Description
Within this criteria relating to entrepreneurial finance happiness to on entrepreneur is a positive cosh flow.
13
Entrepreneurial Finance
"Happiness to on entrepreneur isa positive cosh flow."
Fred Adler
Venture Capitalist
Results Expected
Upon completion of this chapter, you will have:
1. Examinedcritical issuesinfinancingnewventures.
2. Studiedthedifferencebetweenentrepreneurialfinanceandconventional
administrativeorcorporatefinance.
3. Examined the process of crafting financial and fund-raising strategies and the critical
variables involved, including identifyingthefinancial lifecycles of newventures,a
financial strategyframework, andinvestorpreferences.
4. Analyzedthe"FAX InternationalJapan"casestudy.
Venture Financing:
The Entrepreneur's Achilles' Heel
l
Therearethreecoreprinciplesofentrepreneurialfi-
nance: (1) more cash is preferred to less cash,
(2) cash soonerispreferredto cash later, and(3)less
risky cash is preferred to more risky cash. While
theseprinciplesseemsimpleenough,entrepreneurs,
chiefexecutiveofficers,anddivision managersoften
seemto ignorethem.To theseindividuals, financial
analysis seemsintimidating, regardlessofthesize of
thecompany. Evenmanagementteams,comfortable
withthefinancialissues, may notbeadeptat linking
strategic andfinancial decisions to theircompanies'
challenges and choices. Take, for example, the fol-
lowingpredicaments:
• Reviewingtheyear-endresultsjusthandedto
you byyourchieffinancialofficer, you see no
surprises-exceptthatthecompanylossiseven
largerthanyou hadprojectedthreemonths
earlier.Therefore,for thefourthyearin arow,
you willhave to walk into theboardroomand
deliverbadnews. Afamilv-ownedbusiness
since 1945, thecompanyhas survivedand
prosperedwithaverageannualsales growthof
17percent. In fact, thecompany'smarketshare
has actuallyincreasedduringrecentyears
despitethelosses. Withtheannualgrowthrate
in theindustryaveragingless than5percent,
yourmaturemarketsofferfew opportunities
for sustaininghighergrowth. Howcan this be
happening?Wheredo you andyourcompany
gofromhere?Howdoyou explain to theboard
thatforfouryears you have increasedsales and
marketsharebutproducedlosses?Howwill
you proposeto tumthesituationaround?
• Duringthepast20years,yourcabletelevision
companyhas experiencedrapidgrowththrough
theexpansionofexistingpropertiesand
'Thissectionwasdrawn from JeHiy A.Timmons,"Financial ManagementBreakthroughfor Entrepreneurs."
443
444 Part TV Financing Entrepreneurial Ventures
numerous acquisitions. At your company's peak
vour net worth reached $25 million. The next
decade of expansion was fueled by the high
leverage common in the cable industry and
valuations soared. Ten years later, your
company had a market value in the $,500
million range. You had a mere $300 million in
debt, and you owned 100 percent of the
company. Just two years later, your $200 million
net worth is an astonishing zero! Additionally,
you now face the personally exhausting and
financially punishing restructuring battle to
survive; personal bankruptcy is a very real
possibility. How could this happen? Can the
company be salvaged?2
• At mid-decade, your company was the industry
leader, meeting as well as exceeding your
business plan targets for annual sales,
profitability, and new stores. Exceeding these
targets while doubling sales and profitability
each year has propelled your stock price from
$15 at the initial public offering to the mid
$30s. Meanwhile, you still own a large chunk of
the company. Then the shocker-at decade's
end your company loses $78 million on just
over $90 million in sales! The value of your
stock plummets. A brutal restructuring follows
in which the stock is stripped from the original
management team, including you, and you are
ousted from the company you founded and
loved. Why did the company spin out of
control? Why couldn't you as the founder have
anticipated its demise? Could you have saved
the company in time?
• As the chairman of a rapidly growing
telecommunications firm, you are convening
your first board meeting after a successful
public stock offering. As you think about the
agenda, your plans are to grow the company to
$15 million in sales in the next three years,
which is comfortable given the $5 miilion in
sales last year, the $3.5 million of cash in the
bank, and no debt on the balance sheet. Early
in the meeting, one of the two outside directors
asks the controller and the chief financial
officer his favorite question, "When will you
run out of cash?" The chief financial officer is
puzzled at first, then he is indignant, if not
outraged, by what he considers to be an
irrelevant question. After all, he reasoned, our
company has plenty of cash and we don't need
a bank line, However, 16 months later, without
waruing from the chief financial officer, thc
company is out of cash and has overdrawn its
$llllillion credit line by $700,000 and the
hemorrhaging may get worse. The board fires
the president, the chief financial officer, and
the senior audit partner from a major
accounting firm. The chairman has to take O\'eT
the helm and must personally invest half a
million dollars in the collapsing company to
keep it afloat. At this point, it's the bank that is
indignant and outraged, You have to devise an
emergency battle plan to get on top of the
financial crisis. How can this be done?
Financial Management Myopia:
It Can't Happen to Me
All of these situations have three things in common.
First, they are real companies and these are actual
events.f Second, each of these companies was led by
successful entrepreneurs who knew enough to pre-
pare audited financial statements. Third, in each ex-
ample, the problems stemmed from financial man-
agement myopia, a combination of self-delusion and
just plain not understanding the complex dynamics
and interplay between financial management and
business strategy. Why is this so?
Getting Beyond "Collect Early, Pay Late"
During our 30-plus years as educators, authors, di-
rectors, founders, and investors in entrepreneurial
companies, we have met a few thousand entrepre-
neurs and managers, including executives participat-
ing in an executive MBA program, MBA students,
Kauffman Fellows, company founders, presidents,
members of the Young Presidents Organization, and
the chief executive officers of middle-market compa-
nies. By their own admission, they felt uniformly un-
comfortable, if not downright intimidated and terri-
fied, by their lack ofexpertise in flnancial analysis and
its relationship to management and strategy. The vast
majority of entrepreneurs and nonfinancial managers
are disadvantaged. Beyond "collect early, pay late,"
there is precious little sophistication and an enor-
mous level of discomfort when it comes to these com-
plex and dynamic financial interrelationships. Even
good managers who are reveling in major sales in-
creases and profit increases often fail to realize until
it's too late the impact increased sales have on the
cash flow required to finance the increased receiv-
abies and inventory.
"For more detail, see Burton C. Hurlock and William A. Sahlman, "Star Cahlevision Group: Harvesting in a Bull Market," HBS Case 293-036, Harvard Business
Schuol Publishing.
3Their outcomes have ranged from demise tu moderate success, to radical downsizing followed hy dramatic recovery, to still heing in the midst of a turnaround.
445 Chapter 1:3 Entrepreneurial Finance
EXHIBIT 13.1
The Crux of It: Anticipation and Financial Vigilance
Toavoid someofthegreat tar pitslike theonesdescribed earlier, entrepreneurs needanswers toquestionsthat linkstrategic business
decisions tofinancial plansand choices. Thecrux of it isanticipation: What is most likely to happen? When? What can go right along
the way? What can go wrong? What has to happen to achieve our business objectives and to increase or to preserve our options?
Financiallysavvyentrepreneurs know thatsuchquestionstriggera processthatcan lead to creative solutionsto their financial challenges
and problems. At a practical level, financiallyastuteentrepreneurs and managers maintain vigilanceover numerouskeystrategic and
financial questions:
• Whatare thefinancial consequencesand implicationsof crucial businessdecisions suchaspricing, volume, and policychanges
affecting thebalancesheet,income statement,and cashflow? Howwill thesechange over time?
• Howcan we measureand monitorchanges inour financial strategy and structurefrom a management, not justa GAAP, perspective?
• Whatdoes itmean togrowtoo fastin our industry? Howfastcan we growwithoutrequiring outside debt or equity? Howmuch
capital isrequired if we increase or decrease our growth by Xpercent?
• Whatwill happen toour cashflow, profitability, return on assets,and shareholderequity if we growfasteror slower by Xpercent?
• Howmuchcapitalwill thisrequire? Howmuchcan be financed internallyand howmuchwill have to comefrom external sources?
Whatisa reasonablemix of debt and equity?
• Whatif we are 20% lessprofitablethan our plan calls for? Or 20% more profitable?
• Whatshould beour focusand priorities? Whatare thecashflow and netincome break-even points for eachof our productlines?For
our company? Forour businessunit?
• Whataboutour pricing, our volume, and our costs?Howsensitiveare our cashflow and netincome to increasesor decreases in
price, variable costs,or volume? Whatprice/volume mix will enable ustoachieve thesamecashflow and netincome?
• Howwill thesechanges in pricing, costs,and volume affect our keyfinancial ratios and howwill we stackupagainstothersinour
industry? Howwill our lendersview this?
• Ateach stage-startup, rapidlygrowing, stagnating, or maturecompany-howshouldwe bethinking about thesequestionsand issues?
The Spreadsheet Mirage Itis hard to imagine
any entrepreneur who would not want ready answers
to many financial vigilance questions, such as in Ex-
hibit 13.]. Until now, however, getting the answers to
these questions was a rarity. If the capacity and infor-
mation are there to do the necessarv analysis (and all
too often they are not), it can take up to se'veral weeks
to get a response. In this era of spreadsheet mania,
more often than not, the answers will come in the
form of a lengthy report with innumerable scenarios,
pages of numbers, backup exhibits, and possibly a
presentation by a staff financial analyst, controller, or
chief financial officer.
Too often the barrage of spreadsheet exhibits is re-
ally a mirage. What is missing? Traditional spread-
sheets can only report and manipulate the data. The
numbers may be there, the trends may be identified,
but the connections and interdependencies between
financial structure and business decisions inherent in
key financial questions may be missed. As a result,
gaining true insights and getting to creative alterna-
tives and new solutions may be painfully slow, if not
interminable. By themselves, spreadsheets cannot
model the more complex financial and strategic in-
terrelationships that entrepreneurs need to grasp.
And for the board of directors, failure to get this in-
formation would be fatal and any delay would mean
too little and too late. Such a weakness in financial
know-how becomes life threatening for entrepre-
neurs such as those noted earlier, when it comes to
anticipating the financial and risk-reward conse-
quences of their business decisions. During a finan-
cial crisis, such a weakness can make an already dis-
mal situation worse.
