Teaching Suggestions Revised 22222

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Chapter 1Introduction

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 organizationalform, should be made carefully with an eye to future growth and strategic goals. Thischapter explores bootstrapping as a source of funds and relates the choice oforganizational form to future growth aspirations.

Major Points

The difference between entrepreneurial ventures and other forms of smallbusiness is significant. It is important to distinguish between these two types ofbusiness at the outset because their structure and financing are impacted by

growth aspirations. Entrepreneurial ventures are typically associated with highgrowth aspirations while life style businesses are more concerned with control.While the focus of the majority of this book is on the high growth entrepreneurialventure, we do provide data and statistics for lifestyle ventures as well.

There is an important connection between entrepreneurship and the health of theoverall economy. Statistics show that virtually all innovation and job growth inthe United States is supplied by the entrepreneurial sector of the economy. Thismakes it important to foster this sector at a policy level and take steps to increasethe odds of success at a firm level.

A major part of increasing the odds of success for a new business is anunderstanding of why new businesses fail. Since failure rates are so high forbusiness start-ups it is very important to study the reasons for business failure inthe hopes of avoiding common pitfalls. Several reasons for business failure arelisted in the chapter.

Bootstrapping is defined as the financing options most commonly available inthe very earliest stages of a companys life. Bootstrapping is simply doing morewith less. It is critical to explore low cost ways to start and leverage a newbusiness to increase the chances for success.

There is a relationship between the organizational form chosen and futurebusiness and financial strategic options. Raising capital is inextricably tied tocertain organizational forms. To avoid violating securitys laws and to expeditefuture financing, it is important to choose the organizational form at start-up thatis best for the long run growth of the company.


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Teaching Tip

Stress the various aspects of bootstrapping. Money is much harder to come by today thanit was five years ago so it is crucial that students think about maximizing the use ofpersonal 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 successfulbootstrappers 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. Alsoto untangle a partnership and convert to a C Corp at the time of capital raising may addunwanted 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 beleft to family heirs. Creating wealth via a high growth company with large sales prospectsmotivates most entrepreneurs. Whereas the lifestyle entrepreneur may be looking for ajob until retirement, the entrepreneur may be looking for a challenge for the next fewyears 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 toinefficiencies and waste. The dot-com era is replete with cases of venture capital spent onluxurious office space, high-end furniture and equipment and first class travel expenses.Less money forces creativity, frugality and efficiency for survival. These skills willbenefit the company throughout its life.

4. C-CorporationPros: expands access to capital, allows for faster growth, spreads risk to other investors.Cons: entrepreneur must share ownership, more owners may complicate future decisionmaking, more owners complicates capital structure, which may inhibit future capitalraising from professional investors. Accepting money from friends and family may alsolead to destroyed relationships if the business fails.

5. The main cost of limited growth is the ability of competition to enter and capturemarket share. There may also be some economies of scale that are unable to be realized atlower 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 orproduct knowledge. Managerial skills may be nonexistent or underdeveloped.Likewise, good entrepreneurs seldom make good managers since the skill sets


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differ. Relating to the first item, lack of financial knowledge by managementalso contributes to the firms inability to manage cash flow and budget.

3. Marketing: poor or inadequate market research, failure to listen to customersand adapt to actual needs.

In all of these cases, problems can be reduced by complementing the entrepreneurs skillsby adding people to an advisory board that have the skills and knowledge that theentrepreneur lacks. Under capitalization can be avoided by researching the financialdemands of starting the business and drawing on all available personal resources to lineup adequate capital in advance.

Case 1-1 New Tech

1. Stuart should organize as a C-corporation if he anticipates raising much externalcapital for the business. Professional investors demand the C-corporation form toallow new investors to enter and exit easily and to offer protection to investors

from corporate liabilities. While other organizational forms could be used at start-up this would involve a restructuring down the road, with possible complicatingownership issues.

2. Since New Tech has been in operation since 2005, they probably have enoughoperating history to qualify for at least some bank debt. New Techs inventorycould serve as collateral for a loan. Some financing is also available from NewTechs suppliers in the form of trade credit. New Tech should investigate thepossibility of those same suppliers investing in the company, either through equityor perhaps subordinated debt. Finally, additional outside equity is possible in theform 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 seeksecond depends on New Techs cash flow situation. If their cash flow will allowthey should seek bank debt, since debt is the lowest cost source of capital andownership need not be diluted to obtain it. Supplier investment in the company isprobably the next logical step. Suppliers are already familiar with New Tech andtheir business so the sales pitch to obtain financing should be much easier withsuppliers 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 amanagement team in place.

5. Future milestones which could be tied to financing would be specific dollar salesincreases, for example to $5 million, successful launch of the new power moduleproduct, and further penetration into the home market.


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Chapter 2Alternatives in Venture FinancingDebt Capital

Overview

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

Major Points

Debt is always cheaper than equity for a given firm and should be included in thefirms capital structure.

Bank debt is not a major source of capital for new firms. In general to qualify for abank loan, a firm will need a three to five year operating history to demonstratecredit worthiness. This effectively removes bank debt as a viable source of capitalfor 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 throughleasing.

o Finance companies provide loans as well as factoring of accountsreceivable.

o Vendors may be a source of financing, either through trade credit or directinvestment in the business.

o The Small Business Administration increases the entrepreneurs odds ofobtaining bank debt by guaranteeing traditional bank loans.

o Customer prepayments can also be a source of capital to the cash strappedfirm. If a customer prepays for goods or service a liability is created forthe 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 capitalstructure theory sense due to their limited access to equity and the necessity offocusing on cash flow above all else. This point provides an opportunity to discussthe assumptions implicit in optimal capital structure theory and to demonstrate thatwhen the assumptions underlying a theory do not hold neither does the theory.


