CH-11-15 Financial Preparation for Entrepreneurial Ventures – Entrepreneurship: Theory, Process, and Practice: Chapter Notes

This Document Contains Chapters 11 to 15 CHAPTER 11 FINANCIAL PREPARATION FOR ENTREPRENEURIAL VENTURES CHAPTER OUTLINE I. The Importance of Financial Information for Entrepreneurs II. Understanding the Key Financial Statements A. The Balance Sheet 1. UNDERSTANDING THE BALANCE SHEET a. Current Assets b. Fixed Assets c. Current Liabilities d. Long-Term Liabilities e. Contributed Capital f. Retained Earnings 2. WHY THE BALANCE SHEET ALWAYS BALANCES a. A Credit Transaction b. A Bank Loan c. A Stock Sale B. The Income Statement 1. UNDERSTANDING THE INCOME STATEMENT a. Revenue b. Cost of Goods Sold c. Operating Expenses d. Financial Expense e. Estimated Income Taxes C. The Cash-Flow Statement III. Preparing Financial Budgets A. The Operating Budget B. The Cash-Flow Budget IV. Pro Forma Statements V. Capital Budgeting A. Payback Method B. Net Present Value C. Internal Rate of Return VI. Break-Even Analysis A. Break-Even Point Computation 1. CONTRIBUTION MARGIN APPROACH 2. GRAPHIC APPROACH 3. HANDLING QUESTIONABLE COSTS VII. Ratio Analysis FEATURED CONTENT The Entrepreneurial Process: Watching Your Accounts Receivables The Entrepreneurial Process: Characteristics of Credible Financials LEARNING OBJECTIVES 1 To explain the principal financial statements needed for any entrepreneurial venture: the balance sheet, income statement, and cash-flow statement 2 To outline the process of preparing an operating budget 3 To discuss the nature of cash flow and to explain how to draw up such a document 4 To describe how pro forma statements are prepared 5 To explain how capital budgeting can be used in the decision-making process 6 To illustrate how to use break-even analysis 7 To describe ratio analysis and illustrate the use of some of the important measures and their meanings CHAPTER SUMMARY Three principal financial statements are important to entrepreneurs: the balance sheet, the income statement, and the cash-flow statement. The budgeting process facilitates financial statement preparation. Some key budgets entrepreneurs should prepare are the operating budget, the cash-flow budget, and the capital budget. The operating budget typically begins with a sales forecast, followed by an estimation of operating expenses. A cash-flow budget provides an overview of the inflows and outflows of cash during a specific period. Pro forma financial statements then are prepared as projections of the firm’s financial position over a future period (pro forma income statement) or on a future date (pro forma balance sheet). The operating and cash-flow budgets often are used to prepare these pro forma statements. The capital budget is used to help entrepreneurs make investment decisions. The three most common methods of capital budgeting are the payback period, the net present value method, and the internal rate of return method. Another commonly used decision-making tool is break-even analysis, which tells how many units must be sold in order to break even at a particular selling price. It is possible to use this analysis even when fixed or variable costs can only be estimated. The last part of the chapter examined ratio analysis, which can be a helpful analytical tool for entrepreneurs. Ratios are designed to show relationships between financial statement accounts. LECTURE NOTES I. The Importance of Financial Information for Entrepreneurs Financial information pulls together all of the information presented in the other segments of the business: marketing, distribution, manufacturing, and management. It also quantifies assumptions and historical information concerning business operations. Entrepreneurs make assumptions to explain how numbers are derived, and they correlate them with information presented in other parts of the business operations. Entrepreneurs should follow a clear process to develop the key components of a financial segment. II. Understanding the Key Financial Statements Basic financial statements an entrepreneur needs to be familiar with are the balance sheet, the income statement, and the cash-flow statement. The Balance Sheet Reports a business’s financial position at a specific time. The balance sheet is divided into two parts: •The financial resources owned by the firm •The claims against these resources The financial resources the firm owns are called assets. The claims creditors have against the company are called liabilities. •Short-term liabilities must be paid during the coming 12 months. •Long-term liabilities are not due and payable within the next 12 months. The residual interest of the firm’s owners is known as owners’ equity. UNDERSTANDING THE BALANCE SHEET The balance sheet has three sections: assets, liabilities, and owners’ equity. Current Assets Cash and other assets expected to be turned into cash, sold, or used up during a normal operating cycle (cash, accounts receivable, inventory, prepaid expenses) Fixed Assets Land, building, equipment, and other assets expected to remain with the firm for an extended period; they are not totally used up in the production of the firm’s goods and services. Current Liabilities Obligations due and payable during the next year or within the operating cycle (accounts payable, notes payable, taxes payable, and loans payable). Long-Term Liabilities Obligations not due or payable for at least one year or not within the current operating cycle (bank loans). Contributed Capital When a corporation is owned by individuals who have purchased stock in the business; various kinds of stock can be sold by a corporation, the most typical being common stock and preferred stock. Retained Earnings The accumulated net income over the life of the corporation to date; every year this amount increases by the profit the firm makes and keeps within the company. WHY THE BALANCE SHEET ALWAYS BALANCES The balance sheet always balances because if something happens on one side of the balance sheet, it is offset by something on the other side. A Credit Transaction When a company orders materials from a supplier, their inventory goes up and accounts payable also goes up by the amount the supplier charged. The increase in current assets is offset by an increase in current liabilities. When the bill is paid by the company by issuing a check, cash declines by the billed amount. At the same time, accounts payable decreases by this same amount. Again, these are offsetting transactions, and the balance sheet remains in balance. A Bank Loan A company may have an outstanding bank loan of $200,000 in 2018. If the company increases this loan by $110,000 in 2016, cash goes up by $110,000, and bank loan increases by the same amount. In addition, if the firm uses this $110,000 to buy new machinery, cash decreases by $110,000 and equipment increases by the same amount. A Stock Sale A company issues and sells shares of common stock. The balance sheet action shows that common stock increases as well as cash. The Income Statement Shows the change that has occurred in a firm’s position as a result of its operations over a specific period. Revenue: obtained every time a business sells a product or performs a service Expenses: major expenses, inclusive of costs of goods sold Net income: excess of revenue over expenses UNDERSTANDING THE INCOME STATEMENT The typical income statement has