Entrepreneurial finance

Tài chính doanh nghiệp

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Brief Contents

PART 1

CHAPTER 1 Introduction and Overview 3CHAPTER 2 From the Idea to the Business Plan 37

PART 2Organizing and Operating the Venture 79CHAPTER 3 Organizing and Financing a New Venture 81CHAPTER 4 Measuring Financial Performance 119CHAPTER 5 Evaluating Financial Performance 151

PART 3Planning for the Future 187CHAPTER 6 Financial Planning: Short Term and Long Term 189CHAPTER 7 Types and Costs of Financial Capital 231

CHAPTER 8 Securities Law Considerations When Obtaining Venture Financing 269

PART 4Creating and Recognizing Venture Value 313CHAPTER 9 Valuing Early-Stage Ventures 315CHAPTER10 Venture Capital Valuation Methods 361

PART 5Structuring Financing for the Growing Venture 405CHAPTER11 Professional Venture Capital 407

CHAPTER12 Other Financing Alternatives 431CHAPTER13 Security Structures and Determining Enterprise Values 457

PART 6Exit and Turnaround Strategies 493CHAPTER14 Harvesting the Business Venture Investment 495CHAPTER15 Financially Troubled Ventures: Turnaround Opportunities? 529

PART 7

CASE 2 Coral Systems, Inc 595CASE 3 Spatial Technology, Inc 621

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Preface xvii

PART 1Background and Environment 1

C H A P T E R 1Introduction and Overview 3

While Accounting Is the Language of Business, Cash Is the Currency

It Is Dangerous to Assume That People Act Against Their Own Self-Interests

An Interview with the Founder (Entrepreneur) and Management Team: Qualitative

Appendix A Applying the VOS Indicator™: An Example 75

PART 2Organizing and Operating the Venture 79

C H A P T E R 3Organizing and Financing a New Venture 81

C H A P T E R 4Measuring Financial Performance 119

Liabilities and Owners’ Equity 125

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5.3 Cash Burn Rates and Liquidity Ratios 156

PART 3Planning for the Future 187

C H A P T E R 6Financial Planning: Short Term and Long Term 189

C H A P T E R 7Types and Costs of Financial Capital 231

A Life Cycle–Based WACC Example 257

Appendix A Using WACC to Complete the Calibration of EVA 267

C H A P T E R 8Securities Law Considerations When Obtaining Venture Financing 269

Rule 504: Exemption for Limited Offerings and Sales of Securities Not Exceeding

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Rule 505: Exemption for Limited Offers and Sales of Securities Not Exceeding $5

PART 4Creating and Recognizing Venture Value 313

C H A P T E R 9Valuing Early-Stage Ventures 315

C H A P T E R 1 0Venture Capital Valuation Methods 361

10.5 Adjusting VCSCs for Incentive Ownership 372

C H A P T E R 1 1Professional Venture Capital 407

C H A P T E R 1 2Other Financing Alternatives 431

C H A P T E R 1 3Security Structures and Determining Enterprise Values 457

PART 6Exit and Turnaround Strategies 493

C H A P T E R 1 4Harvesting the Business Venture Investment 495

C H A P T E R 1 5Financially Troubled Ventures: Turnaround Opportunities? 529

Venture Example: Jeremy’s MicroBatch Ice Creams, Inc 545

PART 7Capstone Cases 563

C A S E 1Eco-Products, Inc 565

C A S E 2Coral Systems, Inc 595

C A S E 3Spatial Technology, Inc 621Glossary 645

Index 655

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The life of an entrepreneur is exciting and dynamic The challenge of envisioning

a new product or service, infecting others with entrepreneurial zeal, and bringing

a product to market can be one of the great learning experiences in life All tures require financing—taking investors’ money today and expecting to return a signifi-cantly larger amount in the future Typically the return comes from the venture’s publicoffering, sale, or merger In the interim, the venture must manage its financial resources,communicate effectively with investors and partners, and create the harvest value ex-pected by investors

ven-TEXTBOOK MOTIVATION

The purpose of the textbook is to introduce financial thinking, tools, and techniquesadapted to the realm of entrepreneurship We believe that, while much of traditional fi-nancial analysis may not be ideally suited to the venture context, there is great value inapplying venture adaptations