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Personal guarantees are usually required for an entrepreneurial venture to obtainbank financing. This point is worth stressing since students may think that theincorporation of a business completely separates the owner from the business in alegal sense. When the credit history of a firm is insufficient, the bank will draw nodistinction 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 isdrawn down as needed and thus the entrepreneur does not pay interest for money thatthey are not using. To obtain a bank LOC the entrepreneur must be able to show theability, usually annually, to pay down the LOC. Sometimes banks will charge astandby fee for making the LOC available. Entrepreneurs should shop around untilthey 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 itemof 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 providefinancing either through pledging or selling (factoring) of the receivables. For themajority 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 financialneeds. This includes a sales and profits forecast as well as a forecast of investment inassets, which will allow for the calculation of the cash flow forecast. It is importantto emphasize the difference between cash flows and profits and that cash flow is kingfor 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 thosenarrow ranges fixed costs usually increase in a stepwise fashion invalidating thebreakeven calculation. Very few costs are truly fixed. As output increases virtuallyall 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 classdiscussion 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 behavioralconsequences of financing an expansion with debt. Students should discuss the financialadvantages and disadvantages of using debt and then explore some of the non-financialissues raised in the case. What is the effect on growth of using debt versus internallygenerated equity?


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The MDO case provides an opportunity to discuss the forecasting of fixed and variablecosts. Students should think about how they would go about stratifying their costs andhow they would forecast them without an operating history to draw on. They may besurprised to think of marketing costs as having a fixed component for example.

Finally, the Cajun Yachts case demonstrates the steps in forecasting pro forma statementsand the calculation of financial need, which will be the basis for the loan request.


1. Creating the sales forecast is a crucial but difficult task. Future sales depend notonly on the quality of your product, but also on customers willingness to adopt orswitch to your product. This involves some thought as to switching and adoptioncosts the customer may have to incur before the product is operational. Thoughtmust also be given to competitors response to your entry into the market. It isimportant 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 salesforecasting. Define the market tightly and narrowly and think in terms of a largeshare of a small market rather than 2% of China.

2. Bank covenants can impose real costs on a firm. While the costs may not seemonerous at loan inception, future growth may be prohibited by trying to complywith bank imposed ratios. Typical covenants a bank might impose would be tomaintain a working capital ratio of X, a times interest earned ratio of Y or a totaldebt ratio of Z. A bank may specify that any future borrowing be subordinated tothe current loan, which renders it more expensive. Dividend restrictions are alsocommon 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 cashflow is the primary concern, and debt may exacerbate an already difficultproblem. On the other hand debt is cheaper than equity and preserves ownershipwithin the existing management group. Equity does not impose a cash flow coston the firm, but it does dilute ownership of the original management team. Equityinvestors are more likely to become involved in management decisions and day-to-day operations, which may or may not be a benefit. The optimal source offinancing depends largely on the firms forecast of time to positive cash flow. Afirm 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 are365/(60-10) = 7.3 compounding periods in the year, thus the cost of trade creditis:

(1+.0309)7.31 = 24.88%.


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24.9% seems to be a very high price to pay for credit. If the firm can borrow froma bank, on any basis, for less than 24.9% they should pursue the bank loan and payon day 10. If other lending options are not available the firm will have to bite thebullet and pay the high cost of trade credit. Depending on the firms operating cycle50 days financing may be sufficient to get them through the business cycle and

preserve the business.


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Case 2-1New Tech

This case gives students the opportunity to experiment with creating an actual forecast ofpro forma financial statements. The case provides good practice in forecasting since eventhough 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 noright solution for the case. To complete the forecast students must be fairly proficientin EXCEL and utilize EXCELs Goal seek function to balance the balance sheets. To usegoal seek it is imperative that the financial statements be populated with formulas andthat relevant accounts (e.g. accumulated depreciation and retained earnings) are linkedacross 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 isassumed to hold steady at 15%.

2. The percent of sales method is used to forecast most items. Percentage of sales in2010 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 totaldepreciation that each line represents in 2010 is used to break the total down in2011 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 for2013-2015.

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 wereassumed to hold steady beyond 2012. It is imperative that the accumulated

depreciation account be linked to the depreciation expense in the incomestatement to have the forecast flow accurately. Obviously, if students assumesome growth in capital assets beyond 2012, the need for external financing willincrease.

10.In 2011, with our assumptions, New Tech suffers a net loss. The tax is shown as atax credit, which assumes there are prior income taxes that can be recoupedthrough a tax credit.


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11.The outstanding amount of long-term debt is reduced by the amount in CurrentPortion of LTD each year.

Using the Goal Seek function in EXCEL, the balancing item for years in which assets aregreater 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 theTerm Loan reaches $1,628,000, however it falls rapidly after that point and is paid off by2015. If the $1,575,000 is the maximum that New Tech can borrow changes could bemade 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 CurrentAssets which makes the Current, Quick and Sales/Working Capital ratios much belowindustry averages. The TIE ratio does not reach industry average until 2015. Long-termdebt 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 islow due to the high level of interest. New Tech does exceed the industry average ROAand ROE by 2013-14 however.

Overall, New Tech does not present a bad picture to the bank. In the short run thereliance on debt is very high, but New Tech demonstrates the ability to pay the debt down

over time and exceed average profitability ratios.


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Chapter 3 - Alternatives in Venture FinancingEarly Stage

Equity Capital

Overview

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

Major Points

It is important to draw a distinction betweenpublic andprivate equity. The focus

of this chapter is on private equityownership shares without a ready market forsecondary trading.

Private equity is not usually the end of the story for equity. Private equity is oftenissued to employees, directly or through stock options. It is also sold to angelinvestors and other individuals with ties to the company. In all cases, for theequity to have value, it must be tradable. This means that at some point the stockmust be available for salemost commonly through acquisition of the companyby another company. This fact means that the entrepreneur must come to termswith 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 classdiscussion. Why is there a capital gap? What solutions are possible to minimizethe informational asymmetries surrounding firms in this category? Is the capitalgap a barrier to mid size firms achieving financial stability? Is there an impact onthe 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 andinformal networks. They are best located through networking in your local

community.

Angels typically invest amounts of $10,000 - $500,000 in a single company, butby aggregating the investments of several angels up to $2 million may be madeavailable to the company.


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Angels tend to invest near their homes, in technologies with which they arefamiliar. Many angels invest for the mentoring role that the investmentopportunity 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 venturecapitalists, perhaps due to the psychic income angels receive by becominginvolved in an early stage venture.