five major sections: (1) sales revenue, (2) cost of goods sold, (3) operating expenses, (4) financial expense, and (5) income taxes estimated. Revenue—sales revenue is often referred to as gross revenue. Cost of Goods Sold—the cost of goods for a given period equals the beginning inventory plus any purchases the firm makes minus the inventory on hand at the end of the period. Operating Expenses—major expenses, exclusive of costs of goods sold, are classified as operating expenses. Expenses often are divided into two broad subclassifications: selling expenses and administrative expenses. Financial Expense—financial expense is the interest expense on long-term loans. Estimated Income Taxes— corporations pay estimated income taxes. The Cash-Flow Statement The cash-flow statement shows the effects of a company’s operating, investing, and financing activities on its cash balance. Key questions answered by the cash-flow statement: •How much cash did the firm generate from operations? Operating cash flows: cash generated from or used in the course of business operations of the firm. •How did the firm finance fixed capital expenditures? Financing activities: cash flow effect of financing decisions of the firm (sale of stocks and bonds, repurchase of securities, and payment of dividends) •How much new debt did the firm add? Investing activities: cash flow effects from long-term investing activities, such as purchase or sale of plant and equipment III. Preparing Financial Budgets The operating budget is a statement of estimated income and expenses during a specified period of time. Another common type of budget is the cash-flow budget, which is a statement of estimated cash receipts and expenditures during a specified period of time. The Operating Budget The first step in an operating budget is the preparation of the sales forecast. Simple linear regression is a technique in which a linear equation states the relationship among three variables. Y = a + bx Y is a dependent variable, x is an independent variable, a is a constant, and b is the slope of the line (the change in Y divided by the change in x). After forecasting sales for the budget period, expenses must be estimated. Production budget: estimate of the number of units to be produced to meet the sales forecast. The last step in preparing the operating budget is to estimate the operating expenses for the period. •fixed costs •variable costs •mixed costs The Cash-Flow Budget A statement of estimated cash receipts and expenditures over a specified period of time is considered the cash-flow budget. •Cash sales •Cash payments received on account •Loan proceeds IV. Pro Forma Statements The final step in the budget process. These are projections of a firm’s financial position during a future period or on a future date. There are two kinds of pro forma statements. •Income statements—done first, as in normal accounting. The firm will have already prepared the pro forma income statements for each month in the budget period. •Balance sheet— followed by the income statement as in the normal accounting cycle but is more complex. The last balance sheet prepared before the budget period began, the operating budget, and the cash-flow budget are needed to prepare it. V. Capital Budgeting A technique the entrepreneur can use to help plan for capital expenditures. The first step is to identify cash flows and timing. The second step is to obtain reliable estimates of savings and expenses. There are three common methods used in capital budgeting. Payback Method •Easiest •The length of time required to “pay back” the original investment is the determining criterion. •A problem that occurs is that it ignores cash flows beyond payback period. Net Present Value (NPV) •This technique helps to minimize some of the shortcomings of the payback method by recognizing the future cash flows beyond the payback period. •This concept works on the premise that a dollar today is worth more than a dollar in the future—how much more depends on the applicable cost of capital for the firm. Internal Rate of Return •This method is similar to NPV in that the future cash flows are discounted. They are discounted at a rate that makes the NPV of the project equal to zero. This rate is what is referred to as the internal rate of return on the project. The project with the highest IRR is then selected. Thus, a project that would be selected under the NPV method would also be selected under the IRR method. •One of the drawbacks to using the IRR method is the difficulty that can be encountered when using the technique. VI. Break-Even Analysis Entrepreneurs need relevant, timely, and accurate information that will enable them to price their products and services competitively and still be able to earn a fair profit. Break-Even Point Computation It helps determine how many units must be sold to break even at a particular selling price. CONTRIBUTION MARGIN APPROACH Difference between selling price and variable cost per unit is the amount per unit that is contributed to cover all other costs. 0 = (SP – VC) S – FC or FC = (SP – VC)S SP = Unit selling price VC = Variable costs per unit S = Sales in units FC = Fixed Cost GRAPHIC APPROACH The entrepreneur needs to graph at least two numbers: total revenue and total costs. The intersection of these two lines is the firm’s break-even point. HANDLING QUESTIONABLE COSTS This approach is used when firms have expenses that are difficult to assign. This technique calculates break-even points under alternative assumptions of fixed or variable costs to see if a product’s profitability is sensitive to cost behavior. The decision rules for this concept are as follows: If expected sales exceed the higher break-even point, the product should be profitable, regardless of the other break-even point; if expected sales do not exceed the lower break-even point, then the product should be unprofitable. VII. Ratio Analysis An analysis of the firm’s ratios is generally the key step in a financial analysis. The ratios are designed to show relationships among financial statement accounts. Ratio analysis can be applied from two directions: Vertical and Horizontal. Vertical analysis is the application of ratio analysis to one set of financial statements; an analysis “up and down” the statements is done to find signs of strengths and weaknesses. Horizontal analysis looks at financial statements and ratios over time. The trends are critical. CHAPTER 12 DEVELOPING AN EFFECTIVE BUSINESS PLAN CHAPTER OUTLINE I. Pitfalls to Avoid in the Venture Planning Process A. Pitfall 1: No Realistic Goals B. Pitfall 2: Failure to Anticipate Roadblocks C. Pitfall 3: No Commitment or Dedication D. Pitfall 4: Lack of Demonstrated Experience (Business or Technical) E. Pitfall 5: No Market Niche (segment) II. Business Model Canvas: Initiating the Venture Formation Process III. What Is a Business Plan? IV. Benefits of a Business Plan V. Developing a Well-Conceived Business Plan A. Who Reads the Plan? B. Putting the Package Together C. Guidelines to Remember 1. KEEP THE PLAN RESPECTABLY SHORT 2. ORGANIZE AND PACKAGE THE PLAN APPROPRIATELY 3. ORIENT THE PLAN TOWARD THE FUTURE 4. AVOID EXAGGERATION 5. HIGHLIGHT CRITICAL RISKS 6. GIVE EVIDENCE OF AN EFFECTIVE ENTREPRENEURIAL TEAM 7. DO NOT OVER-DIVERSIFY 8. IDENTIFY THE TARGET MARKET 9. KEEP THE PLAN WRITTEN IN THE THIRD PERSON 10. CAPTURE THE READER’S INTEREST