This entrepreneurial finance text introduces the theories, knowledge, and financialtools an entrepreneur needs to start, build, and harvest a successful venture Sound finan-cial management practices are essential to a venture’s operation The successful entrepre-neur must know how and where to obtain the financing necessary to launch and developthe venture Eventually, that same successful entrepreneur must know how and when tointeract with financial institutions and regulatory agencies to take the venture to its poten-tial and provide a return and liquidity for the venture’s investors

THE LIFE CYCLE APPROACH

We incorporate a life cycle approach to the material in this text Successful venturestypically begin with an initial development stage where the entrepreneurial team gen-erates ideas and assesses the associated business opportunities Most entrepreneurs re-alize that a business plan can greatly improve the chance that an idea will become acommercially viable product or service Startup stage ventures focus on the formula-tion of a business model and plan As marketing and selling products and services be-gins, survival stage ventures often refocus or restructure Rapid growth stage venturesincrease their momentum, and begin to demonstrate value creation Maturity stageventures typically look for ways to harvest the value created and provide a return totheir investors

Each stage in the life cycle requires a specific understanding of the financial agement tools and techniques, potential investors and their mindset, and the finan-cial institutions supporting that venture stage During the early stages of a venture’slife, cash management tools and survival planning are the dominant forms of financialanalysis Cash burn rates are very high and additional sources of financing are usuallylimited, making it critical for the successful venture to project and accommodate neces-sary operating costs The need to measure and adjust investment in working capital andproperty, plant, and equipment is evident The process of anticipating and

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accommodating costs and asset investments begins with the analysis of historical cial experience and then projects future financial positions using projected financialstatements or their proxies Successful ventures emerging from their survival stages canconcentrate more on value creation and calibration Consequently, our financial manage-ment emphases for this stage are valuation tools and techniques.

finan-Equally important as sound financial management practices is the need for the trepreneur to understand the types and sources of financial capital and the relatedinvestment processes During the development stage, seed financing usually comesfrom the entrepreneur’s personal assets and possibly from family and friends Businessangels and venture capitalists are important financing sources during the startup stage

en-First-round financing from business operations, venture capitalists, suppliers, customers,and commercial banks may be initiated during the survival stage The rapid growth stageinvolves second-round, mezzanine, and liquidity stage financing from business opera-tions, suppliers, customers, commercial banks, and investment bankers Once a ventureenters its maturity stage, seasoned financing replaces venture financing Seasoned financ-ing takes the form of cash flow from business operations, bank loans, and stocks andbonds issued with the assistance of investment bankers or others Our approach is tointroduce the types and sources of financial capital that become available as we progressthrough a successful venture’s life cycle

The successful entrepreneur must understand the legal environment regulatingfinancial relationships between the venture, investors, and financial institutions in-cluding venture capital funds and investment banks.We cover the basic securities lawsand regulatory agencies, particularly the Securities and Exchange Commission (SEC), rel-evant to the entrepreneur when considering how to obtain financial capital at each stage

To summarize, we take a comprehensive three-pronged stage-sensitive approach toentrepreneurial finance Our coverage of entrepreneurship-adapted financial analysisand relevant institutional details provides a relevant financial analysis base for the entre-preneur in each of the various stages as he or she develops the idea, brings it to market,grows the venture’s value, and ultimately provides an exit for venture investors We iden-tify and explain the types and sources of financing available during the various stagesand introduce the relevant legal and regulatory environment the entrepreneur must con-sider when seeking financing throughout the venture’s life cycle

DISTINCTIVE FEATURES

This text considers a successful firm as it progresses through various maturity stages

