exceed some predetermined number. For example, the entity will self-insure up to $10 million in loss. After that point they will carry insurance to cover the additional losses.

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Using derivatives to hedge financial risks, changing commodity prices or foreign exchange exposures, may make sense as a risk reduction strategy. An interesting example helps illustrate the point. Starbucks would seem to be in a relatively simple business with identifiable risk exposures. One risk they face is the fluctuating price of coffee. Coffee bean futures contracts exist and could be used to stabilize Starbucks expected raw material costs. As it turns out, the actual cost of the coffee bean is a relatively insignificant cost of the cup of coffee, with the packaging and labor costs far exceeding the cost of the coffee itself. Starbucks has determined that the variation in the cost of coffee is not significant enough to warrant hedging with futures contracts and it chooses to bear the risk rather than mitigate it.

Discussion Questions
1. Fire or other damage to structure and contents installation of sprinkler systems, fire insurance. Customer injury on the premises liability insurance Employee injury on the job employee training, ergonomic tools, workmans compensation insurance Loss of a key employee due to death or disability key man insurance Loss of revenue due to a change in the exchange rate related to accounts receivable interest rate futures Theft property insurance Revenue loss due to business interruption business interruption insurance Pollution from manufacturing operations pollution control equipment 2. It is optimal to self insure if the expected value of the loss, the probability of the loss multiplied by the expected dollar amount of the loss, is less than the cost of insurance. This can happen if the company is less inclined to suffer a loss than the average firm in its risk pool. 3. If the probability of loss is sufficiently small, it may make sense to do nothing. An example would be earthquake insurance in the vast majority of the United States. On the other extreme if the expected value of the loss is small relative to the operating cash flows of the company, losses can be absorbed into operating expenses and insurance is unnecessary. 4. Any financial risk emanating from fluctuating exchange rates or changes in interest rates can be hedged via financial derivatives. Examples would be loss of revenue on accounts receivable due to a fall in the value of the dollar relative to the currency in which the accounts receivable are denominated. Likewise, a rise in the value of the dollar increases the dollar cost of accounts payable due foreign suppliers. Interest rate sensitive assets, such as leases, loans or annuities are subject to swings in value due to changes in interest rates and can be hedged with interest rate futures contracts. Finally, any commodity for which futures contracts exist, can be hedged to protect the firm from rising commodity costs.

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Chapter 12 Opportunities To Do Business and Raise Capital Globally

Overview
In todays business climate all businesses operate in a global environment. Even if all of a business current customers and suppliers are domestic a future opportunity for global trade may present itself at any time. This chapter is an introduction to finding trade partners internationally and finding international sources of finance.

Major Points
One critical key to success in foreign markets is ex ante research. Prior to launching any operations in a foreign country the entrepreneur must research trade rules, export and import requirements, existing products and services currently available in the foreign country, potential business partners, government assistance programs both in the U.S. and the host country, local labor laws, taxation and regional customs. Focus on the customer their needs and opportunities (this is good advice no matter what country you are operating in). Learn about your customers culture and at least some of their language. Communicate your message clearly avoiding American colloquialisms. Work with the foreign countrys consulate in the US to gain information about specific companies. It is very helpful to identify a foreign partner in the host country to communicate on your behalf in the local language and help you navigate the mass of local laws and customs. Take advantage of trade assistance offered by US and local governmental organizations. US governmental agencies encourage foreign trade as a source of jobs and tax revenues and provide many helpful resources to expand trade. Several web sites are noted in the chapter. Investigate the business climate in the foreign country yourself. Talk to potential customers, suppliers and partners to make contacts and access their openness to your product. Selling a product in a foreign country is typically done through an agent or a reseller. An agent markets your product for you but final sale, delivery, billing and warranty are provided by you. A reseller, on the other hand, purchases your product from you and resells it at a price that includes their markup. The reseller also provides all the services retained by you in the agent relationship. 53

It is not a good idea to establish an exclusive relationship with a reseller right off the bat. Set sales goals and other conditions, which if met will lead to an exclusive relationship in the future. Always retain the right to cancel the exclusivity clause if the reseller does not live up to your expectations. Private equity capital is less available and less structured outside of the United States. In Europe, Latin America and the Far East angels and venture capitalists do exist and should be researched as to focus and size of investment just as is done domestically. Networking with lawyers and accountants in the host country may provide a source of entre to the world of private equity in that country. Doing business in countries that are transitioning to market economies is fraught with danger. The usual capitalist mechanisms of allocating resources are typically absent, and connections and cronyism tend to rule trade. It is likely to be very difficult to crack existing relationships and channels. The process of acquiring private equity abroad is similar to the process in the US. Investors want to see pro forma financial statements demonstrating high rates of return, coupled with a strong management team and a well thought out exit strategy. IPO as exit strategy is not nearly as common outside the U.S. as it is in the U.S. More likely is acquisition by a large multinational company. While most countries today do have a stock exchange, the liquidity in the secondary markets of these exchanges is severely limited relative to liquidity in the U.S. markets. Individual share ownership is relatively rare, which makes it more likely that an individual shareholder could acquire a large block of stock and more easily take control of your company if listed on a foreign exchange. In addition, limited liquidity does not provide an exit mechanism for founders of the firm wishing to sell their shares.

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