D. Questions to Be Answered VI. Elements of a Business Plan A. Executive Summary B. Business Description C. Marketing Segment D. Market Niche and Market Share 1. COMPETITIVE ANALYSIS 2. MARKETING STRATEGY 3. PRICING POLICY 4. ADVERTISING PLAN E. Research, Design, and Development Segment F. Operations Segment G. Management Segment H. Financial Segment 1. THE PRO FORMA BALANCE SHEET 2. THE INCOME STATEMENT 3. THE CASH-FLOW STATEMENT I. Critical-Risks Segment J. Harvest Strategy Segment K. Milestone Schedule Segment L. Appendix and/or Bibliography Segment VII. Updating the Business Plan A. A Practical Example of a Business Plan VIII. Presentation of the Business Plan: “The Pitch” A. Suggestions for Preparation B. What to Expect FEATURE CONTENT The Entrepreneurial Process: Common Business Planning Mistakes The Entrepreneurial Process: Straying from Your Business Plan? Sample Business Plan LEARNING OBJECTIVES 1 To explore the planning pitfalls that plague many new ventures 2 To explain the business model canvas as an initial step in the planning process 3 To define a business plan and demonstrate its value 4 To describe the benefits of a business plan 5 To set forth the viewpoints of those who read a business plan 6 To emphasize the importance of coordinating the business plan segments 7 To review key recommendations by venture capital experts regarding a plan 8 To present a complete outline of an effective business plan 9 To present some helpful hints for writing an effective business plan 10 To highlight points to remember in the presentation of a business plan CHAPTER SUMMARY This chapter provided a thorough definition and examination of an effective business plan. The critical factors in planning and the pitfalls to be avoided were discussed. Indicators of these pitfalls and ways to avoid them also were presented. Next, the benefits for both entrepreneurs and financial sources were reviewed. Developing a well-conceived plan was presented from the point of view of the audience for whom the plan is written. The typical six-step reading process of a business plan was presented to help entrepreneurs better understand how to put the business plan together. Ten guidelines in developing a business plan were provided, collated from the advice of experts in venture capital and new-business development. The next section illustrated some of the major questions that must be answered in a complete and thorough business plan. The business plan was outlined, and every major segment was addressed and explained. The chapter then presented some helpful hints for preparing a business plan, along with a self-analysis checklist for doing a careful critique of the plan before it is presented to investors. Finally, the chapter closed with a review of how to present a business plan to an audience of venture capital sources. Some basic presentation tips were listed, together with a discussion of what to expect from the plan evaluators. LECTURE NOTES I. Pitfalls to Avoid in the Venture Planning Process No Realistic Goals •Lack of attainable goals •Lack of time frame to accomplish things •Lack of priorities •Lack of action steps Failure to Anticipate Roadblocks •No recognition of future problems •No admission of possible flaws or weaknesses in the plan •No contingency or alternative plans No Commitment or Dedication •Copying the latest social craze •No interest in researching the idea •No desire to invest personal money •Appearance of making a “fast buck” from an “app” or a “whim” Lack of Demonstrated Experience (Business or Technical) •No experience in business •No experience in the specific area of the business •Lack of understanding of the industry in which the venture fits •Failure to convey a clear picture of how and why the venture will work and who will accept it No Market Niche (Segment) •Uncertainty about who will buy the basic idea(s) behind the venture •No proof of need or desire for the good or product being proposed Assumption that there will be customers or clients just because the entrepreneur thinks so II. Business Model Canvas: Initiating the Venture Formulation Process The Business Model Canvas is a structured brainstorming tool for entrepreneurs to use to define and understand the strategic focus and the questions that need to be answered for each of the nine business building blocks. A business model is a description of how a venture will create and deliver value. There are nine essential components: 1. Value Proposition: The products and services that create value for a specific customer segment. Value can be provided through various elements such as newness, performance, customization, design, brand, status, price, risk reduction, accessibility, and convenience. 2. Customer Segments: The different groups of people or entities that the venture aims to reach and serve. Customers can be segmented based on different needs and attributes. 3. Channels: Ways the venture communicates with and reaches its customer segments. Effective channels nay be opening a store, using major distributors, or a combination of both. These channels need to be fast, efficient, and cost effective. 4. Customer Relationships: The types of relationships a venture establishes with specific customer segments. These may include personal assistance, self-service, automated services, or community platforms. 5. Revenue Streams: The cash a new venture proposes to generate from the particular customer niche. These may include selling an item, service fees, subscription fees, lease or rental income, licensing fees, or advertising income. 6. Key Activities: These are the most important elements that a venture must do. For example, if lower prices are the unique value proposition then creating an efficient supply chain to drive down costs would be a key activity. 7. Key Resources: The most important assets required to make the business model work and create value for the customer. These are needed to sustain and support the business and could be human, financial, physical, or intellectual. 8. Key Partners: The network of suppliers and partners that optimize operations and reduce risks to make the business model work. 9. Cost Structure: The most significant costs incurred to operate the business model. Characteristics of cost structures include: a. Fixed costs—unchanged b. Variable costs—vary depending on the amount of production of goods or services c. Economies of scale—costs go down as the amount of good are ordered or produced d. Economies of slope—costs go down due to incorporating other businesses which have a direct relation to the original product III. What Is a Business Plan? A business plan is the written document that details the proposed venture. It must describe current status, expected needs, and projected results of the new business. Every aspect of the business needs to be covered. It is the entrepreneur’s road map for a successful enterprise. The business plan describes to investors and financial sources all of the events that may affect the proposed venture. The business plan should be the result of meetings and reflections on the direction of the new venture. It is the major tool for determining the essential operation of a venture. A major benefit is that helps the enterprise avoid common pitfalls. IV. Benefits of a Business Plan The entire business planning process forces the entrepreneur to analyze all aspects of the venture and