Specific examples of stage-relevant skills and techniques we introduce include:

• Brainstorming and Screening:Chapter 2 (From the Idea to the Business Plan)introduces qualitative and quantitative venture screening devices Chapter 3’s(Organizing and Financing a New Venture) treatment of intellectual propertyissues demonstrates important issues and concepts for the earliest stage ventures

• Raising External Funds:Chapter 8’s (Securities Law Considerations WhenObtaining Venture Financing) treatment of securities law introduces readers tothe restrictions and warnings for the growing venture seeking external financing

• Venture Diagnostics and Valuation: Chapter 9 (Valuing Early-Stage Ventures)presents our versions of traditional valuation techniques important to internal andexternal perceptions of a venture’s financial health While the material is traditional,our treatment provides a unifying approach to projecting financial statements,extracting pseudo-dividends, and assessing a venture’s value

• Venture Capital Valuation Methods:Chapter 10 (Venture Capital ValuationMethods) introduces representative multi-stage venture capital valuation methods

and interprets them relative to more traditional procedures It provides a unifiedexample of traditional pre-money and post-money valuations and the shortcutsemployed by many venture capitalists.

• Professional VCs:Chapter 11 (Professional Venture Capital) explores the historicaldevelopment of venture capital and describes the professional venture investing cyclefrom determining the next fund objectives and policies to distributing cash andsecurities proceeds to investors

• Harvest:Chapter 14 (Harvesting the Business Venture Investment) considers a widerange of venture harvest strategies including private sales (to outsiders, insiders, andfamily), transfers of assets, buyouts, and initial public offerings

• Turnaround Opportunities:Chapter 15 (Financially Troubled Ventures: TurnaroundOpportunities?) introduces important aspects of financial distress and alternativerestructuring approaches (operations, asset, and financial) to rescue a struggling venture

INTENDED AUDIENCE AND USE

The material contained in this text has been used successfully at the upper division(junior/senior) undergraduate, MBA, and executive MBA levels For MBAs, the coursecan easily be conducted in two ways In the first, what we term the life cycle approach,

we recommend the addition of illustrative cases, each at different life cycle stages cently, entrepreneurial finance cases have been available individually from the usual pro-viders and in collected form in entrepreneurial case books The second, or what we termthe venture capital approach, emphasizes the money management aspects of financingentrepreneurial ventures For this approach, we recommend supplementing the texttreatments with venture capital cases (available individually or in collected case books)and journal articles covering private equity (venture capital) and initial public offerings(investment banking) For an abbreviated mini-semester course or compressed executiveMBA, we recommend concentrating on the text and using our capstone cases as focalpoints for integrating the venture financing perspective

Re-We have also used this text for semester-long upper division (junior/senior-level) graduate courses involving finance and non-finance business majors Most academic busi-ness programs require students to take basic background courses in both accounting andfinance prior to upper division courses such as entrepreneurial finance Chapters 9, 10,and 13 present a rigorous and conceptually advanced approach to financial valuation Ourexperience is that these chapters provide the greatest intellectual challenge and require rela-tively sophisticated spreadsheet skills The fourth edition of this textbook has been written

under-to support two different approaches under-to the undergraduate entrepreneurial finance course

The more rigorous approach challenges undergraduate students by covering all 15 chaptersincluding all valuation materials and has a decision-making focus An alternative approach

is to teach a more descriptive or conceptual course For those preferring this latter approach,

we recommend that Part 4 (Chapters 9 and 10) and Chapter 13 from Part 5 be omitted orcovered in a descriptive (no modeling or calculations) manner For application, while theincluded capstone cases synthesize a great deal of the text’s material, some instructors find

it useful to have students prepare short cases in lieu of, or prior to, these capstones

Regarding the accounting and basic finance background material in Chapters 4 and 5,

we provide it for student and instructor convenience when the material has not beencovered in prerequisite courses or in instances when a review of the materials is war-ranted The remainder of the text can be used without explicit coverage of this reviewmaterial Additionally, for some adopters, it may be advantageous to alter the sequencingand coverage of the securities law and investment banking material, depending on stu-dent backgrounds and other course offerings