Time and again, the financially fluent and skillful
entrepreneurs push what would otherwise he an av-
erage company toward and even beyond the brink of
greatness. Clearly, financially knowledgeable CEOs
enjoy a secret competitive weapon that can yield a de-
cisive edge over less financially skilled entrepreneurs.
Critical Financing Issues
Exhibit 13.2 illustrates the central issues in entrepre-
neurial finance. These include the creation of value,
the slicing and dividing of value pie among those who
have a stake or have participated in the venture. and
the handling of the risks inherent in the venture. De-
veloping financing and fund-raising strategies, know-
ing what alternatives are available, and obtaining
funding are tasks vital to the survival and success of
most higher potential ventures.
As a result, entrepreneurs face certain critical is-
sues and problems, which hear on the financing of en-
trepreneurial ventures, such as:
• Creating value. Who are the constituencies for
whom value must be created or added to
444
1
Part IV Financing Entrepreneurial Ventures
numerous acquisitions. At your company's peak,
your net worth reached $25 million. The next
decade of expansion was fueled by the high
leverage common in the cable industry and
valuations soared. Ten years later, your
company had a market value in the $500
million range. You had a mere $300 million in
debt, and you owned 100 percent of the
company. Just two years later, your $200 million
net worth is an astonishing zero! Additionally,
you now face the personally exhausting and
financially punishing restructuring battle to
survive; personal bankruptcy is a very real
possibility, How could this happen? Can the
company be salvaged?2
• At mid-decade, your company was the industry
leader, meeting as well as exceeding your
business plan targets for annual sales,
profitability, and new stores. Exceeding these
targets while doubling sales and profitability
each year has propelled your stock price from
$15 at the initial public offering to thc mid
$30s. Meanwhile, you still own a large chunk of
the company. Then the shocker-at decade's
end your company loses $78 million on just
over $90 million in sales! The value of your
stock plummets. A brutal restructuring follows
in which the stock is stripped from the original
management team, including you, and you are
ousted from the company you founded and
loved. Why did the company spin out of
control? \Vhy couldn't you as the founder have
anticipated its demise? Could you have saved
the company in time?
• As the chairman of a rapidly growing
telecommunications firm, you are convening
your first board meeting after a successful
public stock offering, As you think about the
agenda, your plans are to grow the company to
$15 million in sales in the next three years,
which is comfortable given the $5 million in
sales last year, the $3.5 million of cash in the
bank, and no debt on the balance sheet. Early
in the meeting, one of the two outside directors
asks the controller and the chief financial
officer his favorite question, "When will you
run out of cash?" The chief financial officer is
puzzled at first, then he is indignant, if not
outraged, by what he considers to he an
irrelevant question. After all, he reasoned, our
company has plenty of cash and we don't need
a bank line. However, 16 months later, without
warning from the chief financial officer, the
company is out of cash and has overdrawn its
$1 million credit line by $700,000 and the
hemorrhaging may get worse. The board fires
the president, the chief financial officer, and
the senior audit partner from a major
accounting firm. The chairman has to take over
the helm and must personally invest half a
million dollars in the collapsing company to
keep it afloat. At this point, it's the bank that is
indignant and outraged. You have to devise an
emergency battle plan to get 011 top of the
financial crisis. How can this be done?
Financial Management Myopia:
It Can't Happen to Me
All of these situations have three things in common.
. First, they are real companies and these are actual
events.:' Second, each of these companies was led by
successful entrepreneurs who knew enough to pre-
pare audited financial statements. Third, in each ex-
ample, the problems stemmed from financial man-
agement myopia, a combination of self-delusion and
just plain not understanding the complex dynamics
and interplay between financial management and
business strategy. \Vhy is this so?
Getting Beyond "Collect Early, Pay Late"
During our 30-plus years as educators, authors. di-
rectors, founders. and investors in entrepreneurial
companies, we have met a few thousand entrepre-
neurs and managers, including executives participat-
ing in an executive MBA program, \1BA students,
Kauffman Fellows, company founders, presidents,
members of the Young Presidents Organization, and
the chief executive officers of middle-market compa-
nies. By their own admission, they felt uniformly un-
comfortable, if not downright intimidated and terri-
fied, by their lack of expertise in financial analysis and
its relationship to management and strategy. The vast
majority of entrepreneurs and nonfinancial managers
are disadvantaged. Beyond "collect early, pay late."
there is precious little sophistication and an enor-
mous level of discomfort when it comes to these com-
plex and dynamic financial interrelationships. Even
good managers who are reveling in major sales in-
creases and profit increases often fail to realize until
it's too late the impact increased sales have on the
cash flow required to finance the increased receiv-
ables and inventory.
"For more detail, see Burton C, Hurlock and William A Saltlman, "Star Cablevision Group: Harvesting in a Bull Market," HBS Case 293-036, Harvard Business
School Puhlishing,
JTheir outcomes have ranged from demise to moderate success, to radical (hw.. TIsizing followed by dramatic recovery, to still being in the midst of a turnaround
I
446 PartIV FinaneingEntrepreneurialVentures
£XH1811 13.2
Central Issues in Entrepreneurial Finance
Shareholders
Value creation Customers
Employees
Allocatingrisks
andreturns
Slicing the valuepie
Cash-Risk-Time
Debt: Take control
Coveringrisk
Equity: Staged
commitments
achieve apositivecash flowandto develop
harvestoptions?
• Slicing the value pie. Howare deals, bothfor
startupsand for thepurchasesofexisting
ventures,structuredandvalued,andwhatare
thecriticaltaxconsequencesofdifferent
venturestructures?Whatisthelegal process
andwhatare thekey issuesinvolvedin raising
outsideriskcapital?
• Howdo entrepreneursmake effective
presentationsoftheirbusinessplansto
financingandothersources?Whatare someof
thenastierpitfalls, minefields, andhazardsthat
needto be anticipated,preparedfor, and
respondedto? Howcriticaland sensitiveis
timingin eachof theseareas?
• Covering risk. Howmuchmoneyisneededto
start,acquire,or expandthebusiness,and
when,where, andhow canitbeobtainedon
acceptableterms?Whatsourcesofrisk and
venturecapitalfinancing-s-equity, debt,and
otherinnovative available, andhow
isappropriatefinancingnegotiatedand
obtained?
• Whoare thefinancialcontactsandnetworks
thatneedto beaccessedanddeveloped?
• Howdo successfulentrepreneursmarshalthe
necessaIyfinancial resourcesandother
financialequivalentsto seize andexecute
opportunities,andwhatpitfalls do theymanage
to avoid, andhow?
• Canastagedapproachto resourceacquisition
mitigateriskandincreasereturn?
A clear understanding ofthe financing require-
ments is especiallyvital for new andemergingcom-
panies because new ventures go through financial
'hell' compared to existing firms, both smaller and
larger, thathave acustomerbaseandrevenuestream.
In theearly going, new firms are gluttonsfor capital.
yet are usuallynotverydebt-worthy.Tomake matters
worse, the faster they grow, the more gluttonous is
theirappetitefor cash.
This phenomenon is best illustrated in Exhibit
13.3 where loss as a percentage ofinitial equity is
4 - •
plottedagainsttime. Theshadedarearepresentsthe
cumulativecash flowof157companiesfrom theirin-
ception.Forthesefirms, ittook 30monthsto achieve
operatingbreakevenand75months(orgoingintothe
seventh year) to recovertheinitialequity. Ascan be
seenfrom the illustration, casn goes out for a lOll:!,
time before it starts to come in. This phenomenonis
at the heart ofthe financing challenges facing new
andemergingcompanies.
Entrepreneurial Finance: The Owner's
Perspective
Ifan entrepreneurwho has hadresponsibilityfor fi-
nancingin a large establishedcompanyandin apri-
vate emergingfirmisaskedwhethertherearediffer-
encesbetweenthetwo, thepersonaskingwillget an
earful. While there is some common ground, there
are bothstarkandsubtle differences, both in theorv
and in practice, between entrepreneurial finance
practicedin higherpotentialventures andcorporate
or administrative finance, which usually occurs in
larger, publiclytradedcompanies. Further,thereare
importantlimits to somefinancialtheoriesasapplied
to new ventures.
Students and practitioners ofentrepreneurial fi-
nancehave alwaysbeendubious aboutthereliabilitv
and relevance ofmuch ofso-called modern
"Special appreciationisdue to Bert Twaalfboven. founderand chairmanof Indivers, the Dutchfirm that compiledthis and that owns the finn eu wbic:hd....-
chartisbased. Mr. Twaalfhovenwas alsoaleaderinthe Class of19.54at HarvardBusiness School and has been active in supportingthe Entrepreneurial
ManagementInterestGroupandresearchefforts there.
'See Paul A. Campers and William A. Sahlman, Entrepreneurial Finance (New York: John Wiley & Sons, 2002).
-"anc\' A. Nichols, "In Question: Efficient? Chaotic? What's the New Finance?" Harvard Business Review, March-April 1993, p. 50.
Ibid.. p. 52.
"Ibrd.. p. 60.
447
cepts, the efficient market hypothesis, portfolio the-
ory, and CAPM, have had a profound impact on how
the financial markets relate to the companies they
seek to value . . . They have derailed and blessed
countless investment projects.:" Nancy Nichols, con-
cluded that "despite tidy theories, there may be no
single answer in a global economy.T'
It is especially noteworthy that even the most pres-
tigious of modern finance theorists, prominent Nobel
laureate Robert Merton of Harvard 0 niversity, may
have a lot to learn. His works and theories of finance
were the basis for Long Term Capital Management,
Inc. The total collapse of that firm in the late 1990s
threatened to topple the entire financial system.
Acquiring knowledge of the limits of financial the-
ories, of differences in the domain of entrepreneurial
finance, and of understanding the implications is a
core task for entrepreneurs. To begin to appreciate
the character and flavor of these limits and differ-
ences, consider the following sampling.