to prepare an effective strategy to deal with the uncertainties that arise, which may help avoid a project doomed to failure. Benefits for the entrepreneur •Forces the entrepreneur to view venture critically and objectively •Subjects the entrepreneur to close scrutiny of his or her assumptions about the success of the venture •Causes the entrepreneur to develop and examine operating strategies and expected results for outside evaluators •Quantifies goals and objectives by providing measurable benchmarks for comparing forecasts with actual results •Provides the entrepreneur with a communication tool for outside financial sources as well as an operational tool for guiding the venture towards success Benefits for financial sources •Provides details of the market potential and plans for securing a share of that market •Illustrates the venture’s ability to service debt or provide an adequate return on investment •Identifies critical risks and crucial events with a discussion of contingency plans •Gives financial sources a clear, concise document that contains the necessary information for a thorough business and financial evaluation •Provides a useful guide for assessing the individual entrepreneur’s planning and managerial ability V. Developing a Well-Conceived Business Plan Who Reads the Plan? Numerous professionals such as venture capitalists, bankers, angel investors, potential large customers, lawyers, consultants, and suppliers may read the business plan. Entrepreneurs need to clearly understand three main viewpoints when preparing the plan. Entrepreneurs Viewpoint—the one developing the venture and clearly has the most in-depth knowledge of the technology or creativity involved. Marketplace Viewpoint—establishing an actual market and documenting who will buy the product or use the service and documenting that the anticipated percentage of this market is appropriate for the venture’s success are valuable criteria. Investors Viewpoint—they are concentrated on the financial forecast. Putting the Package Together When presenting the business plan to potential investors, the entire package is important. It gives financiers their first impressions of the company and its principals. They expect it to look good, but not too good, be clearly and concisely explained, and not contain bad grammar or typographical or spelling errors. Guidelines to Remember KEEP THE PLAN RESPECTABLY SHORT ORGANIZE AND PACKAGE THE PLAN APPROPRIATELY ORIENT THE PLAN TOWARD THE FUTURE AVOID EXAGGERATION HIGHLIGHT CRITICAL RISKS GIVE EVIDENCE OF AN EFFECTIVE ENTREPRENEURIAL TEAM DO NOT OVER-DIVERSIFY IDENTIFY THE TARGET MARKET KEEP THE PLAN WRITTEN IN THE THIRD PERSON CAPTURE THE READER’S INTEREST Questions to be Answered •Is your plan organized so key facts leap out at the reader? •Is your product/service and business mission clear and simple? •Are you focused on the right things? •Who is your customer? •Why will customers buy? How much better is your product/service? •Do you have a competitive advantage? •Do you have a favorable cost structure? •Can the management team business a business? •How much money do you need? •How does your investor get a cash return? V. Elements of a Plan Executive Summary This should be a clever snapshot of the complete plan. The statements for a summary should briefly touch on the venture itself, the market opportunities, the financial needs and projections, and any special research. Business Description A general description of the business, industry background, goals and potential of the business and milestones, and the uniqueness of the product or service are included. Marketing Segment This segment must be written as to convince investors that a market exists, that sales projections can be achieved, and that competition can be beaten. Market Niche and Market Share These are all the people who have a need for the newly proposed product or service. COMPETITIVE ANALYSIS MARKETING STRATEGY PRICING POLICY ADVERTISING PLAN Research, Design, and Development Segment This segment is applicable only if R&D is involved in the business plan Operations Segment This segment begins by describing the location based on appropriate terms of labor availability, wage rate, proximity of suppliers and customers, and community support. Management Support This segment identifies the key personnel, their positions and responsibilities, and the career experiences that qualifies them for those roles. The entrepreneur’s role should be clearly outlined. Financial Segment THE PRO FORMA BALANCE SHEET THE INCOME STATEMENT THE CASH-FLOW STATEMENT Critical-Risks Segment Potential risks such as effect of unfavorable trends in the industry, design or manufacturing costs, difficulties of long lead times are a few that need to be considered. Harvest Strategy Segment Every business plan should provide insights into the future harvest strategy. With foresight, entrepreneurs can keep their dreams alive. Milestone Schedule Segment This will provide investors with a timetable for the various activities to be accomplished. They need to be realistic and can be established within any appropriate time frame such as quarterly, monthly, or weekly. They must be coordinated with other aspects of the production and operations schedule. Appendix and/or Bibliography Segment This is not a mandatory segment, but it allows for additional documentation that is not appropriate in the main parts of the plan. Diagrams, blueprints, financial data, vitae of management team, and any bibliographical information that supports the other segments of the plan. VII. Updating the Business Plan There are many reasons to update the business plan which include financials changes, additional financing, changes in the market, launch of a new product or service, new management team, and to reflect the new reality. A Practical Example of a Business Plan An example of an actual business plan prepared for potential and business plan funding competitions is included in Appendix 12A at the end of this chapter: Hydraulic Wind Power. VIII. Presentation of the Business Plan: “The Pitch” •Know the outline •Use keywords •Rehearse •Be familiar with technology used in the presentation •Practice the complete presentation the day before Suggestions for Preparation When presenting to venture capitalists, they agree that the context should be focused and the delivery should be sharp. •Focus on the “pain” for which your venture will be the solution. •Demonstrate the reachable market. •Explain the business model. •Tout the management team. •Explain your metrics. •Motivate the audience. •Why you and why now? What to Expect Do not expect enthusiastic acceptance or even polite praise. The remarks are going to be likely critical. Never expect results in 20 minutes. Don’t feel defeated but rather make a commitment to improve the plan for the future. The goal is not so much to succeed the first time, as it is to succeed. CHAPTER 13 STRATEGIC ENTREPRENEURIAL GROWTH CHAPTER OUTLINE I. Strategic Planning and Emerging Firms II. The Nature of Strategic Planning A. The Lack of Strategic Planning B. The Value of Strategic Planning C. Fatal Visions in Strategic Planning D. Entrepreneurial and Strategic Actions E. Strategic Positioning: The Entrepreneurial Edge F. An Entrepreneurial Strategy Matrix Model III. Managing Entrepreneurial Growth A. Venture Development Stages 1. NEW-VENTURE DEVELOPMENT 2. START-UP