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ADDITIONS AND CHANGES IN THE FOURTH EDITION

Overall changes to content and organization include:

• Addition of a new feature in each chapter: a“From the Headlines” story relating to

an entrepreneurial venture A discussion question related to the“From the lines” feature is provided in the end of chapter material

Head-• Addition of pedagogical guidance: each exercise/problem at the end of each chapter

is preceded by a brief description in italics of the content or focus of the exercise orproblem

• Chapter 1 (Introduction and Overview) was substantially rewritten to reflect thecurrent focus on environmentally friendly products and“clean tech” and “cleanenergy” potential applications and entrepreneurial venture opportunities was added

The appendix on“Internet Concepts and Developments” was removed Discussion

of the 2007–2009 financial crisis and resulting entrepreneurial ventureopportunities was added

• Chapter 3 (Organizing and Financing a New Venture) includes updated personaland corporate income tax information and reorganized problems to follow chaptertopics

• Chapter 5 (Evaluating Financial Performance) was edited to improve the clarity ofthe cash burn discussion We added new financial ratio problems and restructuredthe mini-case

• Chapter 6 (Financial Planning: Short Term and Long Term) includes addition ofproblem materials on sustainable sales growth rates and additional funds needed

The Pharma Biotech mini-case was restructured

• Chapter 9 (Valuing Early-Stage Ventures) was reorganized consolidating the ple approaches to free cash flow valuation methods Some of the materials weremoved into a Learning Supplement

multi-• Chapter 13 (Security Structures and Determining Enterprise Values) includes asubstantially rewritten section on“Valuing Ventures with Complex Capital Struc-tures: The Enterprise Method” with the focus on presenting one method consistentwith Chapter 9 An alternative enterprise valuation method is now presented asLearning Supplement 13A

• Chapter 14 (Harvesting the Business Venture Investment) includes new material on

“employee stock ownership plans (ESOPs).” Material in the “Post-IPO Trading”

section was updated to reflect current NYSE and NASDAQ listing requirementsdata

• New Capstone Case: Eco-Products, Inc We added a new case for a company thatproduces and sells environmentally sound food service products from renewable re-sources The related early-stage financing decisions involve: (a) raising fundsthrough a private placement memorandum, and (b) a proposed private placementwith an investment firm utilizing a term sheet Excerpts from the private placementmemorandum and the term sheet are provided for student review and analysis

SUPPLEMENTS

Instructor’s Manual with Test BankWritten by the text authors, the Instructor’s Manual includes short answers to end-of-chapter questions and answers to end-of-chapter problems The Test Bank includestrue/false and multiple choice questions, as well as short test problems Both Instructor’sManual and Test Bank are available on the text Web site for instructors only

PowerPoint Lecture SlidesCreated by the text authors, the PowerPoint slides present a point-by-point lecture out-line, including graphics and equations, for instructors to use in the classroom They areavailable on the text Web site for instructors only.

Excel SolutionsExcel Solutions to end-of-chapter problems requiring Excel are provided for instructors

on the text Web site

Text Web SiteThe text Web site at www.cengagebrain.com provides access to these supplements

AcknowledgmentsDuring the several years we spent developing and delivering this material, we benefitedfrom interactions with colleagues, students, entrepreneurs, and venture capitalists Wethank the numerous sections of students who became the sounding board for our pre-sentation of this material We also thank the members of the Venture Capital Associa-tion of Colorado who opened their professional lives and venture capital conferences toour students Additionally, we have benefited from detailed valuable comments and in-put by Craig Wright and Michael Meresman Clinton Talmo and Robert Donchez con-tributed to the preparation of the Instructor’s Manual