Breakeven,
20 -
30 months
10
Years
:::J
7
0-
Initial
Q)
co
equity +"'
c
breakeven,
a
75 months
+"'
c
Q)
-30 u
a;
3-
-40
Vl
Vl
a
--'
-50
-601 '\
Average of 157 companies
at various stages
-70
L
\
/
ofdevelopment
Chapter 13 Entrepreneurial Finance
EXHIBI113.3
Initial Losses by Small New Ventures
theory, including the capital asset pricing model
(CAPM), beta, and so on.
s
Apparently, this skepticism
is gaining support from a most surprising source, cor-
porate finance theorists. As reported in a Harvard
Business Review article:
One of the strongest attacks is coming from a man who
helped launch modern finance, University of Chicago
Professor Eugene Fama. His research has cast doubt on
the validityof a widely used measure of stock volatility:
beta. A second group of critics is looking for a new fi-
nancial paradigm; they believe it will emerge from the
study of nonlinear dynamics and chaos theory. A third
group, however, eschews the scientific approach alto-
gether, arguing that investors aren't always rational and
that managers' constant focus on the markets is ruining
corporate America. In their view, the highlyfragmented
U.S. financial markets do a poor job of allocatingcapital
and keeping tabs on management."
Challenging further the basic assumptions of corpo-
rate finance, the author continued: "These three con-
Source: Indivers.
448 Part IV Financing Entrepreneurial Ventures
Cash Flow and Cash Cash flowand cash are king
and queen in entrepreneurial finance. Accrual-based
accounting, earnings per share, or creative and aggres-
sive use of the tax codes and rules of the Securities and
Exchange Commission are not. Just ask Enron!
Time and Timing Financing alternatives for the
financial health of an enterprise are often more sensi-
tive to, or vulnerable to, the time dimension. In en-
trepreneurial finance, time for critical flnancing
moves often is shorter and more compressed, the op-
timum timing of these moves changes more rapidly,
and flnancing moves are subject to wider, more
volatile swings from lows to highs and back.
Capital Markets Capital markets for more than
95 percent of the financing of private entrepreneurial
ventures are relatively imperfect, in that they are fre-
quently inaccessible, unorganized, and often invisi-
ble, Virtually all the underlying characteristics and as-
sumptions that dominate such popular financial
theories and models as the capital asset pricing model
Simply do not apply, even up to the point of a publie
offering for a small company. In reality, there are so
many and such Significant information, knowledge,
and market gaps and asymmetries that the rational,
perfect market models suffer enormous limitations.
Emphasis Capital is one of the least important
factors in the success of higher potential ventures.
Rather, higher potential entrepreneurs seek not only
the best deal but also the hacker who will provide the
most value in terms of know-how, wisdom, counsel,
and help. In addition, higher potential entrepreneurs
invariably opt for the value added (beyond money),
rather than just the best deal or share price.
Strategies for Raising Capital Strategies that
optimize or maximize the amount of money raised
can actually increase risk in new and emerging com-
panies, rather than lower it. Thus, the concept of
"staged capital commitments," whereby money is
committed for a 3- to-18- month phase and is followed
by subsequent commitments based on results and
promise, is a prevalent practice among venture capi-
talists and other investors in higher potential ven-
tures. Similarly, wise entrepreneurs may refuse excess
capital when the valuation is less attractive and when
they believe that valuation will rise substantially.
Downside Consequences Consequences of fi-
nancial strategies and decisions are eminently more
personal and emotional for the owners of new and
emerging ventures than for the managements ofJarge
companies. The downside consequences for such en-
trepreneurs of running out of cash or failing are mon-
umental and relatively catastrophic, since personal
guarantees of bank or other loans are common. Con-
trast these situations ','liththat of the president of RJR
Nabisco. His bonus for signing and his five-year em-
ployment package guarantees him a total of $25 mil-
lion, and he could earn substantially more based on
his performance. However, even' if he does a
mediocre or lousy job, his downside is $25 million.
Risk-Reward Relationships While the high-
risk/high-reward and low-risk/low-reward relationship
(a so-called law of economics and finance) works fairlv
well in efficient, mature, and relatively perfect capital
markets (e.g., those with money market accounts, de-
posits in savings and loan institutions, widely held and
traded stocks and bonds, certificates of deposit), the
opposite occurs too often in entrepreneurial finance
to permit much comfort with this law. Some of the
most profitable, highest return venture investments
have been quite low-risk propositions from the outset.
Many leveraged buyouts IIsing extreme leverage are
probably much more risky than many startups. Yet.
the way the capital markets price these deals isjust the
reverse. The reasons are anchored in the second and
third points noted above-s-timing and the asymme-
tries and imperfections of the capital markets for
deals. Entrepreneurs or investors who create or rec-
ognize lower risk/very high-yield business proposi-
tions, before others jump on the Brink's truck, will
defy the laws of economics and finance. The recent
bankruptcies of Kmart and Enron illustrate this point.
Valuation Methods Established company valu-
ation methods, such as those based on discounted
cash flow models used in Wall Street megadeals.
seem to favor the seller, rather than the buyer, of pri-
vate emerging entrepreneurial companies. A seller
loves to see a recent MBA or investment banking fim1
alumnus or alumna show up with an HP calculator or
the latest laptop personal computer and then proceed
to develop "the lO-year discounted cash flow stream."
The assumptions normally made and the mind-set
behind them are irrelevant or grossly misleading for
valuation of smaller private firms because of dynamic
and erratic historical and prospective growth curves.
Conventional Financial Ratios Current finan-
cial ratios are misleading when applied to most pri-
vate entrepreneurial companies. For one thing, en-
trepreneurs often own more than one company at
once and move cash and assets from one to another-
For example, an entrepreneur may own real estate
and equipment in one entity and lease it to another
company. Use of different fiscal years compounds the
difficulty of interpreting what the balance sheet realh
means and the possibilities for aggressive tax avoid-
Chapter 13 Entrepreneurial Finance 449
ance. Further, many of the most important value and
equity builders in the business are ofT the balance
sheet or are hidden assets: the excellent management
team; the best scientist, technician, or designer;
know-how and business relationships that cannot be
bought or sold, let alone valued for the balance sheet.
Goals Creating value over the long term, rather
than maximizing quarterly earnings, is a prevalent
mind-set and strategy among highly successful entre-
preneurs. Since profit is more than just the bottom
line, financial strategies are geared to build value, of-
ten at the expense of short-term earnings. The growth
required to build value often is heavily self-financed,
thereby eroding possible accounting earnings.
Determining Capital Requirements
How much money does my venture need? When is it
needed? How long will it last? Where and from whom
can it be raised? How should this process be orches-
trated and managed? These are vital questions to any
entrepreneur at any stage in the development of a
company. These questions are answered in the next
two sections.
Financial Strategy Framework
The financial strategy framework shown in Exhibit 13.4
is a way to begin crafting financial and fund-raising
strategies." The exhibit provides a flow and logic with
which an otherwise confusing task can be attacked.
The opportunity leads and drives the business strat-
egy, which in turn drives the [inancial requirements,
the sources and deal structures, and the financial
strategy. (Again, until this part of the exercise is well-
defined, developing spreadsheets and "playing with
the numbers" is just that-playing.)
Once an entrepreneur has defined the core of the
market opportunity and the strategy for seizing it (of
course, these may change, even dramatically), he or
she can begin to examine the financial requirements
in terms of (1) asset needs (for startup or for expan-
sion facilities, equipment, research and development,
and other apparently onetime expenditures) and
this framework was developed for the Financing Entrepreneurial Ventures course at Babson College and has been used in the Entrepreneurial Finance course at
the Harvard Business School.
EXHIBIT 13.4
Financial Strategy Framework
Financial
strategy
Degrees of strategic freedom:
Time to OOC
Time to close
Future alternatives
Risk/Reward
Personal concerns
Opportunity
Sources and deal
structure
Business
strategy
Debt
Equity
Other Operations
Marketing
Finance
Financial
requirements
Value creation
Driven by:
Burn rate
Operati ng needs
Working capital
Asset requirements
and sales
450 Part IV Financing Entrepreneurial Ventures
(2) operating needs (i.e., working capital for opera-
tions). This framework leaves ample room for crafting a
financial strategy, for creatively identifYing sources, for
devising a fund-raising plan, and for structuring deals.
Each fund-raising strategy, along with its accom-
panying deal structure, commits the company to ac-
tions that incur actual and real-time costs and may en-
hance or inhibit future financing options. Similarly,
each source has particular requirements and costs-
both apparent and hidden-that carry implications
for both financial strategy and financial requirements.
The premise is that successful entrepreneurs are
aware of potentially punishing situations, and that
they are careful to "sweat the details" and proceed
with a certain degree of wariness as they evaluate, se-
lect, negotiate, and craft business relationships with
potential funding sources. In doing so, they are more
likely to find the right sources, at the right time, and
on the right terms and conditions. They are also more
likely to avoid potential mismatches, costly sidetrack-
ing for the wrong sources, and the disastrous mar-
riage to these sources that might follow.
Certain changes in the financial climate, such as
the aftershocks felt after March 2000 and October
1987, can cause repercussions across financial mar-
kets and institutions serving smaller companies.
These take the form of greater caution by both
lenders and investors as they seek to increase their
protection against risk. When the financial climate
becomes harsher, an entrepreneur's capacity to devise
financing strategies and to effectively deal with fi-
nancing sources can be stretched to the limit and be-
yond. Also, certain lures of cash that come in unsus-
pecting ways tum out to be a punch in the wallet.
(The next chapter covers some of these potentially fa-
tal lures and some of the issues and considerations
needed to recognize and avoid these traps while de-
vising a fund-raising strategy and evaluating and ne-
gotiating with different sources.)
Free Cash Flow: Burn Rate, OOC,
and TTC
The core concept in determining the external financ-
ing requirements of the venture is free cash flow.
Three vital corollaries are the bum rate (projected or
actual), time to OOC (when will the company be out
of cash), and TIC (or the time to close the financing
and have the check clear). These have a major impact
on the entrepreneur's choices and relative bargaining
power with various sources of equity and debt capital.
which is represented in Exhibit 13..5. Chapter 1.5 ad-
dresses the details of deal structuring, terms, condi-
tions, and covenants.
The message is clear: If you are out of cash in 90
days or less, you are at a major disadvantage. ooe
even in six months is perilously soon. But if you han'
a year or more, the options, terms, price, and
covenants that you will be able to negotiate will im-
prove dramatically. The implication is clear: Ideallv.
raise money when you do not need it.
The cash flow generated by a company or project
is defined as follows:
Earnings before interest and taxes (EBIT)
Less Tax exposure (tax rate times EBIT)
Plus Depreciation, amortization, and other noncash charges
Less Increase in operating working capital
Less Capital expenditures
EXHIBIT 13.5
Entrepreneur's Bargaining Power Based on Time to OOC
Highest
Relative
bargaining
power (RBP)
of the
entrepreneur
versus sources
of capital
Nil
Now 3 6 9 12+
lime in months to DOC
Chapter13 EntrepreneurialFinance
4,'5]
Economistscallthis resultfree cash now.Thedef-
inition takes into account the benefits of investing,
theincome generated, and thecostofinvesting, the
amount ofinvestment in working capital and plant
and equipmentrequired to generate a given level of
sales and netincome.