The Small Business Administration is a source of much help for entrepreneursalthough the SBA does not invest funds directly in any business. It is aworthwhile exercise to have the students go the SBA website to investigate themany programs available.

The SBAs SBIC program allows investors to form venture capital funds usingSBA 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 thevalue of the business assuming it receives the desired investment and achieves theprojections in the business plan. The size of the share of the business given up inexchange for an investment is completely dependent on the post money valuationof the company. Since few investors want to own more than 40-50% of a businessthis 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 investorare, the growth rate in sales or earnings, net income and the multiple used toestablish the value of the business in the future. Investors tend to rely onestablished rules of thumb for the multiple, so the first two variables are likely tobe more fruitful sources for negotiation.

Have the students link the stages of growth that a company goes through to thesources of financing most likely available at each stage of growth.

Have the students discuss the need for capital in the first place. Capital required isdirectly related to the type of business, with service businesses requiring the leastinvested capital. For this reason many capital intensive businesses are probablyimpossible to launch as new ventures.

Inc Magazine provides many entertaining stories of businesses launched on verylittle capital that can be used in class to illustrate the point that large sums ofmoney are not required to start all businesses.

The two New Tech cases in this chapter are included to demonstrate how to puttogether a financing package and to provide some examples of how to conduct themarket research necessary for a funding package.


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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 personalresources and friends and family investment. Hiring of key personnel may takeangel investment or venture capital. Pilot program installation should beachievable without much additional investment given that the program iscomplete. Sales goals require a sales staff and possibly a VP of marketing, which

would likely require angel investment or venture capital. Achieving a marketshare goal may require venture capital or even sale of the business through IPO orsale 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 toearnings in time three to establish a value as well as a required rate of return forthe investor. Fifteen percent for $500,000 equates to a company value today of:

$500,000 = $3,333,333.

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Assuming investors require a 40% return on investment this would equate to atime 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 forthe company of:

$9,146,666 = $1,524,444.

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Case 3-1: EcoTurista

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


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information and suppliers of travel experiences they can dramatically lowersearch costs for travelers and agents.

Threats to successful implementation of the business model are plentiful. IfEcoTurista 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 revenuegeneration model relies on travel agents willingness to adopt the technology-based system in an industry that has traditionally been characterized byrelationship building. Success with the business model will depend on the qualityof the travel experiences the EcoTurista is able to provide. This means thatmonitoring of the destination providers is essential and quality standards must beupheld and maintainedoften difficult in this part of the world.EcoTuristas major strength is its first mover advantage. It is not clear from theExecutive Summary what individual strengths, if any, the founders bring to theproject.

Finally, a major weakness is that the founders do not mention any travel agencyexperience or connections to the industry in Latin America. The model will befairly labor intensive, to develop and maintain the catalog, monitor quality andcreate a network in an industry where they do not appear to have a reputation tobuild on.

2. This business does not appear to be terribly capital intensive. It will be laborintensive to build the network, the catalog, the relationships with serviceproviders and travel agents and to grow the business. Major capital needs are acomputer network and software development costs.

3. EcoTuristas revenue forecast assumes 339% annual growth over the three yearsof the forecast. Year 3 revenue of $15.6 million is a small fraction of the totalonline travel market of $28 billion forecast. While the growth rate is high, theforecast starts from a relatively low base, which makes the ultimate number seemachievable. The companys costs will largely be fixed as the computer costs andpersonnel needed will be necessary over a wide range of volume. It is hard tojudge based on the information in the case but costs are likely to be slightly moreheavily 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 averageprofit margin which should not attract competition but if costs are higher thanforecast the profit margin may be too low to interest investors. Likewise,EcoTurista may have to price the product low to gain market acceptance whichwill lower their profit margins further.

5. EcoTuristas EBITA in Year 3 are forecast to be $2,375,237. Assuming a multipleof 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 valuationfor 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 businesswhich 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 withspecial attention paid to the financial portion of the plan. Market research is discussedwith emphasis on competitionexisting and potential. The importance of themanagement team in attracting investment is stressed. The business plan is also discussedfrom the viewpoint of investors. What are investors looking for in a plan? In addition tothe financial statements required in a plan, breakeven analysis and scenario analysis arecovered.

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 externalfunding, creation of a business plan forces the entrepreneur to think hard about thebusiness model. Additionally, it can and should be used to create milestones formonitoring progress in the future.

Some time should be spent in class discussing the apparently contradictorystatements regarding the importance of the business plan and the fact that mostplans 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 mostreaders of the plan will not read beyond the Executive Summary merely

underscores the importance of the summary itself. Even though few readers of theplan will take the financial projections as fact, it is still a useful exercise for theentrepreneur to put together the financials to see if the business model is viable.

The Executive Summary should be written last, and should clearly convey theneed for the business and the owners passion for the idea. The sense of passionand excitement about the opportunity cannot be stressed enough. Investors aredeluged with plans and passion about the idea is one of the key criteria they areseeking in entrepreneurs. Key points from the plan should be made in the two tothree page summary to entice the reader to read on.

The business plan is one area where a consultant should not be hired. No oneshould understand the business better than the entrepreneur and no one shouldpossess the entrepreneurs passion for the idea of the business therefore no one isbetter suited to write the plan than the entrepreneur. Consultants may be used forfeedback 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 toarticulate 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 marketdiscontinuity. Beware the hot technology seeking a use!

Time in class should be spent discussing who the competition is for a startupcompany. Using an example startup discuss who the competitors are currently and

where future competition might come from. The latter is especially important toaddress in the market analysis section of the plan as it could prove to be the mostdamaging competition of all. Very often large firms will wait to assess thedemand for a product or service before entering the market.

The management team is the key variable to the reader of a plan. Past experiencewith a similar business inspires confidence in plan readers. Plan writers shouldtake particular care to fill in holes in the management team, and compensate formanagerial weaknesses through the board of directors. While investors do notexpect all of the team to be in place they are looking for experienced managerswith track records for at least the CEO and CTO positions.

The exit strategy section of the plan should be written thoughtfully, recognizingthat IPO is the exit strategy for only a very small number of businesses. Thinkingabout potential acquirers early on may help to fine tune the business plan in theearly stages. Likewise, thoughtful identification of likely suitors will inspireconfidence in investors that a return on their investment is likely.