We recognize the moral support of the Deming Center for Entrepreneurship (BobDeming, and directors Dale Meyer, Denis Nock, Kathy Simon, Steve Lawrence andPaul Jerde) We thank the Coleman Foundation for research support for the Coral Sys-tems, Inc and Spatial Technology, Inc cases and the Educational Legacy Fund for re-search support for the Eco-Products, Inc case

We recognize the valuable contributions of our editorial staff at Cengage Learning,including Michael Mercier, our original acquisitions editor who believed in our book en-ough to publish it; Mike Reynolds, our current Cengage Learning executive editor, andAdele Scholtz our developmental editor Also, we’d like to thank our production man-ager, Tamborah Moore and our marketing manager, Nate Anderson We also thankMartha Leach for research assistance behind the “From the Headlines” stories and forproofreading a complete version of this fourth edition We thank Andre Gygax, HardjoKoerniadi, and Cody Engle who provided several important corrections to previousmaterials

For their patience and insights offered during the process, we thank our colleagueswho reviewed materials for this fourth edition or earlier editions of the text:

Brian Adams, University of Portland

MJ Alhabeeb, University of MassachusettsOlufunmilayo Arewa, Northwestern UniversityDavid Choi, Loyola Marymount UniversitySusan Coleman, University of HartfordDavid Culpepper, Millsaps CollegeJohn Farlin, Ohio DominicanDavid Hartman, Central Connecticut State UniversityWilliam C Hudson, St Cloud State University

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Narayanan Jayaraman, Georgia TechJeffrey June, Miami UniversityMiranda Lam, Salem State CollegeMichael S Long, Rutgers UniversityMichael Owens, University of Tennessee ChattanoogaRobert Patterson, Westminster College

Charles B Ruscher, University of ArizonaSteven R Scheff, Florida Gulf Coast UniversityGregory Stoller, Boston College

Srinivasan Sundaram, Ball State UniversityMichael Williams, University of Denver

Finally, to our families for their patience through four editions, we offer our sincerethanks

J Chris LeachRonald W Melicher

About the Authors

J Chris Leach is Professor and Chair of the Finance Division and the Robert H andBeverly A Deming Professor in Entrepreneurship at the Leeds School of Business, Univer-sity of Colorado at Boulder He received a finance Ph.D from Cornell University, beganhis teaching career at the Wharton School and has been a visiting professor at CarnegieMellon, the Indian School of Business, and the Stockholm Institute for Financial Research(at the Stockholm School of Economics) His teaching experience includes courses forundergraduates, MBAs, Ph.D students, and executives He has been recognized as Gradu-ate Professor of the Year and has received an award for MBA Teaching Excellence Hisresearch on a variety of topics has been published in The Review of Financial Studies, Jour-nal of Financial and Quantitative Analysis, Journal of Business, and Journal of Money,Credit and Banking, among other journals

Chris’s business background includes various startups dating back to his early teens inthe 1970s During his transition to the University of Colorado, he was the chairman of aNew Mexico startup and later, as an investor and advisor, participated in a late 1990s Sili-con Valley startup that subsequently merged into a public company His consulting activi-ties include business and strategic planning advising, valuation, and deal structure for earlystage and small businesses He is a faculty advisor for the Deming Center Venture Fundand a member of the Deming Center Board of Directors MBA teams Chris has sponsoredhave qualified for six international championships of the Venture Capital InvestmentCompetition

Ronald W Melicheris Professor of Finance in the Leeds School of Business at the versity of Colorado at Boulder He earned his undergraduate, MBA, and doctoral degreesfrom Washington University in St Louis, Missouri While at the University of Colorado,