The definition can fruitfullv be refined further.
Operatingworkingcapitalisde'fined as:
Transactions cash balances
Plus Accounts receivable
Plus Inventory
Plus Other operating current assets (e.g., prepaid expenses)
Less Accounts payable
Less Taxes payable
Less Other operating current liabilities (e.g., accrued expenses)
Finally,thisexpandeddefinitioncan becollapsedinto
. I io
asImp erone:
Earnings before interest but after taxes (EBIAT)
Less Increase in net total operating capital (FA + wq
wheretlle increasein nettotal operatingcapitalis
definedas:
Increase in operating working capital
Plus Increase in net fixed assets
Crafting Financial and Fund-Raising
Strategies
Critical Variables
Whenfinancingisneeded,anumberoffactorsaffect
theavailability ofthevarious types offinancing, and
theirsuitabilityandcost:
• Accomplishmentsandperformanceto date.
• Investor'sperceivedrisk.
• Industryandtechnology.
• Ventureupsidepotentialandanticipatedexit
timing.
• Ventureanticipatedgrowthrate.
• Ventureage andstage ofdevelopment.
• Investor's requiredrateofreturnorinternal
rateofreturn.
• Amountofcapitalrequiredand priorvaluations
oftheventure.
• Founders'goalsregardinggrowth,control,
liquidity, andharvesting.
• Relativebargainingpositions.
• Investor's requiredtermsandcovenants.
Numerous other factors, especially an investor's or
lender'sviewofthequalityofa businessopportunity
and the managementteam, willalso playapartin a
decisiontoinvestin or lendto afirm.
Generally,acompany'soperationscanbe financed
through debt and some form of equity financing.
l I
Moreover,it isgenerallybelievedthatanewor exist-
ing businessneedsto obtainbothequityanddebtfi-
nancingifitistohave asoundfinancialfoundationfor
growth without excessive dilution ofthe entrepre-
neur'sequity.
Short-termdebt(i.e.,debtincurredforone yearor
less) usually isusedby abusinessfor workingcapital
and isrepaidoutoftheproceedsofits sales. Longer-
termborrowings (i.e., termloans ofoneto fiveyears
or long-termloans maturingin morethanfiveyears)
are usedforworkingcapitaland/ortofinancethepur-
chase of propertyor equipmentthatserve as collat-
eral for the loan. Equityfinancing is used to fillthe
nonbankablegaps, preserveownership,andlowerthe
riskofloandefaults.
However,anewventurejuststartingoperationswill
have difficulty obtainingeithershort-term or longer-
termbankdebtwithoutasubstantialcushionofequity
financingorlong-termdebtthatissubordinatedorju-
niortoallbankdebt.12 Asfarasalenderisconcerned,
astartuphas little provencapabilityto generatesales,
profits, and cash to payoffshort-term debtand even
lessabilitytosustain profitableoperationsoveranum-
berofyears and retire long-term debt. Even thc un-
derlyingprotectionprovidedbyaventure'sassetsused
as loan collateral may be insufficient to obtain bank
loans.Assetvaluescan erodewith time;intheabsence
ofadequateequitycapitalandgoodmanagement,they
mayprovidelittle realloan securitytoabank.13
Abankmaylendmoneyto astartupto somemax-
imumdebt-to-equityratio. Asaroughrule, astartup
may be able to obtain debt for workingcapital pur-
poses that is equal to its equity and subordinated
debt.Astartupcan alsoobtainloans throughsuch av-
enues as the Small Business Administration, manu-
facturers andsuppliers,or leasing.
IOTlussectionisdrawndirectly from "Note on FreeCash Flow Valuation Models:'HBS 288-02:3, PI" 2-3.
lJInaddition to the purchaseofconuuonstock, equityflnancingismeanttoincludethe purchaseof both stock and suborciinatecldebt,or subordinateddebtwith
stockconve-rsion featuresor warrantsto pllTchase stock.
12Forlendingpurposes, commercial hanks regardsuch subordinated debtasequityVenturecapital investorsnormallysuhordiuatetheirbusinessloan'i to the loans
providedhy the bank or otherfinancial institunons.
'''Thebankloan defaults hythe real estateinvestmenttrusts(RF.1Tslin 197,5and 1989-91are examplesofthe failure of assets toprovideprotectioninthe ahsenceof
soundmanagementand adequateequitycapital,
Part IV Financing Entrepreneurial Ventures 4.52
An existing business seeking expansion capital or
funds for a temporary use has a much easier job obtain-
ing both debt and equity. Sources such as banks, pro-
fessional investors, and leasing and finance companies
often will seek out such companies and regard them as
important customers for secured and unsecured short-
term loans or as good investment prospects. Further-
more, an existing anel expanding business will find it
easier to raise equity capital from private or institutional
sources and to raise it on better terms than the startup.
Awareness of criteria used by various sources of fi-
nancing, whether for debt, equity, or some combina-
tion of the two, that are available for a particular situ-
ation is central to devise a time-effective and
cost -effective search for capital.
Financial Life Cycles
One useful way to begin identifYing equity financing al-
ternatives, and when and if certain alternatives are
available, is to consider what can be called the financial
life cycle of firms. Exhibit 13.6 shows the types of cap-
ital available over time for different types of firms at
different stages of development (i.e., as indicated by
different sales levels). 14 It also summarizes. at different
stages of development (research and development,
startup, early growth, rapid growth, and exit), the prin-
cipal sources of risk capital and costs of risk capital.
As can be seen in the exhibit, sources have different
preferences and practices. including how much money
they will provide, when in a company's life cycle they
wil] invest, and the cost of the capital or expected an-
nual rate of return they are seeking. The available
sources ofcapital change dramatically for companies at
different stages and rates of growth, and there will be
variations in different parts of the country.
Many of the sources of equity are not available un-
til a company progresses beyond the earlier stages of
its growth. Some sources available to early-stage com-
panies, especially personal sources, friends, and other
informal investors or angels, will be insufficient to
meet the financing requirements generated in later
stages if the company continues to grow successfully.
Another key factor affecting the availability of fi-
nancing is the upside potential of a company. Of the
3 million-plus new businesses of all kinds expected to
be launched in the United States in 2003, probably 5
percent or less will achieve the growth and sales lev-
els of high potential firms. Foundation firms will total
about 8 percent to 12 percent of all new firms, which
will grow more slowly but exceed $1 million in sales
and may grow to $5 million to $15 million. Remaining
are the traditional, stable lifestyle firms. High poten-
tial firms (those that grow rapidly and are likely to ex-
ceed $20 million to $25 million or more in sales) are
strong prospects for a public offering and have the
widest array of financing alternatives, including com-
binations of debt and equity and other alternatives
(which are noted later), while foundation firms have
fewer, and lifestyle firms are limited to the personal
resources of their founders and whatever net worth or
collateral they can accumulate.
In general, investors believe the younger the com-
pany, the more risky the investment. This is a varia-
tion of the olel saying in the venture capital business:
The lemons ripen in two-and-a-half years, but the
plums take seven or eight.
While the timeline and dollar limits shown are onlv
guidelines, they do reflect how these money source's
view the riskiness, anel thus the required rate of re-
turn, of companies at various stages of development.
Investor Preferences
Precise practices of investors or lenders may vary be-
tween individual investors or lenders in a given cate-
gory, may change with the current market conditions.
and may vaiYin dillerent areas of the country from time
to time. IdentifYing realistic sources and developing a
fund-raising strategy to tap them depend upon knowing
what kinds of investments investors or lenders are seek ~
ing. While the stage, amount, and return guidelines
noted in Exhibit 13.6 can help, doing the appropriate
homework in advance on specific investor or lender
preferences can save months of wild-goose chases and
personal cash. while Significantlyincreasing the odds of
successfully raising funds on acceptable terms.
Chapter Summary
1. Cash is king and queen. Happiness is a positive cash
flow. More cash is preferred to less cash. Cash sooner
is preferred to cash later. Less risky cash is preferred
to more risky cash.
2. Financial know-how, issues, and analysis are often the-
entrepreneurs' Achilles' heels.
.3. Entrepreneurial finance is the art and science of
quantifying value creation, slicing the value pie, and
managing and covering financial risk.
4. Determining capital requirements, crafting financial
and fund-raising strategies, and managing and
orchestrating the financial process are critical to 11e\\'
venture success.
14William H. Wetzel, [r., of the University of New Hampshire originallv showed the different types of equity capital that are available to three types of companies. TI,,·
exhibit is bused on a chart Ill' Wetzel. which the authors have updated and modified. See William H. Wetzel. [r., "The Cost of Availabilitv of Credit and Risk
Capital in New England," in A Region's StnlggLing Savior: Small Business ill New England. pd. J. A. Timmons and D. E. Gumpert (Waltham, ~ l Small Busiue-c-
Foundation of America, W79).
453 Chapter 1:3 Entrepreneurial Finance
EXHIBIT 13.6
Financing Life Cycles
Sales ($ millions)
20
Equity capital _
15
Risk capital ..
10
Personal savings ..
5
Source: Adapted and updated from the original by W. H. Wetzel, Jr.. "The Cost of Availability of Credit and Risk Capitol in New England," in A
Region's Struggling Savior: Small Business in New England, ed. J. A. Timmons and D. E. Gumpert [Waltham, MA Small BusinessFoundation of
America, 1979), p. 175.
,5. Harvest strategies are as important to the
entrepreneurial process as value creation itself. Value
that is unrealized may have no value.
Study Questions
1. Define the following and explain why they are
important: burn rate, fume date. free eash flow,
aac, TTC, financial management myopia,
spreadsheet mirage.
2. \Vhy is entrepreneurial finance simultaneously both
the least and most important palt of the
entrepreneurial process? Explain this paradox.
3. What factors affect the availability, suitability, and
cost of various types of financing? Why are these
factors eritical?
4. What is meant by Free eash flow, and why do
entrepreneurs need to understand this?
5. Why do financially savvy entrepreneurs ask the
financial and strategic questions in Exhibit 13.1? Can
you answer these questions for your venture?
doc_677242946.pdf
Within this criteria relating to entrepreneurial finance happiness to on entrepreneur is a positive cosh flow.