ACTIVITIES 3. GROWTH 4. BUSINESS STABILIZATION 5. INNOVATION OR DECLINE B. Transitioning from Entrepreneurial to a Managerial 1. Balancing the Focus: Entrepreneurial versus Managerial C. Understanding the Growth Stage 1. KEY FACTORS DURING THE GROWTH STAGE a. Control b. Responsibility c. Tolerance of Failure d. Change D. Managing Paradox and Contradiction 1. BUREAUCRATIZATION VERSUS DECENTRALIZATION 2. ENVIRONMENT VERSUS STRATEGY 3. STRATEGIC EMPHASES: QUALITY VERSUS COST VERSUS INNOVATION E. Confronting the Growth Wall IV. Building an Entrepreneurial Company in the Twenty-First Century A. The Entrepreneurial Mind-Set B. Key Elements for an Entrepreneurial Firm 1. SHARE THE ENTREPRENEUR’S VISION 2. INCREASE THE PERCEPTION OF OPPORTUNITY 3. INSTITUTIONALIZE CHANGE AS THE VENTURE’S GOAL 4. INSTILL THE DESIRE TO BE INNOVATIVE a. A Reward System b. An Environment That Allows for Failure c. Flexible Operations d. The Development of Venture Teams V. Unique Managerial Concerns of Growing Ventures A. The Distinctiveness of Size B. The One-Person-Band Syndrome C. Time Management D. Community Pressures E. Continuous Learning VI. Achieving Entrepreneurial Leadership in the New Millennium FEATURED CONTENT The Entrepreneurial Process: From Entrepreneur to Manager LEARNING OBJECTIVES 1 To introduce the importance of strategic planning with emerging firms 2 To delve into the nature of strategic planning 3 To examine the challenges of managing entrepreneurial growth 4 To discuss the five stages of a typical venture life cycle: development, start-up, growth, stabilization, and innovation or decline 5 To examine the transition that occurs in the movement from an entrepreneurial style to a managerial approach 6 To identify the key factors that play a major role during the growth stage 7 To discuss the complex management of paradox and contradiction 8 To introduce the steps useful for breaking through the growth wall 9 To explore the elements of building an entrepreneurial company 10 To identify the unique managerial concerns with growth businesses CHAPTER SUMMARY Although many ways of strategically planning a venture exist, all have one common element: Each is an extension of the entrepreneur’s vision—each takes the owner’s concept of the business and puts it into action. Entrepreneurs may not use strategic planning for many reasons, among them scarcity of time, lack of knowledge about how to plan, lack of expertise in the planning process, and lack of trust in others. A number of benefits to strategic planning exist. In particular, studies have shown that small firms that use this process tend to have better financial performance than those that do not. Other benefits include more efficient resource allocation, improved competitive position, higher employee morale, and more rapid decision-making. The challenges of managing entrepreneurial growth were then examined. A typical life cycle of a venture has five stages: development, start-up, growth, stabilization, and innovation or decline. This chapter focused on ways to maintain an entrepreneurial frame of mind while making the necessary adjustments to deal with the growth phase. The balance of entrepreneurial and managerial approaches was reviewed in this section. This balance was demonstrated by considering five major factors: strategic orientation, commitment to seize opportunities, commitment of resources, control of resources, and management structure. This differentiation of major factors is important for analyzing aspects of the venture that need either more administrative or more entrepreneurial emphasis. The chapter then examined the importance of a venture’s growth stage. Underscoring the metamorphosis a venture goes through, four factors were discussed: control, responsibility, tolerance of failure, and change. In addition, the challenge of managing paradox and contradiction was presented. The elements involved in building an entrepreneurial firm were then discussed. When building the desired entrepreneurial firm, entrepreneurs need to be concerned with three important responsibilities: (1) increasing the perception of opportunity, (2) institutionalizing change as the venture’s goals, and (3) instilling the desire to be innovative. In addition the unique managerial concerns of growing ventures were outlined for entrepreneurs. Finally, the concept of entrepreneurial leadership was introduced as a way for entrepreneurs to anticipate, envision, maintain flexibility, think strategically, and work with others to initiate changes that will create a viable future for the growth-oriented venture. LECTURE NOTES I. Strategic Planning and Emerging Firms Need for formal planning based upon: •The degree of uncertainty •The strength of competition •The experience of the entrepreneur II. The Nature of Strategic Planning Strategic planning is the formulation of long-range plans for the effective management of environmental opportunities and threats in light of a venture’s strengths and weaknesses. It includes defining the venture’s mission, specifying achievable objectives, developing strategies, and setting policy guidelines. There are five basic steps to follow in strategic planning: 1. Examine the internal and external environments of the venture (strengths, weaknesses, opportunities, threats). 2. Formulate the venture’s long-range and short-range strategies (mission, objectives, strategies, policies). 3. Implement the strategic plan (programs, budgets, procedures). 4. Evaluate the performance of the strategy. 5. Take follow-up action thought continuous feedback. The Lack of Strategic Planning Research has shown a distinct lack of planning on the part of new ventures. There are five basic reasons for the lack of planning: •Time scarcity—Entrepreneurs report that their time is scarce and difficult to allocate to planning in the face of day-to-day operating schedules. •Lack of knowledge—Entrepreneurs have minimal exposure to, and knowledge of, the planning process. •Lack of expertise/skills—Entrepreneurs typically are generalists, and they often lack the specialized expertise necessary for the planning process. •Lack of trust and openness—Entrepreneurs are highly sensitive and guarded about their businesses and the decisions that affect them. •Perception of high cost—Entrepreneurs perceive the cost associated with planning to be very high. This fear of expensive planning causes many business owners to avoid or ignore planning as a viable process. The Value of Strategic Planning Research shows that strategic planning does pay off. There have been many studies conducted that support the contention that strategic planning is of value to a venture. One study examined 253 smaller firms and classified these companies into the following categories: Category I: No written plan (101 firms, or 39.9 percent) Category II: Moderately sophisticated planning, including a written plan and/or some quantified objectives, plans and budgets, external environment factors, and procedures for anticipating or detecting differences between the plan and actual performance (89 firms, or 35.2 percent) Category III: Sophisticated planning including a written plan with all of the following: some quantified objectives, some specific plans and budgets, identification of some external environment factors, and procedures for anticipating or detecting differences between the plan and actual performance (63 