Uni-he has received several distinguisUni-hed teaching awards and was designated as a wide President’s Teaching Scholar He also has held the William H Baugh DistinguishedScholar faculty position, served three multi-year terms as Chair of the Finance Division,served as the Faculty Director of the Boulder Campus MBA Program, and was theAcademic Chair of the three-campus Executive MBA Programs

university-Ron has taught entrepreneurial finance at both the MBA and undergraduate levels Healso teaches corporate finance and financial strategy in the MBA and Executive MBA pro-grams and investment banking to undergraduate students While on sabbatical leave fromthe University of Colorado, Ron has taught at the INSEAD Graduate School of Business inFontainebleau, France and at the University of Zurich in Zurich, Switzerland He has de-livered numerous university-offered executive education non-credit courses and has taughtin-house finance education materials for IBM and other firms He has given expert witnesstestimony on cost of capital in regulatory proceedings and has provided consulting exper-tise in the areas of financial management and firm valuation

Ron’s research interests focus on mergers and acquisitions, corporate restructurings,and the financing and valuation of early-stage firms His previous research has been pub-lished in major finance journals including the Journal of Finance, Journal of Financial andQuantitative Analysis, and Financial Management He is the co-author of Introduction

to Finance: Markets, Investments, and Financial Management, Fourteenth Edition (JohnWiley & Sons, 2011)

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P A R T 1

Background and Environment

Chapter 1Introduction and Overview

Chapter 2From the Idea to the Business Plan

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C H A P T E R 1 Introduction

and Overview

FIRST THOUGHTSOnly those individuals with entrepreneurial experience can say,“Been there, done that!”

With aspiring entrepreneurs in mind, we start at the beginning and consider how trepreneurial finance relates to the other aspects and challenges of launching a new ven-ture Our goal is to equip you with the terms, tools, and techniques that can help turn abusiness idea into a successful venture

en-LOOKING AHEADChapter 2 focuses on the transformation of an idea into a business opportunity and themore formal representation of that opportunity as a business plan Most successful ideasare grounded in sound business models We present qualitative and quantitative screen-ing exercises that can help determine an idea’s commercial viability We provide a briefdiscussion of a business plan’s key elements

CHAPTER LEARNING OBJECTIVESThis chapter presents an overview of entrepreneurial finance We hope to convey thepotential benefit of embracing standard entrepreneurial finance methods and techniques

We consider an entrepreneur’s operating and financial decisions at each stage, asthe venture progresses from idea to harvest After completing this chapter, you will beable to:

1 Characterize the entrepreneurial process

2 Describe entrepreneurship and some characteristics of entrepreneurs

3 Indicate three megatrends providing waves of entrepreneurial opportunities

4 List and describe the seven principles of entrepreneurial finance

5 Discuss entrepreneurial finance and the role of the financial manager

6 Describe the various stages of a successful venture’s life cycle

7 Identify, by life cycle stage, the relevant types of financing and investors

8 Understand the life cycle approach used in this book

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It is estimated that more than one million new businesses are started in the United

States each year The Office of Advocacy of the United States Small BusinessAdministration (SBA) documents that “employer firm births” have exceeded600,000 annually in recent years.1 Reasonable estimates place non-employer (e.g., singleperson or small family) businesses started each year at a similar number In addition tothese formally organized startups, countless commercial ideas are entertained andabandoned without the benefit of a formal organization The incredible magnitude ofpotential entrepreneurial opportunities is a clear reflection of the commercial energyfostered by a market economy We believe that the time spent on this book’s treatment

of financial tools and techniques may be one of the more important investments youmake

From the Headlines

Small Wind Gets a Gust from CLEANtricity Power

According to a recent poll, 89% of U.S

vo-ters, including 84% of Republicans, 88% of

Independents, and 93% of Democrats,

be-lieve that increasing the amount of energy

their nation gets from wind is a good idea.1

While these voters and their parties find

plenty of issues on which they vehemently

disagree, there is little doubt that the United

States and the world will continue to

in-crease its efforts to harvest energy from

the wind In 2008, 42% of all new generating

capacity in the United States came from

wind, up from only 2% in 2004.2

Much of the public’s attention has been

focused on large-scale wind farming,

com-plete with landscape photos of rows of

tow-ering wind turbines sporting massive

propellers Less in the limelight, but every

bit as much in the game, are ventures

target-ing small-scale wind turbine electricity

gen-eration Like their cousins in other renewable

energy categories, including those working

with micro biofuel and solar energy

produc-tion, small-scale wind energy generation

ventures are contributing to the debate on

viable paths forward in the renewable

en-ergy markets.