13
Entrepreneurial Finance
"Happiness to on entrepreneur isa positive cosh flow."
Fred Adler
Venture Capitalist
Results Expected
Upon completion of this chapter, you will have:
1. Examinedcritical issuesinfinancingnewventures.
2. Studiedthedifferencebetweenentrepreneurialfinanceandconventional
administrativeorcorporatefinance.
3. Examined the process of crafting financial and fund-raising strategies and the critical
variables involved, including identifyingthefinancial lifecycles of newventures,a
financial strategyframework, andinvestorpreferences.
4. Analyzedthe"FAX InternationalJapan"casestudy.
Venture Financing:
The Entrepreneur's Achilles' Heel
l
Therearethreecoreprinciplesofentrepreneurialfi-
nance: (1) more cash is preferred to less cash,
(2) cash soonerispreferredto cash later, and(3)less
risky cash is preferred to more risky cash. While
theseprinciplesseemsimpleenough,entrepreneurs,
chiefexecutiveofficers,anddivision managersoften
seemto ignorethem.To theseindividuals, financial
analysis seemsintimidating, regardlessofthesize of
thecompany. Evenmanagementteams,comfortable
withthefinancialissues, may notbeadeptat linking
strategic andfinancial decisions to theircompanies'
challenges and choices. Take, for example, the fol-
lowingpredicaments:
• Reviewingtheyear-endresultsjusthandedto
you byyourchieffinancialofficer, you see no
surprises-exceptthatthecompanylossiseven
largerthanyou hadprojectedthreemonths
earlier.Therefore,for thefourthyearin arow,
you willhave to walk into theboardroomand
deliverbadnews. Afamilv-ownedbusiness
since 1945, thecompanyhas survivedand
prosperedwithaverageannualsales growthof
17percent. In fact, thecompany'smarketshare
has actuallyincreasedduringrecentyears
despitethelosses. Withtheannualgrowthrate
in theindustryaveragingless than5percent,
yourmaturemarketsofferfew opportunities
for sustaininghighergrowth. Howcan this be
happening?Wheredo you andyourcompany
gofromhere?Howdoyou explain to theboard
thatforfouryears you have increasedsales and
marketsharebutproducedlosses?Howwill
you proposeto tumthesituationaround?
• Duringthepast20years,yourcabletelevision
companyhas experiencedrapidgrowththrough
theexpansionofexistingpropertiesand
'Thissectionwasdrawn from JeHiy A.Timmons,"Financial ManagementBreakthroughfor Entrepreneurs."
443
444 Part TV Financing Entrepreneurial Ventures
numerous acquisitions. At your company's peak
vour net worth reached $25 million. The next
decade of expansion was fueled by the high
leverage common in the cable industry and
valuations soared. Ten years later, your
company had a market value in the $,500
million range. You had a mere $300 million in
debt, and you owned 100 percent of the
company. Just two years later, your $200 million
net worth is an astonishing zero! Additionally,
you now face the personally exhausting and
financially punishing restructuring battle to
survive; personal bankruptcy is a very real
possibility. How could this happen? Can the
company be salvaged?2
• At mid-decade, your company was the industry
leader, meeting as well as exceeding your
business plan targets for annual sales,
profitability, and new stores. Exceeding these
targets while doubling sales and profitability
each year has propelled your stock price from
$15 at the initial public offering to the mid
$30s. Meanwhile, you still own a large chunk of
the company. Then the shocker-at decade's
end your company loses $78 million on just
over $90 million in sales! The value of your
stock plummets. A brutal restructuring follows
in which the stock is stripped from the original
management team, including you, and you are
ousted from the company you founded and
loved. Why did the company spin out of
control? Why couldn't you as the founder have
anticipated its demise? Could you have saved
the company in time?
• As the chairman of a rapidly growing
telecommunications firm, you are convening
your first board meeting after a successful
public stock offering. As you think about the
agenda, your plans are to grow the company to
$15 million in sales in the next three years,
which is comfortable given the $5 miilion in
sales last year, the $3.5 million of cash in the
bank, and no debt on the balance sheet. Early
in the meeting, one of the two outside directors
asks the controller and the chief financial
officer his favorite question, "When will you
run out of cash?" The chief financial officer is
puzzled at first, then he is indignant, if not
outraged, by what he considers to be an
irrelevant question. After all, he reasoned, our
company has plenty of cash and we don't need
a bank line, However, 16 months later, without
waruing from the chief financial officer, thc
company is out of cash and has overdrawn its
$llllillion credit line by $700,000 and the
hemorrhaging may get worse. The board fires
the president, the chief financial officer, and
the senior audit partner from a major
accounting firm. The chairman has to take O\'eT
the helm and must personally invest half a
million dollars in the collapsing company to
keep it afloat. At this point, it's the bank that is
indignant and outraged, You have to devise an
emergency battle plan to get on top of the
financial crisis. How can this be done?
Financial Management Myopia:
It Can't Happen to Me
All of these situations have three things in common.
First, they are real companies and these are actual
events.f Second, each of these companies was led by
successful entrepreneurs who knew enough to pre-
pare audited financial statements. Third, in each ex-
ample, the problems stemmed from financial man-
agement myopia, a combination of self-delusion and
just plain not understanding the complex dynamics
and interplay between financial management and
business strategy. Why is this so?
Getting Beyond "Collect Early, Pay Late"
During our 30-plus years as educators, authors, di-
rectors, founders, and investors in entrepreneurial
companies, we have met a few thousand entrepre-
neurs and managers, including executives participat-
ing in an executive MBA program, MBA students,
Kauffman Fellows, company founders, presidents,
members of the Young Presidents Organization, and
the chief executive officers of middle-market compa-
nies. By their own admission, they felt uniformly un-
comfortable, if not downright intimidated and terri-
fied, by their lack ofexpertise in flnancial analysis and
its relationship to management and strategy. The vast
majority of entrepreneurs and nonfinancial managers
are disadvantaged. Beyond "collect early, pay late,"
there is precious little sophistication and an enor-
mous level of discomfort when it comes to these com-
plex and dynamic financial interrelationships. Even
good managers who are reveling in major sales in-
creases and profit increases often fail to realize until
it's too late the impact increased sales have on the
cash flow required to finance the increased receiv-
abies and inventory.
"For more detail, see Burton C. Hurlock and William A. Sahlman, "Star Cahlevision Group: Harvesting in a Bull Market," HBS Case 293-036, Harvard Business
Schuol Publishing.
3Their outcomes have ranged from demise tu moderate success, to radical downsizing followed hy dramatic recovery, to still heing in the midst of a turnaround.
445 Chapter 1:3 Entrepreneurial Finance
EXHIBIT 13.1
The Crux of It: Anticipation and Financial Vigilance
Toavoid someofthegreat tar pitslike theonesdescribed earlier, entrepreneurs needanswers toquestionsthat linkstrategic business
decisions tofinancial plansand choices. Thecrux of it isanticipation: What is most likely to happen? When? What can go right along
the way? What can go wrong? What has to happen to achieve our business objectives and to increase or to preserve our options?
Financiallysavvyentrepreneurs know thatsuchquestionstriggera processthatcan lead to creative solutionsto their financial challenges
and problems. At a practical level, financiallyastuteentrepreneurs and managers maintain vigilanceover numerouskeystrategic and
financial questions:
• Whatare thefinancial consequencesand implicationsof crucial businessdecisions suchaspricing, volume, and policychanges
affecting thebalancesheet,income statement,and cashflow? Howwill thesechange over time?
• Howcan we measureand monitorchanges inour financial strategy and structurefrom a management, not justa GAAP, perspective?
• Whatdoes itmean togrowtoo fastin our industry? Howfastcan we growwithoutrequiring outside debt or equity? Howmuch
capital isrequired if we increase or decrease our growth by Xpercent?
• Whatwill happen toour cashflow, profitability, return on assets,and shareholderequity if we growfasteror slower by Xpercent?
• Howmuchcapitalwill thisrequire? Howmuchcan be financed internallyand howmuchwill have to comefrom external sources?
Whatisa reasonablemix of debt and equity?
• Whatif we are 20% lessprofitablethan our plan calls for? Or 20% more profitable?
• Whatshould beour focusand priorities? Whatare thecashflow and netincome break-even points for eachof our productlines?For
our company? Forour businessunit?
• Whataboutour pricing, our volume, and our costs?Howsensitiveare our cashflow and netincome to increasesor decreases in
price, variable costs,or volume? Whatprice/volume mix will enable ustoachieve thesamecashflow and netincome?
• Howwill thesechanges in pricing, costs,and volume affect our keyfinancial ratios and howwill we stackupagainstothersinour
industry? Howwill our lendersview this?
• Ateach stage-startup, rapidlygrowing, stagnating, or maturecompany-howshouldwe bethinking about thesequestionsand issues?
The Spreadsheet Mirage Itis hard to imagine
any entrepreneur who would not want ready answers
to many financial vigilance questions, such as in Ex-
hibit 13.]. Until now, however, getting the answers to
these questions was a rarity. If the capacity and infor-
mation are there to do the necessarv analysis (and all
too often they are not), it can take up to se'veral weeks
to get a response. In this era of spreadsheet mania,
more often than not, the answers will come in the
form of a lengthy report with innumerable scenarios,
pages of numbers, backup exhibits, and possibly a
presentation by a staff financial analyst, controller, or
chief financial officer.
Too often the barrage of spreadsheet exhibits is re-
ally a mirage. What is missing? Traditional spread-
sheets can only report and manipulate the data. The
numbers may be there, the trends may be identified,
but the connections and interdependencies between
financial structure and business decisions inherent in
key financial questions may be missed. As a result,
gaining true insights and getting to creative alterna-
tives and new solutions may be painfully slow, if not
interminable. By themselves, spreadsheets cannot
model the more complex financial and strategic in-
terrelationships that entrepreneurs need to grasp.
And for the board of directors, failure to get this in-
formation would be fatal and any delay would mean
too little and too late. Such a weakness in financial
know-how becomes life threatening for entrepre-
neurs such as those noted earlier, when it comes to
anticipating the financial and risk-reward conse-
quences of their business decisions. During a finan-
cial crisis, such a weakness can make an already dis-
mal situation worse.