When discussing the financial section of the business plan, much discussion needsto center on sources of information for creating the financial forecasts. The SmallBusiness Administration has some data, organized by industry, and industry tradeassociations may provide data. Market research firms collect and sell market datathat may be helpful. Robert Morris and Associates or Dunn and Bradstreet canprovide ratio information that is helpful in creating the income statement andbalance sheet, but information for the sales forecast itself will result from themarket research carried out by the entrepreneur.

The level of detail that underlies the business plan is critical. The entrepreneurmust think about the number of people in each position and their salary level. Thecompensation structure for sales personnel must be addressedfixed vs. variable?Commission tied to what? Pricing issues must be resolved to create the revenuestream. While none of this detail is shown in the actual pro forma, it should betied to the financial statements through a series of linked assumption pages.

When forecasting the balance sheet it is important to distinguish between fixedand variable line items. The most likely relationship to sales for the variablecomponents must be decided upon and modeled. Thought must be given to overwhat 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 ofthe Cash Flow Statement and to demonstrate how this statement provides crucialinformation 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, theweaknesses in New Techs team and what hires need to be done immediately toround out the team.

Discussion Questions

1. This is a good exercise to familiarize students with the resources available and tofamiliarize them with the basic format of a business plan. While there aredifferences across sites, the basic structure of all business plans is essentially thesame.

2. To forecast sales you must have a specific estimate of the market niche you aretargeting. If there is competition what share does each have and how will youwrest share away from the competition? How long will market acceptance take?When forecasting a growth rate in sales, what is the likelihood of new competitionentering to slow your growth rate? If there are competitors, at what rate have theirsales grown?

3. A capitalization table with many owners potentially complicates things for newinvestors. Since each share of stock is entitled to one vote, a block of minorityshareholders could band together against the new owners, to block progress or

otherwise slow down the companys growth plans. For shareholder votes allowners must be contacted, which increases the transaction costs of running thecorporation.

4. Amazons options are very limited. They have basically used up their borrowingcapacity and a huge debt payment is looming in the very near future putting animminent large drain on cash flow. Amazon has two choices: raise prices or cutcosts. Since Amazons contribution margin is so small, simply increasing saleswill not be sufficient to solve the cash flow problem. Amazon has chosen tofollow the cost cutting approach to date, reducing the number of distributioncenters 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 thatoutsource production. The market is currently estimated at $1.7 billion andexpected to grow to $50 billion overthe next few years. Web Wireds niche is


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supply chain management for the 700,000 companies that fit that description. Theniche 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 fouryears, a 331% compounded annual growth rate. $172 million represents 10% of

the current market for e-collaboration applications and a much smaller fraction ofthe 2012 total market. Given that Web Wired has already signed on Lucent andBP as clients, their revenue projections seem attainable.

3. Web Wireds profit margin in 2017 is forecast to be 23%. 23% margin for asoftware company is not out of line. (Students should use published ratios toverify the typical margin in the software industry).Web Wired will be a peoplecentered service business, which is characterized by higher margins than a moreasset 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 theirtechnology as the standard for e-collaboration. The second barrier would seem tobe their hub and spoke model. As client companies become reliant on Web Wiredfor their outsourcing process management, the path of least resistance is tocontinue 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 becomehubs with their own suppliers.

5. Web Wired is proposing a viral marketing strategy. If the service delivery is errorfree and easily implemented their strategy could work well. By signing clients upas spokes they are essentially entering into pilot programs for the software withmany potential clients. This approach minimizes the use of sales people andessentially rules out cold calling. If the system does not work well the hub andspoke model could prove disastrous.

6. The management team collectively has many years of experience (actually muchmore experience than was typical of most startups during this period). They haveidentified their missing link (marketing VP) and are planning to fill the positionduring the next round of financing. Based on the limited information in the casethis team would seem to inspire confidence in investors.

7. The financials presented in this abridged version of the case are clearly notsufficient. 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 predictingprofitability for another couple of years. An accounting of their spending to dateas well as detailed pro forma statements would be required. Capital spendingshould 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 thefirst $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 somespokes into hubs to demonstrate the viability of the marketing strategy.


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Chapter 5 ValuationSurvey of Methods

Overview

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

Major Points

In the world of entrepreneurial finance valuation tends towards the simplesimple rules of thumb and simple methods. The more sophisticated methodologiesare not generally relied upon simply because the information available for valuinga new venture is so speculative and so subject to estimation error that the moreinvolved techniques are not viewed as being worth the effort involved. For theentrepreneur, however, the exercise of creating a well thought out discounted cashflow valuation for the firm is time well spent. As with the business plan itself, theexercise of forecasting future cash flows forces the entrepreneur to think throughthe assumptions and relationships underlying the business model.

It is important to stress to students that there is nothing wrong with the DCFmodel itself. The problem lies with the cash flow estimates and there is nothingbut 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 typicallyused to value a going concern. All three of the methods in this section would beused to set a lower bound for the valuation or used when the purchaser is buyingthe 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 accountingprinciples are added to the balance sheet to determine firm value. Obviously thismethod is time-consuming and expensive to employ due to the need to hire avariety of specialized appraisers. This expense results in the method not beingused much in practice.

Market multiples are the methodology of choice among practitioners. There areseveral 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 isjustified since firms tend to be more alike than different at various stages of theirgrowth. Third, investors argue against using DCF stating that the cash flowestimates 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 alwaysreflecting the current market. When using multiples it is incumbent upon theentrepreneur to make the case for why his business is different than the norm andthus subject to a higher multiple.

If more discussion in class is desired around determining comparable firms toestablish multiples, any of Shannon Pratts valuation texts contain severalinteresting case studies of court cases where various, not always obvious, firmattributes 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 beennormalized to remove unusual and nonrecurring items.

The relationship between the market multiple, which is essentially a PE ratio, andthe standard dividend discount model should be stressed. When the equalitybetween the two equations is demonstrated it becomes clear that risk and growthare the driving forces behind the multiple.