CLEANtricity Power, located in

Broom-field, Colorado, is one of the new players

in the “small wind market.” The American

Wind Energy Association characterizes that

market by the target customers and the rated capacity of the generating technology:

Small wind turbines are electric rators that utilize wind energy to pro- duce clean, emissions-free power for individual homes, farms, and small businesses With this simple and in- creasingly popular technology, indivi- duals can generate their own power and cut their energy bills while helping

gene-to protect the environment The United States leads the world in the produc- tion of small wind turbines, which are defined as having rated capacities of

100 kilowatts and less, and the market

is expected to continue strong growth

CLEANtricity’s intent is to manufacture small-scale wind turbines that “enable indivi- duals, businesses, and communities to gener- ate reliable, affordable clean energy where they use it.” Their current product offering, known as the SHAPEshifter, is a vertical-axis self-adjusting wind turbine capable of electric- ity generation at lower wind speeds than the usual 30 miles per hour targeted by competing technology It accomplishes this versatility by morphing into a more efficient shape depend- ing on the speed of the wind Co-founder and chief executive officer Daniel Sullivan sum-

marizes this capability as “it’s large in low winds and small in high winds…the blades move naturally to their optimum position.”4Given that North American wind speeds at

60 feet above ground only average 7.3 miles per hour, SHAPEshifter’s functionality at lower speeds and its ability to adapt to higher speeds offer a potentially important advantage

in the small-scale wind generation market.

CLEANtricity is a self-funded 2009 startup and was one of twelve semifinalists at the 2009 Rocky Mountain Region Clean Tech Open At the time we met with them with prototype, provisional patent, and field tests in hand, they were seeking $2 million in external financing.

1 American Wind Energy Association press release, April 22, 2010, citing poll conducted by Neil New- house of Public Opinion Strategies and Anna Ben- nett of Bennett, Petts & Normington; press release available at http://www.awea.org/newsroom/

SECTION 1.1THE ENTREPRENEURIAL PROCESSThe entrepreneurial process comprises: developing opportunities, gathering resources,and managing and building operations, all with the goal of creating value Figure 1.1provides a graphical depiction of this process Many entrepreneurship students have for-mulated ideas for possible new products and services However, prior to committing sig-nificant time and resources to launching a new venture, it can really pay to take the timeand effort to examine the feasibility of an idea, screen it as a possible venture opportu-nity, analyze the related competitive environment, develop a sound business model, andprepare a convincing business plan.

The second aspect of a successful entrepreneurial process involves gathering the ical assets, intellectual property, human resources, and financial capital necessary tomove from opportunity to entrepreneurial venture The venture should organize formallyand legally, the process of which also provides an opportunity for founders to build con-sensus for the new venture’s boundaries of authority and basic ethical framework Everystartup needs“seed” financing and must have a strategy for acquiring it

phys-The third piece of the entrepreneurial process is managing and building the venture’soperations An effective business model must generate revenues to cover operating costs

in the foreseeable future Eventually, a growing venture will also need to provide enoughcash flow to cover planned expansion and reinvestment Additional financing rounds,possibly including those available through public securities offerings, may be necessaryfor growth in later years

Figure 1.1 depicts an intersection of all three components—creating value Each of thecomponents contributes to the overall value As a reminder of the wider context, weplace the components and their intersection in the context of the venture’s economic,legal, and social environment

entrepreneurial

process

developing opportunities,

gathering resources, and

managing and building

operations with the goal

of creating value

FIGURE 1.1 THE ENTREPRENEURIAL PROCESS

Creating Value Managing and

Building Operations

Developing Opportunities

Gathering Resources Economic, Legal, and Social Environment

Chapter 1: Introduction and Overview 5

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CONCEPT CHECK Q What are the components of the entrepreneurial process?