Time and again, the financially fluent and skillful
entrepreneurs push what would otherwise he an av-
erage company toward and even beyond the brink of
greatness. Clearly, financially knowledgeable CEOs
enjoy a secret competitive weapon that can yield a de-
cisive edge over less financially skilled entrepreneurs.
Critical Financing Issues
Exhibit 13.2 illustrates the central issues in entrepre-
neurial finance. These include the creation of value,
the slicing and dividing of value pie among those who
have a stake or have participated in the venture. and
the handling of the risks inherent in the venture. De-
veloping financing and fund-raising strategies, know-
ing what alternatives are available, and obtaining
funding are tasks vital to the survival and success of
most higher potential ventures.
As a result, entrepreneurs face certain critical is-
sues and problems, which hear on the financing of en-
trepreneurial ventures, such as:
• Creating value. Who are the constituencies for
whom value must be created or added to
444
1
Part IV Financing Entrepreneurial Ventures
numerous acquisitions. At your company's peak,
your net worth reached $25 million. The next
decade of expansion was fueled by the high
leverage common in the cable industry and
valuations soared. Ten years later, your
company had a market value in the $500
million range. You had a mere $300 million in
debt, and you owned 100 percent of the
company. Just two years later, your $200 million
net worth is an astonishing zero! Additionally,
you now face the personally exhausting and
financially punishing restructuring battle to
survive; personal bankruptcy is a very real
possibility, How could this happen? Can the
company be salvaged?2
• At mid-decade, your company was the industry
leader, meeting as well as exceeding your
business plan targets for annual sales,
profitability, and new stores. Exceeding these
targets while doubling sales and profitability
each year has propelled your stock price from
$15 at the initial public offering to thc mid
$30s. Meanwhile, you still own a large chunk of
the company. Then the shocker-at decade's
end your company loses $78 million on just
over $90 million in sales! The value of your
stock plummets. A brutal restructuring follows
in which the stock is stripped from the original
management team, including you, and you are
ousted from the company you founded and
loved. Why did the company spin out of
control? \Vhy couldn't you as the founder have
anticipated its demise? Could you have saved
the company in time?
• As the chairman of a rapidly growing
telecommunications firm, you are convening
your first board meeting after a successful
public stock offering, As you think about the
agenda, your plans are to grow the company to
$15 million in sales in the next three years,
which is comfortable given the $5 million in
sales last year, the $3.5 million of cash in the
bank, and no debt on the balance sheet. Early
in the meeting, one of the two outside directors
asks the controller and the chief financial
officer his favorite question, "When will you
run out of cash?" The chief financial officer is
puzzled at first, then he is indignant, if not
outraged, by what he considers to he an
irrelevant question. After all, he reasoned, our
company has plenty of cash and we don't need
a bank line. However, 16 months later, without
warning from the chief financial officer, the
company is out of cash and has overdrawn its
$1 million credit line by $700,000 and the
hemorrhaging may get worse. The board fires
the president, the chief financial officer, and
the senior audit partner from a major
accounting firm. The chairman has to take over
the helm and must personally invest half a
million dollars in the collapsing company to
keep it afloat. At this point, it's the bank that is
indignant and outraged. You have to devise an
emergency battle plan to get 011 top of the
financial crisis. How can this be done?
Financial Management Myopia:
It Can't Happen to Me
All of these situations have three things in common.
. First, they are real companies and these are actual
events.:' Second, each of these companies was led by
successful entrepreneurs who knew enough to pre-
pare audited financial statements. Third, in each ex-
ample, the problems stemmed from financial man-
agement myopia, a combination of self-delusion and
just plain not understanding the complex dynamics
and interplay between financial management and
business strategy. \Vhy is this so?
Getting Beyond "Collect Early, Pay Late"
During our 30-plus years as educators, authors. di-
rectors, founders. and investors in entrepreneurial
companies, we have met a few thousand entrepre-
neurs and managers, including executives participat-
ing in an executive MBA program, \1BA students,
Kauffman Fellows, company founders, presidents,
members of the Young Presidents Organization, and
the chief executive officers of middle-market compa-
nies. By their own admission, they felt uniformly un-
comfortable, if not downright intimidated and terri-
fied, by their lack of expertise in financial analysis and
its relationship to management and strategy. The vast
majority of entrepreneurs and nonfinancial managers
are disadvantaged. Beyond "collect early, pay late."
there is precious little sophistication and an enor-
mous level of discomfort when it comes to these com-
plex and dynamic financial interrelationships. Even
good managers who are reveling in major sales in-
creases and profit increases often fail to realize until
it's too late the impact increased sales have on the
cash flow required to finance the increased receiv-
ables and inventory.
"For more detail, see Burton C, Hurlock and William A Saltlman, "Star Cablevision Group: Harvesting in a Bull Market," HBS Case 293-036, Harvard Business
School Puhlishing,
JTheir outcomes have ranged from demise to moderate success, to radical (hw.. TIsizing followed by dramatic recovery, to still being in the midst of a turnaround
I
446 PartIV FinaneingEntrepreneurialVentures
£XH1811 13.2
Central Issues in Entrepreneurial Finance
Shareholders
Value creation Customers
Employees
Allocatingrisks
andreturns
Slicing the valuepie
Cash-Risk-Time
Debt: Take control
Coveringrisk
Equity: Staged
commitments
achieve apositivecash flowandto develop
harvestoptions?
• Slicing the value pie. Howare deals, bothfor
startupsand for thepurchasesofexisting
ventures,structuredandvalued,andwhatare
thecriticaltaxconsequencesofdifferent
venturestructures?Whatisthelegal process
andwhatare thekey issuesinvolvedin raising
outsideriskcapital?
• Howdo entrepreneursmake effective
presentationsoftheirbusinessplansto
financingandothersources?Whatare someof
thenastierpitfalls, minefields, andhazardsthat
needto be anticipated,preparedfor, and
respondedto? Howcriticaland sensitiveis
timingin eachof theseareas?
• Covering risk. Howmuchmoneyisneededto
start,acquire,or expandthebusiness,and
when,where, andhow canitbeobtainedon
acceptableterms?Whatsourcesofrisk and
venturecapitalfinancing-s-equity, debt,and
otherinnovative available, andhow
isappropriatefinancingnegotiatedand
obtained?
• Whoare thefinancialcontactsandnetworks
thatneedto beaccessedanddeveloped?
• Howdo successfulentrepreneursmarshalthe
necessaIyfinancial resourcesandother
financialequivalentsto seize andexecute
opportunities,andwhatpitfalls do theymanage
to avoid, andhow?
• Canastagedapproachto resourceacquisition
mitigateriskandincreasereturn?
A clear understanding ofthe financing require-
ments is especiallyvital for new andemergingcom-
panies because new ventures go through financial
'hell' compared to existing firms, both smaller and
larger, thathave acustomerbaseandrevenuestream.
In theearly going, new firms are gluttonsfor capital.
yet are usuallynotverydebt-worthy.Tomake matters
worse, the faster they grow, the more gluttonous is
theirappetitefor cash.
This phenomenon is best illustrated in Exhibit
13.3 where loss as a percentage ofinitial equity is
4 - •
plottedagainsttime. Theshadedarearepresentsthe
cumulativecash flowof157companiesfrom theirin-
ception.Forthesefirms, ittook 30monthsto achieve
operatingbreakevenand75months(orgoingintothe
seventh year) to recovertheinitialequity. Ascan be
seenfrom the illustration, casn goes out for a lOll:!,
time before it starts to come in. This phenomenonis
at the heart ofthe financing challenges facing new
andemergingcompanies.
Entrepreneurial Finance: The Owner's
Perspective
Ifan entrepreneurwho has hadresponsibilityfor fi-
nancingin a large establishedcompanyandin apri-
vate emergingfirmisaskedwhethertherearediffer-
encesbetweenthetwo, thepersonaskingwillget an
earful. While there is some common ground, there
are bothstarkandsubtle differences, both in theorv
and in practice, between entrepreneurial finance
practicedin higherpotentialventures andcorporate
or administrative finance, which usually occurs in
larger, publiclytradedcompanies. Further,thereare
importantlimits to somefinancialtheoriesasapplied
to new ventures.
Students and practitioners ofentrepreneurial fi-
nancehave alwaysbeendubious aboutthereliabilitv
and relevance ofmuch ofso-called modern
"Special appreciationisdue to Bert Twaalfboven. founderand chairmanof Indivers, the Dutchfirm that compiledthis and that owns the finn eu wbic:hd....-
chartisbased. Mr. Twaalfhovenwas alsoaleaderinthe Class of19.54at HarvardBusiness School and has been active in supportingthe Entrepreneurial
ManagementInterestGroupandresearchefforts there.
'See Paul A. Campers and William A. Sahlman, Entrepreneurial Finance (New York: John Wiley & Sons, 2002).
-"anc\' A. Nichols, "In Question: Efficient? Chaotic? What's the New Finance?" Harvard Business Review, March-April 1993, p. 50.
Ibid.. p. 52.
"Ibrd.. p. 60.
447
cepts, the efficient market hypothesis, portfolio the-
ory, and CAPM, have had a profound impact on how
the financial markets relate to the companies they
seek to value . . . They have derailed and blessed
countless investment projects.:" Nancy Nichols, con-
cluded that "despite tidy theories, there may be no
single answer in a global economy.T'
It is especially noteworthy that even the most pres-
tigious of modern finance theorists, prominent Nobel
laureate Robert Merton of Harvard 0 niversity, may
have a lot to learn. His works and theories of finance
were the basis for Long Term Capital Management,
Inc. The total collapse of that firm in the late 1990s
threatened to topple the entire financial system.
Acquiring knowledge of the limits of financial the-
ories, of differences in the domain of entrepreneurial
finance, and of understanding the implications is a
core task for entrepreneurs. To begin to appreciate
the character and flavor of these limits and differ-
ences, consider the following sampling.