Time in class should be spent going through the Superior Plumbing example inthe chapter to illustrate how ratio analysis can be used to justify a multipledifferent from the standard. In the case Superiors superior ratios seem to justify amultiple on the high end of the range of multiples.

Multiple information is available at various sites on the internet. A quick searchshould uncover several sources of information.

While the cap rate tends to be most commonly used in the real estate industry, it isimportant for students to recognize that the cap rate is simply the inverse of themarket multiple and therefore essentially the same method. As with the marketmultiple, the cap rate assumes a zero growth rate in earnings. As the example inthe chapter illustrates this assumption could be potentially costly for theentrepreneur if it is incorrect.

The Excess Earnings Approach was developed by the IRS as a tool to valuegoodwill in valuations for tax purposes. The method has been promulgated as atechnique for general firm valuation, although the IRS strongly discourages its usefor such purposes. The major problem with using the Excess Earnings Approachis that it necessitates the use of two discount rates, both of which are somewhatarbitrary. This introduces more opportunity for error and disagreement betweennegotiating parties.


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When discussing discounted cash flow analysis students should be aware thatthere are two methods for carrying out a DCF analysisthe direct and the indirectmethods. The direct method discounts equity cash flows (after subtracting debtservicing 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 flowsat the companys weighted average cost of capital. The indirect method is morecommonly used because it allows for direct estimation of total firm value (indirectestimation of the value of the equity). The value of the debt is then subtractedfrom 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 isthe only method that allows for a sensitivity analysis. Since DCF values tend to besensitive to the assumptions employed in generating them it is very important toexamine the effect of changes in the assumptions on firm value. The importanceof 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 fewpercent. A definition of the best case and worst-case scenarios should be arrivedat with all of the interlocking assumptions that those cases imply.

A discussion of DCF leads directly to a discussion of estimating the discount ratefor privately held firms. The key point here is that there is no acceptedmethodology to do this. For all of the words written about employing proxy betasto estimate the cost of equity, the fact remains that the entrepreneur is typicallyundiversified, bearing the total risk of the business, and thus in violation of thefundamental underlying assumption of the CAPM. Perhaps the best advise thatcan be given for estimating the cost of equity is to try and assess theentrepreneurs true opportunity cost of remaining in the business at what returndoes it become economically undesirable to retain the firm? That is theentrepreneurs cost of equity.


1. This is a somewhat challenging question. Students must forecast EBIT and TotalOperating Capital for the five years of the explicit forecast period. Using EBIT(1-T) = NOPAT and the change in Total Operating Cash Flows students cancalculate 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 thecost of capital = the value of operations. Adding in the non-operating assets weget the Value of the Firm. Subtracting the interest bearing debt we arrive at thevalue of the equity.


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INPUTS

Cost of Capital 12%

Sales0 $1,000

Non-operating assets $100

Interst-bearing debt $250

Operating Profit Margin 12%

Working Capital/Sales 35%

Fixed Assets/Sales 20%

Tax rate 40%

Forecasted sales growth:

Years 1-2 12%

Years 3-5 8%

6 on 4%

0 1 2 3 4 5

Sales $1,000 1,120$ 1,254$ 1,355$ 1,463$ 1,580$

Operating Profit 134$ 151$ 163$ 176$ 190$NOPAT 81$ 90$ 98$ 105$ 114$

Working Capital $350 392$ 439$ 474$ 512$ 553$

Fixed Assets $200 224$ 251$ 271$ 293$ 316$

Total Operating Capital $550 $616 $690 $745 $805 $869

Change in Total operating Capital $66 $74 $55 $60 $64

Free Cash Flow 15$ 16$ 42$ 46$ 49$

Terminal Value 642$

Total FCF 15$ 16$ 42$ 46$ 692$

PV Of FCF $477.75

Add: non-operating Assets $100

Value of Firm $577.75Subtract: Interest bearing debt $250

Value of Equity $327.75


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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 analysisbelow.

New Tech's Financial Forecast

(000's) 2010 2011 2012 2013 2014 2015

Actual Forecast

Sales 3,000$ 3,900$ 4,700$ 5,640$ 6,700$ 8,040$

Cost of Good Sold1

1,185 1,560 1,645 1,805 2,077 2,412

Gross Margin 1,815$ 2,340$ 3,055$ 3,835$ 4,623$ 5,628$

OPERATING EXPENSES

Selling expense 857 1,326 1,316 1,410 1,474 1,528Administrative expense 555 702 752 846 1,005 1,206

Total Operating cost 1,412 2,028 2,068 2,256 2,479 2,734

Operating Income 403$ 312$ 987$ 1,579$ 2,144$ 2,894$

Taxes (34%) 137 106 336 537 729 984

NET INCOME 266$ 206$ 651$ 1,042$ 1,415$ 1,910$

Working Capital:

Accounts Receivable 450 546 658 733 871 1,045

Inventory 350 429 470 564 670 804

Accounts payable 550 585 658 620 737 884

Net Working Capital 250$ 390$ 470$ 677$ 804$ 965$

Capital Spending 1,100$ 740$ 500$ 500$ 500$1Includes depreciation of 325 375 400 430 490

Operating Income 312$ 987$ 1,579$ 2,144$ 2,894$

NOPAT 206$ 651$ 1,042$ 1,415$ 1,910$

Change in Total Operating Capital 1,240$ 820$ 707$ 627$ 661$

Free Cash Flow (1,034)$ (169)$ 335$ 788$ 1,249$

Terminal Value 11,241$

Total FCF (1,034)$ (169)$ 335$ 788$ 12,490$

PV at 20% $4,615


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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 valuein five years is $3,045,600 so the return is approximately 25%. This does not meet theinvestors desired 30% rate of return. At this point Grant can reexamine the assumptionsin 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. Thisequates 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 comesfrom, how firms are organized and what VCs are looking for in investment opportunitiesare all covered. Changes in the industry in recent times are examined by looking at dataon investment by venture capitalists over the last several years. The venture capitalmethod 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. Theventure 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 insiderslook at the industry. They are usually willing to share details of their career paths, whichmay be helpful to aspiring VCs.