firms, or 24.9 percent). These results demonstrated that more than 88 percent of firms with Category II or III planning performed at or above the industry average. Fatal Visions in Strategic Planning: •Misunderstanding industry attractiveness •No real competitive advantage •Pursuing an unattainable competitive position •Compromising strategy for growth •Failure to explicitly communicate the venture’s strategy to employees Entrepreneurial and Strategic Actions •Strategic = exploit competitive advantages •Entrepreneurial = search for competitive advantages Within these commonalities between entrepreneurship and strategic management are specific domains of innovation, networks, internationalization, organizational learning, top management teams and governance, and growth. Strategic Positioning: The Entrepreneurial Edge •The process of perceiving new positions that attract customers from established positions or draw new customers into the market •Requires creativity and insight An Entrepreneurial Strategy Matrix Model Researchers Sonfield and Lussier developed an entrepreneurial strategy matrix that measures risk and innovation. Innovation is the creation of something new and different. Risk is the probability of major financial loss. The model places innovation on the vertical axis and risk on the horizontal axis. It denotes the levels of these two variables by using I and R for high levels in i and r for low levels. The value of the matrix is that it suggests appropriate avenues for different entrepreneurs. III. Managing Entrepreneurial Growth Managing entrepreneurial growth may be the most critical tactic for the future success of the business enterprises. Venture Development Stages Venture development states are life cycle stages of an enterprise. NEW-VENTURE DEVELOPMENT Consists of activities associated with the initial formulation of the venture. START-UP ACTIVITIES Encompasses the foundation work needed for creating a formal business plan. GROWTH This stage is a transition from the entrepreneurial one-person leadership to managerial team-oriented leadership. BUSINESS STABILIZATION Sales begin to stabilize and the entrepreneur must begin thinking about the enterprise will go over the next three to five years. This stage is often a “swing” stage in that it precedes the period when the firm either swings into a higher gear and greater profitability or swings toward decline and failure. INNOVATION OR DECLINE Firms that begin to fail to innovate will die. Transitioning from Entrepreneurial to a Managerial This is a key transition where the entrepreneur shifts into a managerial style. BALANCING THE FOCUS: ENTREPRENEURIAL VERSUS MANAGERIAL It is important for an entrepreneur to remember two important points. First, an adaptive firm needs to retain certain entrepreneurial characteristics to encourage innovation and creativity. Second, the entrepreneur needs to translate this spirit of innovation and creativity to his or her personnel while personally making a transition toward a more managerial style. A framework for comparing the entrepreneurial and administrative characteristics and pressures relative to five major factors: strategic orientation, commitment to seize opportunities, commitment of resources, control of resources, and management structure. At the two ends of the continuum are specific points of view. The Entrepreneur’s Point of View Where is the opportunity? How do I capitalize on it? What resources do I need? How do I gain control over them? What structure is best? The Administrative Point of View What resources do I control? What structure determines our organization’s relationship to its market? How can I minimize the impact of others on my ability to perform? What opportunity is appropriate? Understanding the Growth Stage The growth stage often signals the beginning of a metamorphosis from a personal venture to a group-structured operation. KEY FACTORS DURING THE GROWTH STAGE Control Growth creates problems in command and control. Three questions need to be answered by the entrepreneur: (1) Does the control system imply trust? (2) Does the resource allocation system imply trust? (3) Is it easier to ask permission than to ask forgiveness? Responsibility As the company grows, the distinction between authority and responsibility becomes more apparent. Authority can always be delegated, but it is important to create a sense of responsibility. Tolerance of Failure Three distinct forms of failure should be distinguished. Moral failure. Violation of trust Personal failure. Brought about by a lack of skill or application. Uncontrollable failure. Caused by external factors and is the most difficult to prepare for or deal with. Change Planning, operations, and implementation are all subject to continual changes as the venture mores through the growth stage and beyond. Managing Paradox and Contradiction BUREAUCRATIZATION VERSUS DECENTRALIZATION Increased hiring stimulates bureaucracy ENVIRONMENT VERSUS STRATEGY High environmental turbulence and competitive conditions favor company cultures that support risk taking, autonomy, and employee participation in decision-making. STRATEGIC EMPHASES: QUALITY VERSUS COST VERSUS INNOVATION Quality versus cost versus innovation—rapidly growing firms strive to simultaneously control costs, enhance product quality, and improve product offerings. Confronting the Growth Wall There are a number of fundamental changes that confront rapid-growth firms, including instant size increases, a sense of infallibility, internal turmoil, and extraordinary resource needs. Entrepreneurs should keep in mind these themes as they develop their ability to manage growth: •The entrepreneur is able to envision and anticipate the firm as a larger entity. •The team needed for tomorrow is hired and developed today. •The original core vision of the firm is constantly and zealously reinforced. •New “big-company” processes are introduced gradually as supplements to, rather then replacements for, existing approaches. •Hierarchy is minimized. •Employees hold a financial stake in the firm. IV. Building an Entrepreneurial Company in the Twenty-First Century The Entrepreneurial Mind-Set It is important for the venture’s manager to maintain an entrepreneurial frame of mind. Key Elements for an Entrepreneurial Firm Entrepreneurs can build an entrepreneurial firm in four ways: SHARE THE ENTREPRENEUR’S VISION INCREASE THE PERCEPTION OF OPPORTUNITY INSTITUTIONALIZE CHANGE AS THE VENTURE’S GOAL INSTILL THE DESIRE TO BE INNOVATIVE A Reward System An Environment That Allows for Failure Flexible Operations The Development of Venture Teams V. Unique Managerial Concerns of Growing Ventures Emerging businesses differ in many ways from larger, more structured businesses. The Distinctiveness of Size Smallness gives emerging businesses certain disadvantages, such as a limited market and a smaller staff to do the work. The One-Person-Band Syndrome Occurs when an entrepreneur refuses to delegate responsibility to employees. Time Management Entrepreneurs should learn to use time as a resource and not allow time to use them. To perform daily managerial activities in the most time-efficient manner, owner/managers should follow four critical steps: 1. Assessment 2. Prioritization 3. Creation of procedures 4. Delegation Community Pressures The community exerts pressure on the entrepreneur in regards to