Breakeven,
20 -
30 months
10
Years
:::J
7
0-
Initial
Q)
co
equity +"'
c
breakeven,
a
75 months
+"'
c
Q)
-30 u
a;
3-
-40
Vl
Vl
a
--'
-50
-601 '\
Average of 157 companies
at various stages
-70
L
\
/
ofdevelopment
Chapter 13 Entrepreneurial Finance
EXHIBI113.3
Initial Losses by Small New Ventures
theory, including the capital asset pricing model
(CAPM), beta, and so on.
s
Apparently, this skepticism
is gaining support from a most surprising source, cor-
porate finance theorists. As reported in a Harvard
Business Review article:
One of the strongest attacks is coming from a man who
helped launch modern finance, University of Chicago
Professor Eugene Fama. His research has cast doubt on
the validityof a widely used measure of stock volatility:
beta. A second group of critics is looking for a new fi-
nancial paradigm; they believe it will emerge from the
study of nonlinear dynamics and chaos theory. A third
group, however, eschews the scientific approach alto-
gether, arguing that investors aren't always rational and
that managers' constant focus on the markets is ruining
corporate America. In their view, the highlyfragmented
U.S. financial markets do a poor job of allocatingcapital
and keeping tabs on management."
Challenging further the basic assumptions of corpo-
rate finance, the author continued: "These three con-
Source: Indivers.
448 Part IV Financing Entrepreneurial Ventures
Cash Flow and Cash Cash flowand cash are king
and queen in entrepreneurial finance. Accrual-based
accounting, earnings per share, or creative and aggres-
sive use of the tax codes and rules of the Securities and
Exchange Commission are not. Just ask Enron!
Time and Timing Financing alternatives for the
financial health of an enterprise are often more sensi-
tive to, or vulnerable to, the time dimension. In en-
trepreneurial finance, time for critical flnancing
moves often is shorter and more compressed, the op-
timum timing of these moves changes more rapidly,
and flnancing moves are subject to wider, more
volatile swings from lows to highs and back.
Capital Markets Capital markets for more than
95 percent of the financing of private entrepreneurial
ventures are relatively imperfect, in that they are fre-
quently inaccessible, unorganized, and often invisi-
ble, Virtually all the underlying characteristics and as-
sumptions that dominate such popular financial
theories and models as the capital asset pricing model
Simply do not apply, even up to the point of a publie
offering for a small company. In reality, there are so
many and such Significant information, knowledge,
and market gaps and asymmetries that the rational,
perfect market models suffer enormous limitations.
Emphasis Capital is one of the least important
factors in the success of higher potential ventures.
Rather, higher potential entrepreneurs seek not only
the best deal but also the hacker who will provide the
most value in terms of know-how, wisdom, counsel,
and help. In addition, higher potential entrepreneurs
invariably opt for the value added (beyond money),
rather than just the best deal or share price.
Strategies for Raising Capital Strategies that
optimize or maximize the amount of money raised
can actually increase risk in new and emerging com-
panies, rather than lower it. Thus, the concept of
"staged capital commitments," whereby money is
committed for a 3- to-18- month phase and is followed
by subsequent commitments based on results and
promise, is a prevalent practice among venture capi-
talists and other investors in higher potential ven-
tures. Similarly, wise entrepreneurs may refuse excess
capital when the valuation is less attractive and when
they believe that valuation will rise substantially.
Downside Consequences Consequences of fi-
nancial strategies and decisions are eminently more
personal and emotional for the owners of new and
emerging ventures than for the managements ofJarge
companies. The downside consequences for such en-
trepreneurs of running out of cash or failing are mon-
umental and relatively catastrophic, since personal
guarantees of bank or other loans are common. Con-
trast these situations ','liththat of the president of RJR
Nabisco. His bonus for signing and his five-year em-
ployment package guarantees him a total of $25 mil-
lion, and he could earn substantially more based on
his performance. However, even' if he does a
mediocre or lousy job, his downside is $25 million.
Risk-Reward Relationships While the high-
risk/high-reward and low-risk/low-reward relationship
(a so-called law of economics and finance) works fairlv
well in efficient, mature, and relatively perfect capital
markets (e.g., those with money market accounts, de-
posits in savings and loan institutions, widely held and
traded stocks and bonds, certificates of deposit), the
opposite occurs too often in entrepreneurial finance
to permit much comfort with this law. Some of the
most profitable, highest return venture investments
have been quite low-risk propositions from the outset.
Many leveraged buyouts IIsing extreme leverage are
probably much more risky than many startups. Yet.
the way the capital markets price these deals isjust the
reverse. The reasons are anchored in the second and
third points noted above-s-timing and the asymme-
tries and imperfections of the capital markets for
deals. Entrepreneurs or investors who create or rec-
ognize lower risk/very high-yield business proposi-
tions, before others jump on the Brink's truck, will
defy the laws of economics and finance. The recent
bankruptcies of Kmart and Enron illustrate this point.
Valuation Methods Established company valu-
ation methods, such as those based on discounted
cash flow models used in Wall Street megadeals.
seem to favor the seller, rather than the buyer, of pri-
vate emerging entrepreneurial companies. A seller
loves to see a recent MBA or investment banking fim1
alumnus or alumna show up with an HP calculator or
the latest laptop personal computer and then proceed
to develop "the lO-year discounted cash flow stream."
The assumptions normally made and the mind-set
behind them are irrelevant or grossly misleading for
valuation of smaller private firms because of dynamic
and erratic historical and prospective growth curves.
Conventional Financial Ratios Current finan-
cial ratios are misleading when applied to most pri-
vate entrepreneurial companies. For one thing, en-
trepreneurs often own more than one company at
once and move cash and assets from one to another-
For example, an entrepreneur may own real estate
and equipment in one entity and lease it to another
company. Use of different fiscal years compounds the
difficulty of interpreting what the balance sheet realh
means and the possibilities for aggressive tax avoid-
Chapter 13 Entrepreneurial Finance 449
ance. Further, many of the most important value and
equity builders in the business are ofT the balance
sheet or are hidden assets: the excellent management
team; the best scientist, technician, or designer;
know-how and business relationships that cannot be
bought or sold, let alone valued for the balance sheet.
Goals Creating value over the long term, rather
than maximizing quarterly earnings, is a prevalent
mind-set and strategy among highly successful entre-
preneurs. Since profit is more than just the bottom
line, financial strategies are geared to build value, of-
ten at the expense of short-term earnings. The growth
required to build value often is heavily self-financed,
thereby eroding possible accounting earnings.
Determining Capital Requirements
How much money does my venture need? When is it
needed? How long will it last? Where and from whom
can it be raised? How should this process be orches-
trated and managed? These are vital questions to any
entrepreneur at any stage in the development of a
company. These questions are answered in the next
two sections.
Financial Strategy Framework
The financial strategy framework shown in Exhibit 13.4
is a way to begin crafting financial and fund-raising
strategies." The exhibit provides a flow and logic with
which an otherwise confusing task can be attacked.
The opportunity leads and drives the business strat-
egy, which in turn drives the [inancial requirements,
the sources and deal structures, and the financial
strategy. (Again, until this part of the exercise is well-
defined, developing spreadsheets and "playing with
the numbers" is just that-playing.)
Once an entrepreneur has defined the core of the
market opportunity and the strategy for seizing it (of
course, these may change, even dramatically), he or
she can begin to examine the financial requirements
in terms of (1) asset needs (for startup or for expan-
sion facilities, equipment, research and development,
and other apparently onetime expenditures) and
this framework was developed for the Financing Entrepreneurial Ventures course at Babson College and has been used in the Entrepreneurial Finance course at
the Harvard Business School.
EXHIBIT 13.4
Financial Strategy Framework
Financial
strategy
Degrees of strategic freedom:
Time to OOC
Time to close
Future alternatives
Risk/Reward
Personal concerns
Opportunity
Sources and deal
structure
Business
strategy
Debt
Equity
Other Operations
Marketing
Finance
Financial
requirements
Value creation
Driven by:
Burn rate
Operati ng needs
Working capital
Asset requirements
and sales
450 Part IV Financing Entrepreneurial Ventures
(2) operating needs (i.e., working capital for opera-
tions). This framework leaves ample room for crafting a
financial strategy, for creatively identifYing sources, for
devising a fund-raising plan, and for structuring deals.
Each fund-raising strategy, along with its accom-
panying deal structure, commits the company to ac-
tions that incur actual and real-time costs and may en-
hance or inhibit future financing options. Similarly,
each source has particular requirements and costs-
both apparent and hidden-that carry implications
for both financial strategy and financial requirements.
The premise is that successful entrepreneurs are
aware of potentially punishing situations, and that
they are careful to "sweat the details" and proceed
with a certain degree of wariness as they evaluate, se-
lect, negotiate, and craft business relationships with
potential funding sources. In doing so, they are more
likely to find the right sources, at the right time, and
on the right terms and conditions. They are also more
likely to avoid potential mismatches, costly sidetrack-
ing for the wrong sources, and the disastrous mar-
riage to these sources that might follow.
Certain changes in the financial climate, such as
the aftershocks felt after March 2000 and October
1987, can cause repercussions across financial mar-
kets and institutions serving smaller companies.
These take the form of greater caution by both
lenders and investors as they seek to increase their
protection against risk. When the financial climate
becomes harsher, an entrepreneur's capacity to devise
financing strategies and to effectively deal with fi-
nancing sources can be stretched to the limit and be-
yond. Also, certain lures of cash that come in unsus-
pecting ways tum out to be a punch in the wallet.
(The next chapter covers some of these potentially fa-
tal lures and some of the issues and considerations
needed to recognize and avoid these traps while de-
vising a fund-raising strategy and evaluating and ne-
gotiating with different sources.)
Free Cash Flow: Burn Rate, OOC,
and TTC
The core concept in determining the external financ-
ing requirements of the venture is free cash flow.
Three vital corollaries are the bum rate (projected or
actual), time to OOC (when will the company be out
of cash), and TIC (or the time to close the financing
and have the check clear). These have a major impact
on the entrepreneur's choices and relative bargaining
power with various sources of equity and debt capital.
which is represented in Exhibit 13..5. Chapter 1.5 ad-
dresses the details of deal structuring, terms, condi-
tions, and covenants.
The message is clear: If you are out of cash in 90
days or less, you are at a major disadvantage. ooe
even in six months is perilously soon. But if you han'
a year or more, the options, terms, price, and
covenants that you will be able to negotiate will im-
prove dramatically. The implication is clear: Ideallv.
raise money when you do not need it.
The cash flow generated by a company or project
is defined as follows:
Earnings before interest and taxes (EBIT)
Less Tax exposure (tax rate times EBIT)
Plus Depreciation, amortization, and other noncash charges
Less Increase in operating working capital
Less Capital expenditures
EXHIBIT 13.5
Entrepreneur's Bargaining Power Based on Time to OOC
Highest
Relative
bargaining
power (RBP)
of the
entrepreneur
versus sources
of capital
Nil
Now 3 6 9 12+
lime in months to DOC
Chapter13 EntrepreneurialFinance
4,'5]
Economistscallthis resultfree cash now.Thedef-
inition takes into account the benefits of investing,
theincome generated, and thecostofinvesting, the
amount ofinvestment in working capital and plant
and equipmentrequired to generate a given level of
sales and netincome.