Major Points

The most important point to stress in this chapter is the very small number offirms for which venture capital is a viable option. In the current environment thatnumber is even smaller than it has been. Venture capitalists are looking for firmswith huge market potential (in the billion dollar range) and very high growthprospects. The vast majority of entrepreneurial firms do not fit these criteria andare therefore not likely candidates for venture capital.

It is very important to stress the connection between the venture capital marketand the stock market. Even though sale to another firm is a far more common exitstrategy than IPO, if the stock market is unreceptive to IPOs the effect on theventure 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. Inindustries change over time and the flow of venture capital moves towards whatshot 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 moreefficient and more effective. Firms also look to leverage synergies between theirportfolio firms. This all means that the entrepreneur needs to do substantial duediligence of their own before approaching any venture capital firm to increasetheir odds of success.

Some time in class should be spent discussing venture capital compensation. Thefixed portion of VC compensation is based on committedcapital, which differs


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from investedcapital. Currently firms are sitting on large piles of committedfunds and hesitant to invest them. Obviously the committed portion increases theircompensation and explains why firms do not just pay a dividend to returnuninvested capital to investors (the general partners in the fund). This strategycannot go on indefinitely, however, as investors will eventually demand a return

on their investment. The variable portion of VC compensation, the carriedinterest, is the profit sharing arrangement that occurs when the firm is sold.

Many large corporations have venture capital divisions or subsidiaries. Usuallythe motivation for corporate venture capitalists is different than it is forcommercial VCs. Most corporate VCs invest primarily for strategic reasons. Howwould this effect the likely exit strategy for the recipient of corporate venturecapital, if at all?

A look at Table II reveals that required rates of return on venture capital are veryhigh. 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, therequired rate of return must be of the magnitude in Table II in order to realizerates of return in the mid twenty percent range. Realized rates of return are muchmore 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 ofvaluation. More complicated formulas are available when the investor chooses notto invest in subsequent rounds but wishes to maintain a certain percentage of thebusiness. These formulae are not included here because most VCs will invest insubsequent rounds if they are concerned about maintaining a specific percentageof the business.

The key variable in the Venture Capital Method of valuation is the future value ofthe firm which depends on the net income in the future and the market multipleapplied to that net income. VCs tend to hold firm on the multiples and requiredrates of return used in the valuation, so any negotiation must center on theultimate net income. This of course depends on assumptions made about sales andexpense growth over the forecast period.

Some time is spent in the chapter on how to get before a VC firm. Unsolicitedplans are almost never read so a strategy of blanketing various firms with abusiness plan will typically lead nowhere. The best strategy is to find a contactthat can provide an introduction or recommendation that increases the likelihoodthat a business plan will get read.

It is important to know that once negotiations with a venture capitalist areunderway, the entrepreneur must stop shopping for alternative funding. Failure todo 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 actualterm sheet such as the term sheet in the appendix to the chapter, from an agencycost perspective. For each term we can ask, what agency cost is the VC trying tomitigate and how does this term do so? The terms in the term sheet will clearlydemonstrate that term sheets are written by VCs for VCs.


1. All of the clauses below have the intent to reduce the VCs risk by increasing theexpected return on the investment.

Dividends: This is a typical feature of preferred stockthe dividend preference.It is unlikely that a venture-backed firm would be paying dividends but if itshould the holders of the preferred are entitled to an 8% dividend prior to the

common stockholders receiving anything. Obviously the VC is protectingthemselves 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 toVCs at the time of any liquidation of the company. This increases the odds of theVC achieving their desired rate of return. At a minimum, if there is any value inthe liquidating company, the VC will get their investment back before thefounders receive anything. Note that liquidation does not imply bankruptcy butrather a change in majority ownership of the company.

Conversion: This term allows the preferred stockholders to convert to commonstock when the stock goes public. This gives them the benefit of the upsidepotential of the stock in the marketplace. This particular term guarantees the VCat least a 3X return on their investment in an IPO but also allows them to convertat their discretion. This allows them to become common stockholders if theliquidity event is other than an IPO.

Anti-dilution Provisions: This is an example of a partial ratchet clause. Thisreduces the conversion price for the VC to reflect shares issued at lowervaluations than the VC paid. The lower conversion price increases the number ofshares the VC will receive thus preventing any dilution due to lower priced

rounds.

Voting Rights: Typically preferred stock is non-voting stock. This provisionconfers on the preferred stockholders the voting rights of the commonstockholders. This reduces the risk that the common shareholders could vote onissues displeasing to the VC.


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Protective Provisions: this provision essentially gives the holders of thepreferred stock more voting rights than the common shareholders. As long as twothirds of the originally issued preferred remains outstanding the majority of thepreferred stock holders have ultimate control over change in ownership or othermajor 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 andpiggyback, and this company is seeking both. Piggyback rights simply say that theholders of the preferred stock can convert their shares to common andpiggyback onto an offering of stock that the company is already making. Thecost to the company of piggyback rights is small and allows the VC to liquidatetheir investment. Demand rights on the other hand, allow the VC to demand thattheir shares be converted to common and sold in a public offering even if thecompany is not doing a stock offering. This clause also says the company will payall 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 aredemanding two demand registrations, which could prove very expensive anddisruptive for the company. The purpose of registration rights is to reduce theliquidity risk to the VC. This allows them to realize a return on their investmentafter five years.

Right of Participation to Significant Holders: this clause allows the VC tomaintain their percentage ownership in the company by purchasing a pro ratashare of any future offerings.

Terms of the Right of First Refusal and Co-Sale: Should the founders desire tosell any of their share in the company the VC has the right of first refusal topurchase those shares. Should the VC not wish to purchase the shares they havethe 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 strongmanagement 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 shouldprovide value added. They should have knowledge and the time to guide andmentor the entrepreneur. Ideally, they would have industry contacts that could behelpful to the entrepreneur. They should also have an investment time frame thatmatches 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 capitalfunding it is not so strong. New Tech has the advantage that the company is upand 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 basisof their future growth. Growth is actually forecast to taper off as the growth in thePowerSelect 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 netincome to continue to grow more rapidly. NewTech forecasts a 20% share of thegrowing market for specialized high-end laptops but does not mention existing orpotential competition. This weakens their pitch. NewTechs proposal is strongerthan a start-ups due to an existing customer base which may be leveraged intopurchasing 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 priormanagement experience although he appears to have been New Techs SalesManager through their rapid growth period. The Production Manager also doesnot seem to have prior experience managing production processes.