participation, leadership, and donations. Continuous Learning Staying abreast of industry changes is another way for entrepreneurs to maintain a competitive edge. VI. Achieving Entrepreneurial Leadership in the New Millennium Entrepreneurial leadership can be defined as the entrepreneur’s ability to anticipate, envision, maintain flexibility, think strategically, and work with others to initiate change. It may be the most critical element in the management of high growth ventures. CHAPTER 14 VALUATION OF ENTREPRENEURIAL VENTURES CHAPTER OUTLINE I. The Importance of Business Valuation II. Underlying Issues When Acquiring a Venture A. Goals of the Buyer and Seller B. Emotional Bias C. Reasons for the Acquisition III. Due Diligence IV. Analyzing the Business V. Establishing a Firm’s Value A. Valuation Methods 1. ADJUSTED TANGIBLE BOOK VALUE 2. PRICE/EARNINGS RATIO (MULTIPLE OF EARNINGS) METHOD 3. DISCOUNTED EARNINGS METHOD VI. Term Sheets in Venture Valuation VII. Additional Factors in the Valuation Process A. Avoiding Start-up Costs B. Accuracy of Projections C. Control Factor FEATURED CONTENT The Entrepreneurial Process: The Valuation of Facebook: Real or Fantasy?? The Entrepreneurial Process: Knowing a Venture’s Pre-Money and Post-Money Valuation LEARNING OBJECTIVES 1 To explain the importance of valuation 2 To examine the underlying issues involved in the acquisition process 3 To describe the basic elements of due diligence 4 To outline the various aspects of analyzing a business 5 To present the major points to consider when establishing a firm’s value 6 To highlight the available methods of valuing a venture 7 To examine the three principal methods currently used in business valuations 8 To consider additional factors that affect a venture’s valuation CHAPTER SUMMARY Entrepreneurs need to understand how to valuate a business for either purchase or sale. Many would like to know the value of their businesses. Sometimes this is strictly for informational purposes, and other times it is for selling the operation. In either case, a number of ways of valuing an enterprise exist. The first step is to analyze the business’s overall operations, with a view to acquiring a comprehensive understanding of the firm’s strong and weak points. Table 14.2 provided a checklist for this purpose. The second step is to establish a value for the firm. Table 14.3 set forth 10 methods for the valuation of a venture. Three of the most commonly used are (1) adjusted tangible assets, (2) P/E (multiple of earnings), and (3) discounted future earnings. The adjusted tangible book value method computes the value of the business by revaluing the assets and then subtracting the liabilities. This is a fairly simple, straightforward process. The P/E method divides the market price of the common stock by the earnings per share and then multiplies by the number of shares issued. For example, a company with a price/earnings multiple of 10 and 100,000 shares of stock would be valued at $1 million. The discounted earnings method takes the estimated cash flows for a predetermined number of years and discounts these sums back to the present using an appropriate discount rate. This is one of the most popular methods of valuing a business. Other factors to consider for valuing a business include start-up costs, accuracy of projections, and the control factor. LECTURE NOTES I. The Importance of Business Valuation Every entrepreneur should be able to calculate the value of his or her business, and should also be able to determine the value of a competitor’s operation. II. Underlying Issues When Acquiring a Venture Goals of the Buyer and Seller The buyer will try to establish the lowest price to be paid while the seller will try to establish the highest possible value. The enterprise is regarded as an investment for the buyer and he or she must assess the profit potential. Emotional Bias It is hard for entrepreneurs to remain bias during a sale because of the time and effort they have put into the business. They must try to be as objective as possible in determining a fair value for the enterprise. Reasons for the Acquisition It is important that the entrepreneur and all other parties are objectively viewing the firm’s operations and potential. III. Due Diligence Due diligence is a thorough analysis of every facet of the existing business. Critical areas that should also be addressed are the future trends of the business and how much capital is needed to buy the venture. IV. Analyzing the Business Factors that distinguish the corporation and valuation of the establishment: History of the Business Market and Competition Sales and Distribution Manufacturing Employees Physical Facilities Ownership Financial Management V. Establishing a Firm’s Value Several traditional valuation methods are presented. Employing these methods will provide the entrepreneur with a general understanding of how the financial analysis of a firm works. Valuation Methods ADJUSTED TANGIBLE BOOK VALUE How to compute a business’s net worth. The computation of the adjusted tangible book value, goodwill, patents, deferred financing costs, and other intangible assets are considered with the other assets and deducted from or added to net worth. PRICE/EARNINGS RATIO (MULTIPLE OF EARNINGS) METHOD Common method used for valuing publicly held corporations. The value is determined by dividing the market price of the common stock by the earnings per share. DISCOUNTED EARNINGS METHOD Determines the true value of the firm. VI. Term Sheets in Venture Valuation The term sheet outlines the material terms and conditions of a venture agreement. It guides legal counsel in the preparation of a “final agreement,” and then guides the final terms of the agreement. VII. Additional Factors in the Valuation Process Avoiding Start-up Costs Buyers are willing to pay more for a business than deal with start-up costs. Buying an old business avoids the need to establish a clientele for the company. Accuracy of Projections Sales and earnings are projected in historical, financial and economic data. Examine trends, fluctuations, and patterns of the company. Analyze the market and earning potential of the firm. Control Factor If the owner of the firm has the control, then the value increases. CHAPTER 15 HARVESTING THE ENTREPRENEURIAL VENTURE CHAPTER OUTLINE I. Harvesting the Venture: A Focus on the Future II. The Management Succession Strategy III. Key Factors in Succession A. Succession Pressures and Interests inside the Firm 1. FAMILY MEMBERS 2. NONFAMILY EMPLOYEES B. Succession Pressures and Interests outside the Firm 1. FAMILY MEMBERS 2. NONFAMILY EMPLOYEES C. Forcing Events D. Sources of Succession E. Legal Restrictions IV. Developing the Succession Strategy A. Understanding Contextual Aspects of Succession 1. TIME 2. TYPE OF VENTURE 3. CAPABILITIES OF MANAGERS 4. ENTREPRENEUR’S VISION 5. ENVIRONMENTAL FACTORS B. Identifying Successor Qualities C. Writing a Succession Strategy 1. CONSIDER OUTSIDE HELP V. The Exit Strategy: Liquidity Events A. The Initial Public Offering (IPO) VI. Complete Sale of the Venture A. Steps for Selling a Business 1. STEP 1: PREPARE A FINANCIAL ANALYSIS 2. STEP 2: SEGREGATE ASSETS 3. STEP 3: VALUE THE BUSINESS 4. STEP 4: IDENTIFY THE APPROPRIATE TIMING 5. STEP 5: PUBLICIZE THE OFFER TO SELL 6. STEP 6: FINALIZE THE PROSPECTIVE BUYERS 7. STEP 7: REMAIN INVOLVED THROUGH THE CLOSING 8. STEP 8: COMMUNICATE AFTER THE SALE FEATURED CONTENT The Entrepreneurial Process: Harvesting a Business Online The Entrepreneurial Process: Using Buy/Sell Agreements LEARNING OBJECTIVES 1 To present the concept of “harvest” as a plan for the future 2 To examine the key factors in the management succession of a venture 3 To identify and describe some of the most important sources of succession 4 To discuss the potential impact of recent legislation on family business succession 5 To relate the ways to develop a succession strategy 6 To examine the specifics of an IPO as a potential harvest strategy 7 To present “selling out” as a final alternative in the harvest strategy CHAPTER SUMMARY This chapter focused on the harvesting of the venture. Beginning with the issue of management succession as one of the greatest challenges for entrepreneurs, a number of considerations that affect succession were discussed. Using privately held firms as the focal point in this chapter, key issues such as family and nonfamily members—both within and outside the firm—were identified to show the unique pressures on the entrepreneur. Some family members will want to be put in charge of the operation; others simply want a stake in the enterprise. Two types of successors exist: An entrepreneurial successor provides innovative ideas for new-product development, whereas a managerial successor provides stability for day-to-day operations. An entrepreneur may search inside or outside the family as well as inside or outside the business. The actual transfer of power is a critical issue, and the timing of entry for a successor can be strategic. The Oakland Scavenger Company case revealed how legal concerns now exist about the hiring of only family members. Nepotism has been challenged in the courts on the basis of discrimination. Developing a succession plan involves understanding these important contextual aspects: time, type of venture, capabilities of managers, the entrepreneur’s vision, and environmental factors. Also, forcing events may require the implementation of a succession plan, regardless of whether or not the firm is ready to implement one. This is why it is so important to identify successor qualities and carry out the succession plan. The chapter closed with a discussion of the entrepreneur’s decision to sell out. The process was viewed as a method to “harvest” the investment, and eight specific steps were presented for entrepreneurs to follow. LECTURE NOTES I. Harvesting the Venture: A Focus on the Future A harvest plan defines how and when the owners and investors will realize an actual cash return on their investment. Two of the most notable harvest strategies for ventures are the IPO and the sale of the venture. II. The Management Succession Strategy This strategy involves the transition of managerial decision-making in a firm; it is one of the greatest challenges confronting owners and entrepreneurs in privately held businesses. Research shows that only 16 percent of all privately held enterprises make it to a third generation. The average life expectancy for a privately held business is 24 years, which is also the average tenure for the founders of a business. Management succession, which involves the transition of managerial decision making in a firm, is one of the greatest challenges confronting owners and entrepreneurs in privately held businesses. III. Key Factors in Succession Succession is a highly charged emotional issue that requires not only structural changes but cultural changes as well. Succession Pressures and Interests inside the Firm FAMILY MEMBERS Problems can arise such as struggles over control, who will be the business’s heir, and rivalry within the family. NONFAMILY EMPLOYEES Problems can arise such as struggles over control, who will be the business’s heir, and rivalry within the family. Succession Pressures and Interests outside the Firm FAMILY MEMBERS Interested in ensuring that they inherit part of the operation or get involved in the business. NONFAMILY EMPLOYEES Competition continually changes strategies. Other factors: customers, technology, new-product development, tax laws, regulatory agencies, and trends in management practices. Forcing Events The following events could cause the replacement of the owner/manager: death, illness, mental or psychological breakdown, abrupt departure, legal problems, severe business decline, and financial difficulties. Sources of Succession •Entrepreneurial successor: high in ingenuity, creativity, and drive. •Managerial successor: interested in efficiency, internal control, and the effective use of resources. •Entrepreneur looks for an insider: son or daughter, nephew or niece. •Entrepreneur can train a team of executives and choose a successor from the team. •Early versus delayed entry strategy •Ability of the successor to gain credibility with employees •Nonfamily member approach Legal Restrictions •Succession practices challenged in the Oakland Scavenger Company case. •Suit brought by black and Hispanic workers charging racial discrimination. •Oakland Scavenger case will result in new guidelines and limitations for family employment. •Privately-held businesses must be aware of this challenge when preparing succession plans. IV. Developing the Succession Strategy Understanding Contextual Aspects of Succession TIME The earlier the entrepreneur plans for a successor, the better the chances of finding the right person. TYPE OF VENTURE Some entrepreneurs are easy to replace; some cannot be replaced. CAPABILITIES OF MANAGERS Skills, desires, and abilities of the replacement dictate future potential and direction of the enterprise. ENTREPRENEUR’S VISION •A successor, it is hoped, will the share the entrepreneur’s vision. •Outside executive experience may be sought for a more managerial, day-to-day entrepreneurial manager. ENVIRONMENTAL FACTORS Sometimes a successor is needed because the business environment changes. Identifying Successor Qualities Successors should possess many qualities or characteristics. Some of the most common are: business knowledge, honesty and capability, good health, energy, alertness, and perception, enthusiasm about the enterprise, personality, perseverance, stability and maturity, aggressiveness, respect for detail, problem-solving ability. Writing a Succession Strategy A written policy can be established using a succession strategy. It is crucial for entrepreneurs to design a plan for succession very carefully. CONSIDER OUTSIDE HELP Promotion from within is a morale-building philosophy. However, sometimes it is a mistake. V. The Exit Strategy: Liquidity Events An exit strategy is defined as that component of the business plan where an entrepreneur describes a method by which investors can realize a tangible return on their investment. The Initial Public Offering (IPO) The initial public offering (IPO) is used to represent the registered public offering of a company’s securities for the first time. VI. Complete Sale of the Venture Steps for Selling a Business STEP 1: PREPARE A FINANCIAL ANALYSIS STEP 2: SEGREGATE ASSETS STEP 3: VALUE THE BUSINESS STEP 4: IDENTIFY THE APPROPRIATE TIMING STEP 5: PUBLICIZE THE OFFER TO SELL STEP 6: FINALIZE THE PROSPECTIVE BUYERS STEP 7: REMAIN INVOLVED THROUGH THE CLOSING STEP 8: COMMUNICATE AFTER THE SALE Instructor Manual for Entrepreneurship: Theory, Process, and Practice Donald F. Kuratko 9781305576247