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Entrepreneurial finance is the study of value and resource allocation, applied to new ventures.

It
addresses key questions which challenge all entrepreneurs: how much money can and should be
raised; when should it be raised and from whom; what is a reasonable valuation of the startup; and
how should funding contracts and exit decisions be structured.

Entrepreneurial Finance: This article will be the first in a series I am running on the subject of
entrepreneurial finance. Entrepreneurial Finance is the process of making financial decisions for new
ventures. New ventures are inherently different from established ventures, as are entrepreneurs
inherently different from conventional business managers. The financial decisions faced by each are
starkly different as well.
Why is Finance Different for New Ventures than for Established Corporations?
Entrepreneurs face very different finance challenges than do corporate managers. The most obvious,
which most entrepreneurs are familiar with, is "financing". To the average entrepreneur, this means
simply "finding money". It is this process of finding investors that tends to consume nearly all of the focus
of most entrepreneurs. While extremely important, it is not the only financial decision that an
entrepreneur faces. (New Venture Financing will be covered in depth in a later installment).
Notice how the discussion above flowed naturally, interchanging "financing" and "investing". This is the
first fundamental difference between corporate finance and entrepreneurial finance.
1. In entrepreneurial finance, investment decisions and financing decisions are the same thing.
Corporations can sell financial claims in the market at market rates. They can also often fund projects
through allocation of internally generated funds. New ventures, on the other hand, do not have a market
for their financial claims, and thus must raise funds for projects from investors. The result is that
corporations can often finance projects with expectations of a positive net return on investment for which
an new venture would reject the same project unless they can raise investment.
Likewise corporations can diversify their risk. Through risk management techniques, established
corporations can shift project risks in order to reduce overall corporate risk. New ventures are usually
typified by the entrepre

Likewise corporations can diversify their risk. Through risk management techniques, established
corporations can shift project risks in order to reduce overall corporate risk. New ventures are usually
typified by the entrepreneur bearing most of the risk herself, undiversified.
2. Portfolio Theory (valuation based on risk) does not apply to new ventures cleanly.
Entrepreneurs have limited mechanisms by which they can signal and communicate their true intentions.
This creates potential moral hazard and information asymmetry. In contrast, the public corporation has
many formal, standard mechanisms by which information is communicated and incentives are aligned.
3. The Entrepreneur must signal intentions to investors often by willingly undertaking
irreversible, undiversifiable financial risks.
Given the different risk profiles, new ventures are difficult to accurately value. In practice, the value of
most new ventures is largely derived as a function of the value of its options. Called "real options
analysis", this approach applies options valuation techniques to real-world decisions. Venture capital
firms are well known for applying sophisticated options valuation strategies to their portfolio of companies
and decisions about if, when and how much to fund various financing rounds.
4. Real options analysis is a valuable technique for valuing the entire venture.
New ventures are illiquid by definition. They are closely held, private companies which have no explicit
market value. The process of creating a market for investment in the new venture is known as creating
liquidity, or achieving liquidity. Most venture capital firms plan their portfolio around expectations of
liquidity events. Once liquidity is achieved, the firm's value can be harvested.
5. Liquidity is the only way in which new ventures return value to investors.
This leads to the final fundamental difference between corporations and new ventures: the entrepreneur.
In an established corporation, the shareholders are the residual claimants. Incentives are aligned
accordingly. But in a new venture -- one in which the entrepreneur is still participating -- the ultimate
residual claimant is the entrepreneur herself. It is the entrepreneur who has undertaken disproportionate
risk, undiversifiable risk, intangible risk in the form of personal sacrifice. It is therefore no surprise that it is
the entrepreneur who finds herself necessarily driving valuation goals for the venture.
6. The Entrepreneur is the ultimate residual claimant and driver of valuation goals.