4. A 40% share for a $600,000 investment translates into a present value of thecompany 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), 5year time frame equals an IRR of 47.3%. Given the stage of the business thatNew Tech is at, a 47% return is probably sufficient.

5. New Tech does not have the characteristics of a standard venture capitalcandidate. Their potential market is too small, their management team too weakand their growth prospects too low. Additionally, the size of the investment theyare requesting may be too small for most venture capitalists. Even though their

forecasted return seems in line with venture capital required returns, they areprobably 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 timeintroducing other more (and less) common methods of exit for early stage companies.Entrepreneurial ventures have far more exit opportunities than the IPO and for themajority 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 optimalexit strategy cannot be overemphasized. This consideration must occurbefore the

entrepreneur accepts any outside equity investment. No outside investor investswith an unlimited investment horizon. Since dividends are likely to be nonexistentin a start-up, the exit is the only means of providing any return to the investor andmust be explicitly stated at the time of investment. Most equity investors have athree to seven year investment horizon. This means that the entrepreneur mustthink hard about where the company will be in 3-7 years and what the most likelyliquidity opportunity will be at that time.

For the vast majority of firms the most likely exit strategy is exit throughacquisition by another firm. In thinking about an exit via acquisition, theentrepreneur should think specifically. Which firms are likely acquirers? Name

names. What potential synergies would motivate such an acquisition? Look foracquirers where there is a complementarity of process, of product, or a significantsource of added value by joining the two companies. With the recent decline inactivity in the market for IPOs, what has always been the most common exitstrategy, acquisition, is now even more important as a method of achievingliquidity for investors.

In both acquisitions and mergers the tender offered for the stock of the targetcompany is often stock in the acquiring firm. These stock for stock exchangeshave the advantage of being nontaxable as well as doing away with the need forthe 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 necessarilyprovide liquidity for investors. Only if the acquirer is public will liquidity beprovided in an exchange of stock. Even if the company is public, a protractedvesting schedule may not provide the entrepreneur with the liquidity they desire ifthey truly are looking to exit the business.

If the company is profitable, an earn-out may be an effective way to provideliquidity 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 equityat a price that provides an acceptable return to the outside investor. An earn-outhas the obvious benefit of allowing the entrepreneur to buy back the companywithout borrowing money or using personal resources. The danger lies inallocating 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 toreceiving a return on their investment over a protracted period of time.

The management led earn-out differs from a non-management buyer earn-outarrangement in one fundamental way. In a management led earn-out, managersare exerting their own effort to generate the profits that will allow them to buy thebusiness from outside investors. In a non-management led purchase with an earn-out management is working to generate the profits for a third party to buy thebusiness from them. In the first case management will own the business as a resultof their hard labor at the end of the earn-out. In the second case the third partywill own the business.

The debt for equity swap covered in the chapter is not technically an exit strategysince lenders are not owners. It does provide lenders with an opportunity to exittheir positions as lenders, but liquidity, and return, will not be provided until atrue liquidity event takes place. As the example in the chapter illustrates excessivedebt can endanger the firms viability and the debt for equity swap may be moreof 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 remainin place to realize those synergies. Liquidity will be provided if one of the partiesto the merger is public and shares are allowed to be sold subsequent to theacquisition. The biggest risk in a merger is the inability to realize the synergiesforecast due to a clash of cultures of the merging parties. The business press is fullof examples of clashing cultures undermining the success of the merger.Examples include the Boeing McDonnell Douglas merger, General Motors withETS, and the Safeco American States merger. In a class of MBAs it is ourexperience that a majority of them work in companies that have survived a mergerand can speak to the issue of culture clash only too well.

For smaller businesses, especially service businesses, liquidation is a commonstrategy for exit. When a business has few tangible assets and most of thebusiness value derives from the relationships the owner has with customers, theremay be little perceived value in the business as a going concern without theowner. In this case the entrepreneurs best option for exit is to sell what assetsthere are and simply close the business.

In general the highest valuations and most liquidity are provided by an initialpublic offering of the firms stock. These facts may make the IPO the mostdesirable 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 significantmarket share and high growth prospects the IPO is simply not an option.

While liquidity is provided by an IPO many entrepreneurs are surprised by therestrictions 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, managementcan sell only within strictly defined windows of time during the year.

The record keeping and reporting requirements of a public company aresubstantial. In addition to the formal reporting requirements, many CEOs find itnecessary to hire an investor relations specialist to prevent the CEO fromspending all of his or her time with analysts. Like the average offering size, thistoo makes the public form of organization prohibitively expensive for all exceptthe largest firms.

IPO underpricing should lead to a protracted class discussion of the actual IPOprocess. Students should be aware of who the parties to the IPO are, what theirexpertise is and whose interest they are serving during the process. Theunderwriter has strong reasons to underprice new issues and has a potentialconflict of interest in serving both the entrepreneurial venture and the clients onthe buy side of the transaction. Much of what students read from investmentbankers 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 examplein the chapter provides a good illustration of how the process works. What is lessclear is why the process has been slow to be embraced by investors (or perhaps byissuing firms). For Open IPOs to replace the standard method as the method ofchoice, entrepreneurs must be aware of the option and cognizant of the truemotivations of the parties to a traditional IPO. Perhaps this understanding issimply a matter of time in coming. Certainly there has been press portraying theOpen IPO as the option for firms unable to secure traditional investment bankinterest. Without a good understanding of the issues, this may be enough to scarepotential issuers away.

The Direct Public offering, SCOR offerings and the Regulation A and D offeringsdiscussed in the chapter may all be answers to the capital gap problem discussedearlier in the book. None of them are answers to the desire for liquidity by exitinginvestors, however. While each of them provides the entrepreneur with theopportunity to raise relatively small sums of capital from outside investors, noneof the resulting stock is truly liquid and is best seen as a step along the road to trueliquidity.