The definition can fruitfullv be refined further.
Operatingworkingcapitalisde'fined as:
Transactions cash balances
Plus Accounts receivable
Plus Inventory
Plus Other operating current assets (e.g., prepaid expenses)
Less Accounts payable
Less Taxes payable
Less Other operating current liabilities (e.g., accrued expenses)
Finally,thisexpandeddefinitioncan becollapsedinto
. I io
asImp erone:
Earnings before interest but after taxes (EBIAT)
Less Increase in net total operating capital (FA + wq
wheretlle increasein nettotal operatingcapitalis
definedas:
Increase in operating working capital
Plus Increase in net fixed assets
Crafting Financial and Fund-Raising
Strategies
Critical Variables
Whenfinancingisneeded,anumberoffactorsaffect
theavailability ofthevarious types offinancing, and
theirsuitabilityandcost:
• Accomplishmentsandperformanceto date.
• Investor'sperceivedrisk.
• Industryandtechnology.
• Ventureupsidepotentialandanticipatedexit
timing.
• Ventureanticipatedgrowthrate.
• Ventureage andstage ofdevelopment.
• Investor's requiredrateofreturnorinternal
rateofreturn.
• Amountofcapitalrequiredand priorvaluations
oftheventure.
• Founders'goalsregardinggrowth,control,
liquidity, andharvesting.
• Relativebargainingpositions.
• Investor's requiredtermsandcovenants.
Numerous other factors, especially an investor's or
lender'sviewofthequalityofa businessopportunity
and the managementteam, willalso playapartin a
decisiontoinvestin or lendto afirm.
Generally,acompany'soperationscanbe financed
through debt and some form of equity financing.
l I
Moreover,it isgenerallybelievedthatanewor exist-
ing businessneedsto obtainbothequityanddebtfi-
nancingifitistohave asoundfinancialfoundationfor
growth without excessive dilution ofthe entrepre-
neur'sequity.
Short-termdebt(i.e.,debtincurredforone yearor
less) usually isusedby abusinessfor workingcapital
and isrepaidoutoftheproceedsofits sales. Longer-
termborrowings (i.e., termloans ofoneto fiveyears
or long-termloans maturingin morethanfiveyears)
are usedforworkingcapitaland/ortofinancethepur-
chase of propertyor equipmentthatserve as collat-
eral for the loan. Equityfinancing is used to fillthe
nonbankablegaps, preserveownership,andlowerthe
riskofloandefaults.
However,anewventurejuststartingoperationswill
have difficulty obtainingeithershort-term or longer-
termbankdebtwithoutasubstantialcushionofequity
financingorlong-termdebtthatissubordinatedorju-
niortoallbankdebt.12 Asfarasalenderisconcerned,
astartuphas little provencapabilityto generatesales,
profits, and cash to payoffshort-term debtand even
lessabilitytosustain profitableoperationsoveranum-
berofyears and retire long-term debt. Even thc un-
derlyingprotectionprovidedbyaventure'sassetsused
as loan collateral may be insufficient to obtain bank
loans.Assetvaluescan erodewith time;intheabsence
ofadequateequitycapitalandgoodmanagement,they
mayprovidelittle realloan securitytoabank.13
Abankmaylendmoneyto astartupto somemax-
imumdebt-to-equityratio. Asaroughrule, astartup
may be able to obtain debt for workingcapital pur-
poses that is equal to its equity and subordinated
debt.Astartupcan alsoobtainloans throughsuch av-
enues as the Small Business Administration, manu-
facturers andsuppliers,or leasing.
IOTlussectionisdrawndirectly from "Note on FreeCash Flow Valuation Models:'HBS 288-02:3, PI" 2-3.
lJInaddition to the purchaseofconuuonstock, equityflnancingismeanttoincludethe purchaseof both stock and suborciinatecldebt,or subordinateddebtwith
stockconve-rsion featuresor warrantsto pllTchase stock.
12Forlendingpurposes, commercial hanks regardsuch subordinated debtasequityVenturecapital investorsnormallysuhordiuatetheirbusinessloan'i to the loans
providedhy the bank or otherfinancial institunons.
'''Thebankloan defaults hythe real estateinvestmenttrusts(RF.1Tslin 197,5and 1989-91are examplesofthe failure of assets toprovideprotectioninthe ahsenceof
soundmanagementand adequateequitycapital,
Part IV Financing Entrepreneurial Ventures 4.52
An existing business seeking expansion capital or
funds for a temporary use has a much easier job obtain-
ing both debt and equity. Sources such as banks, pro-
fessional investors, and leasing and finance companies
often will seek out such companies and regard them as
important customers for secured and unsecured short-
term loans or as good investment prospects. Further-
more, an existing anel expanding business will find it
easier to raise equity capital from private or institutional
sources and to raise it on better terms than the startup.
Awareness of criteria used by various sources of fi-
nancing, whether for debt, equity, or some combina-
tion of the two, that are available for a particular situ-
ation is central to devise a time-effective and
cost -effective search for capital.
Financial Life Cycles
One useful way to begin identifYing equity financing al-
ternatives, and when and if certain alternatives are
available, is to consider what can be called the financial
life cycle of firms. Exhibit 13.6 shows the types of cap-
ital available over time for different types of firms at
different stages of development (i.e., as indicated by
different sales levels). 14 It also summarizes. at different
stages of development (research and development,
startup, early growth, rapid growth, and exit), the prin-
cipal sources of risk capital and costs of risk capital.
As can be seen in the exhibit, sources have different
preferences and practices. including how much money
they will provide, when in a company's life cycle they
wil] invest, and the cost of the capital or expected an-
nual rate of return they are seeking. The available
sources ofcapital change dramatically for companies at
different stages and rates of growth, and there will be
variations in different parts of the country.
Many of the sources of equity are not available un-
til a company progresses beyond the earlier stages of
its growth. Some sources available to early-stage com-
panies, especially personal sources, friends, and other
informal investors or angels, will be insufficient to
meet the financing requirements generated in later
stages if the company continues to grow successfully.
Another key factor affecting the availability of fi-
nancing is the upside potential of a company. Of the
3 million-plus new businesses of all kinds expected to
be launched in the United States in 2003, probably 5
percent or less will achieve the growth and sales lev-
els of high potential firms. Foundation firms will total
about 8 percent to 12 percent of all new firms, which
will grow more slowly but exceed $1 million in sales
and may grow to $5 million to $15 million. Remaining
are the traditional, stable lifestyle firms. High poten-
tial firms (those that grow rapidly and are likely to ex-
ceed $20 million to $25 million or more in sales) are
strong prospects for a public offering and have the
widest array of financing alternatives, including com-
binations of debt and equity and other alternatives
(which are noted later), while foundation firms have
fewer, and lifestyle firms are limited to the personal
resources of their founders and whatever net worth or
collateral they can accumulate.
In general, investors believe the younger the com-
pany, the more risky the investment. This is a varia-
tion of the olel saying in the venture capital business:
The lemons ripen in two-and-a-half years, but the
plums take seven or eight.
While the timeline and dollar limits shown are onlv
guidelines, they do reflect how these money source's
view the riskiness, anel thus the required rate of re-
turn, of companies at various stages of development.
Investor Preferences
Precise practices of investors or lenders may vary be-
tween individual investors or lenders in a given cate-
gory, may change with the current market conditions.
and may vaiYin dillerent areas of the country from time
to time. IdentifYing realistic sources and developing a
fund-raising strategy to tap them depend upon knowing
what kinds of investments investors or lenders are seek ~
ing. While the stage, amount, and return guidelines
noted in Exhibit 13.6 can help, doing the appropriate
homework in advance on specific investor or lender
preferences can save months of wild-goose chases and
personal cash. while Significantlyincreasing the odds of
successfully raising funds on acceptable terms.
Chapter Summary
1. Cash is king and queen. Happiness is a positive cash
flow. More cash is preferred to less cash. Cash sooner
is preferred to cash later. Less risky cash is preferred
to more risky cash.
2. Financial know-how, issues, and analysis are often the-
entrepreneurs' Achilles' heels.
.3. Entrepreneurial finance is the art and science of
quantifying value creation, slicing the value pie, and
managing and covering financial risk.
4. Determining capital requirements, crafting financial
and fund-raising strategies, and managing and
orchestrating the financial process are critical to 11e\\'
venture success.
14William H. Wetzel, [r., of the University of New Hampshire originallv showed the different types of equity capital that are available to three types of companies. TI,,·
exhibit is bused on a chart Ill' Wetzel. which the authors have updated and modified. See William H. Wetzel. [r., "The Cost of Availabilitv of Credit and Risk
Capital in New England," in A Region's StnlggLing Savior: Small Business ill New England. pd. J. A. Timmons and D. E. Gumpert (Waltham, ~ l Small Busiue-c-
Foundation of America, W79).
453 Chapter 1:3 Entrepreneurial Finance
EXHIBIT 13.6
Financing Life Cycles
Sales ($ millions)
20
Equity capital _
15
Risk capital ..
10
Personal savings ..
5
Source: Adapted and updated from the original by W. H. Wetzel, Jr.. "The Cost of Availability of Credit and Risk Capitol in New England," in A
Region's Struggling Savior: Small Business in New England, ed. J. A. Timmons and D. E. Gumpert [Waltham, MA Small BusinessFoundation of
America, 1979), p. 175.
,5. Harvest strategies are as important to the
entrepreneurial process as value creation itself. Value
that is unrealized may have no value.
Study Questions
1. Define the following and explain why they are
important: burn rate, fume date. free eash flow,
aac, TTC, financial management myopia,
spreadsheet mirage.
2. \Vhy is entrepreneurial finance simultaneously both
the least and most important palt of the
entrepreneurial process? Explain this paradox.
3. What factors affect the availability, suitability, and
cost of various types of financing? Why are these
factors eritical?
4. What is meant by Free eash flow, and why do
entrepreneurs need to understand this?
5. Why do financially savvy entrepreneurs ask the
financial and strategic questions in Exhibit 13.1? Can
you answer these questions for your venture?
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