Entrepreneurial finance is the process of making financial decisions


for new ventures (i.e. startups). New ventures are inherently
different from established ventures, as are entrepreneurs inherently
different from conventional business managers. The financial
decisions faced by each are starkly different as well.
Entrepreneurs face very different finance challenges than do
corporate managers. The most obvious, which most entrepreneurs
are familiar with, is “financing." To the average entrepreneur, this
means simply "finding money.” It is this process of finding investors
that tends to consume nearly all of the focus of most
entrepreneurs. While extremely important, it is not the only financial
decision that an entrepreneur faces, as this blog by Randolfe notes.
Also noted by Randolfe: corporations can sell financial claims
(capital stock) in the public market at market rates. They can also
often fund projects through allocation of internally generated
funds. New ventures, on the other hand, do not have a market for
their financial claims, and thus must raise funds for projects from
investors.
Small Biz Trends notes the four following points on this topic:
1. Seeking outside financing isn’t worth your time. Unless
your business has a lot of hard assets that can be used as collateral
for a loan, or one of a handful of startups that has the super-high
growth potential and exit plan to attract accredited angel investors
and venture capitalists, seeking outside money is unlikely to be
fruitful.
2. Personal credit matters. Data from the Federal Reserve’s
Survey of Small Business Finances shows that the owners of one
quarter of corporations less than five years old, and nearly half of
sole proprietorships that age, personally guarantee the debts of
their businesses. With personal debt, the lender’s decision depends
less on the potential of the business than on the entrepreneur’s
credit and collateral. If you don’t have great personal credit and you
have few assets to pledge against a loan, you will have a hard time
borrowing to finance your new business.
3. You are more likely to get a loan. Only a tiny percentage of
startups are financed by selling equity to accredited angels or
venture capitalists. The statistics show that around 1 percent of
companies get their financing from these two sources combined.
Research shows that these sources are actually more likely to lend
money than to take an equity stake.
4. Tapping trade creditors is where your odds of obtaining
financing for the business itself are highest. According to
analysis of the Federal Reserve’s Survey of Small Business Finance,
next to having a checking account, trade credit is the most common
financial tool used by small businesses.

In conclusion, the matter of financing for a startup is not the only


issue that distinguishes “entrepreneurial finance” from other more
mature forms of business finance. We highly recommend you look
into the matter carefully and conduct your own research to learn
about other financial realities faced by the entrepreneur when
contemplating a start-up.

May 10, 2012 - Session #2 – Principles of Entrepreneurial Finance. In short, we can define
Entrepreneurial Finance as the “application and adaptation of financial tools and techniques to the
planning, funding, operations, and valuation of an entrepreneurial venture.” There are seven key
principles of entrepreneurial ...

7 Principles of Entrepreneurial Finance – Entrepreneurial Finance, Leach &


Melicher
1. Real, human, and financial capital must be rented from owners
2. Risk and expected reward go and in hand
3. While accounting is the language of business, cash is the currency
4. New venture financing involves search, negotiation, and privacy
5. A venture’s financial objective is to increase value
6. It is dangerous to assume that people act against their own self-interests
7. Venture character and reputation can be assets or liabilities
One of the most important commodities for entrepreneurs is free cash – the cash
exceeding that is needed to operate, pay off debts, and invest in assets. Free cash flow
is basically the change in free cash over time. These two are highly important concepts
to grasp because Cash is King – it is the lifeblood of a business. Profit is great, but it
means nothing without positive free cash flow (unless you have just invested in future
assets).
The Successful Venture Life Cycle – There are five stages that can be considered
when looking at the life cycle of a venture. All ventures start at the development stage,
pass through growth stages, and end-up in a mature stage.

(Entreprene

urial Finance, Leach & Melicher)

Each of these stages have various financing needs and sources, which are described in
the figure below. It is important to note that most companies and entrepreneurs go
through the same cycle when it comes to financing. First, the entrepreneur uses his or
her own savings, along with friends/family assets, to finance the development stages.
The next round of financing usually comes from Angels and potentially Venture
Capitalists. The third round of financing, which is typically the largest, comes from large
bank loans and venture capitalists.

As mentioned before, cash is the lifeblood of a new venture. As entrepreneurs we need to create
a sustainable model that will allow us to have free cash flow during the start-up and survival
stages of our business. Cash flow will allow us to invest in new opportunities, operate our
business, and pay our debts.

By the end of this chapter, you should be able to:


 • explain the concept of entrepreneurial finance
 • discuss entrepreneurship and the importance of finance to the
entrepreneur
 • distinguish between entrepreneurial finance and corporate finance
 • define micro, small and medium enterprises
 • explain the characteristics and importance of micro, small and medium
enterprises
 • identify the constraints to the development of micro, small and medium
enterprises

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