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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 strategicacquisition to add value synergy must be created between the parties. Look for

companies that complement what you do either through marketing, distributionchannels or technology or other specialized expertise.

2. The best discussion will result from personal experiences of mergers that thestudents have been through. As mentioned in the teaching notes culture clash isprobably the single biggest obstacle to success in a merger. The ATT acquisitionof McCaw Cellular, the General Motors merger with ETS, and the AOL TimeWarner merger were all plagued by a failure to integrate a large bureaucraticorganization with a more entrepreneurial growth oriented organization. TheDaimler Chrysler merger has struggled due to a true clash of cultures. The SafecoAmerican States merger and a series of Bank of American acquisitions have been

hampered by a failure to integrate (or severely underestimating the cost ofintegrating) 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 consumingall of employees time and energy.

Too often the expectations of the merger are inflated. The merger mayhave been motivated by top management arrogance or greed withoutsufficient due diligence.

Failure to integrate cultures

Failure to define the new business model and unify the direction of allinvolved

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 tosecure the highest price for the shares in an underwriting. No money is left on thetable from the investors standpoint. The major con is the perception that theOpen 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 andreporting than with an IPO. The major con is that it does not provide liquidity orestablish a true market value for the stock. In addition, the burden of due diligencefalls 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 onfinancing and looks in detail at the process of successfully negotiating a term sheet andsubsequent deal. The case is a wrap up of the New Tech case that has been runningthroughout the text.

Teaching Tips

This case can most fruitfully be used as an in-class exercise without the students havingread the material before class. By going through the case in class it can provide the basisfor a class discussion of the issues, hurdles and solutions at each step of the way. Havethe students go through the deliberations that Stuart and Elizabeth went through beforereading 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 andexamining several prospects before approaching the investor most in tune with theircriteria. Unfortunately, too often entrepreneurs are completely focused on the moneywithout 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 establishedby the New Tech management team. Have them choose the top three candidatesaccording to the stated criteria. Do they match New Techs ranking?

New Tech pursues further meetings with two potential investors, Walter Buffetand Chinook Ventures. What company valuations are implied by the ownershipshares 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 theballpark of a valuation. If so, then both offers appear to be demanding too muchof the company for the money offered.


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Discuss Buffets original term sheet and New Techs counter offer. What seemslike a reasonable position, fair to both parties, in each case?

o Clearly, if the Board size is to remain at three, Buffets request tonominate three members is going to be unsatisfactory to Stuart. Two

possible solutions are to increase the board size to retain Stuarts majorityposition, or to reduce the number of directors Buffet can nominate.Stuarts mother and brother most likely have little to offer as mentors andprobably 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 strategiessuch 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 Techsexpenditures are in the $25,000-$50,000 range, perhaps a $50,000

minimum for approval is more appropriate. Thirty days seems unworkablylong 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 theimplementation of the plan should be later, post closing.

Go through the terms of the agreed upon term sheet to make sure the studentsunderstand them and to see the results of the compromise.

o The non-dilutive term means that Buffets purchase of stock will not causethe value per share to fall for the existing stockholders in New Tech. Ifshares are subsequently sold to new investors at a higher price or the firmdoes an IPO with gross proceeds of $4.5 million all current investors maysuffer some dilution of their ownership in the company.

o The second term ensures that Buffets investment is used for its intendedpurpose and not to fund management perqs or some other less desirableend.

o The Board configuration allows Stuart to maintain control while givingBuffet substantial input.

o The right of first refusal is a right to retain Buffets percentage ownershipin the company. Given that Buffets intention to participate must be statedwithin 10 days this should not provide a hardship for the company.

o Buffets approval period was decreased to 10 days and the issues overwhich he has a say are reasonable.

o Item (f) reiterates that Buffet wants to be the majority shareholder and anew shareholder can only acquire 45% of the outstanding shares if heagrees to buy Buffet out. This is a protection for Buffets position as amajority shareholder.

o The ESOP must be in place within six months, which seems a goodcompromise.


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o The IPO is now contingent upon the market being receptive and New Techbeing ready, which should allay New Techs fears from the initial termsheet.

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 thatthe 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 companygrow 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 intoentrepreneurship. Common terms, requirements, costs and benefits are all covered. Threeexamples of actual franchises are presented to expose students to the range of franchisingoptions available and also to allow them to study franchising in the real world. Buyinginto a franchise lies somewhere between starting a business and employment with acompany. 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 interms of franchiser involvement and control. While the investment in monetary termsmay be less than starting a similar business from scratch, the investment in time mostlikely will not be less.

Major Points

It may be enlightening to begin this class session with a discussion about whetherfranchising even qualifies as entrepreneurship. To focus the discussion you couldstart by listing the typical risks and rewards of a start up as well as thecharacteristics of a successful entrepreneur. Now go back through the list and seehow the typical franchise and franchisee match up. Does franchising qualify asentrepreneurship?

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 proventhedreaded ground floor opportunitythen there most likely is not much value in thefranchise opportunity. In addition to the business model, the franchiser and otherfranchisees should provide a wealth of experience and resources for the franchiseeto draw upon.

The probability of success for the franchise depends to a large extent on thefranchiser. This means that due diligence by the franchisee, prior to signing anagreement, is imperative. Interview as many current franchisees of the companyas 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 acrossthe country and can affect ultimate profitability if projections are based on a lowcost 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 virtuallyall cases the franchise fee is a rather small part of the total cost of opening thebusiness. One of the questions at the end of this chapter asks students to researchvarious 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 haveresearched.

Franchises are most commonly divided into product/trade name franchises andbusiness format franchises. Most franchises with which students will be familiar

are of the later type. Independent Coca-Cola bottlers would provide an example ofthe former and may help the students better understand what the product/tradename format involves.

Some explanation of the risk sharing function of franchises may be in order. Thefranchise arrangement allows the franchisee to share risk by spreading the coststhat result in benefits to the entire franchise over the larger organization.Examples would be advertising and marketing costs as well as any research anddevelopment expenditures. This means that the benefit per dollar invested shouldbe higher for a franchise than a stand-alone business and thus the risk of thatexpenditure is less.

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Teaching Suggestions Revised 22222

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