SECTION 1.2ENTREPRENEURSHIP FUNDAMENTALSSuccessful entrepreneurs recognize and develop viable business opportunities, have con-fidence in the market potential for their new products and services, and are committed

to“running the race.” They keep success in sight even when others may have difficultyfocusing

Who Is an Entrepreneur?

After working for a large corporation for nearly five years, you are considering launching

a Web-based business Product development and testing require financing that exceedsyour limited personal resources How much external financing do you need to make acredible attempt with the new venture? How much of the venture’s ownership will youhave to surrender to attract this initial financing?

A friend of yours, who graduated from college three years ago, started a new business

on the conviction that pumpkin stencils and special carving knives could foster an precedented commercial exploration of the market for Halloween crafts Her firm hasexperienced phenomenal growth and is seeking financing for this season’s inventorystockpiling Do her options differ from yours? Do the possible investors for your startupand her later-stage venture move in the same circles?

un-Your neighbor is the chief executive officer (CEO) of a large firm founded twenty yearsago He has accumulated enormous paper wealth and, before retirement, wishes to diversifyhis investments How do your neighbor’s investment goals and your financial needs relate toone another? Is your neighbor a reasonable prospect for startup funding, or is he morelikely to spend the money he has allocated for earlier-stage investing on his own idea for anew product? Does he see himself as an entrepreneur or as one who wants to enable andprofit from other entrepreneurs?

Who will succeed? Who will fail? Who is an entrepreneur? Your pumpkin-carvingfriend? Your CEO neighbor? You? All of you or none of you? We offer no infallible formula

or process for entrepreneurial success None exists We cannot tell you if you should drop aFortune 500 career track and take up drinking from the entrepreneurial fire hose We have

no blueprint for the ideal entrepreneur and no screening device to test for the ial gene Even if we had such a test, rest assured that for many who test positive, the newsmight not be welcome, particularly to friends and family The ups and downs of the en-trepreneurial lifestyle are difficult for those supporting the entrepreneur financially and emo-tionally Nonetheless, we believe that the tools and techniques we introduce can helpentrepreneurs and others anticipate venture challenges, navigate through shortfalls, andachieve important milestones Fortunately for the entrepreneur, employees, backers, andtheir families, these tools and techniques can help smooth out an inevitably bumpy ride

entrepreneur-Basic DefinitionsWhile the academic definition of“entrepreneurship” has evolved, it is useful to formalizeour context for the term Jeffry Timmons and Stephen Spinelli suggest that “entre-preneurship is a way of thinking, reasoning, and acting that is opportunity obsessed,holistic in approach, and leadership balanced for the purpose of value creation and

capture.”2 We adopt a somewhat shorter definition: Entrepreneurship is the process ofchanging ideas into commercial opportunities and creating value An entrepreneur is anindividual who thinks, reasons, and acts to convert ideas into commercial opportunitiesand to create value Whether entrepreneurial efforts succeed or fail, an entrepreneur’smission is to find economic opportunities, convert them into valuable products and ser-vices, and have their worth recognized in the marketplace.

Q Who is an entrepreneur?

Entrepreneurial Traits or CharacteristicsWhile we want to avoid most generalizations about entrepreneurial traits or characteris-tics, there are three we consider important First, successful entrepreneurs recognize andseize commercial opportunities, frequently before others even have an inkling of theirpotential Mark Twain once said, “I was seldom able to see an opportunity, until itceased to be one.” Second, successful entrepreneurs tend to be doggedly optimistic Theglass is never“half empty” and usually not even “half full.” It is “full,” and they are ready

to call for more glasses Third, successful entrepreneurs are not consumed entirely withthe present Their optimism is conditional They know that certain events need to takeplace for this optimism to be justified They do not treat venture planning as the enemy

Seeing a (conditionally) bright future, successful entrepreneurs plan a way to get thereand begin to construct paths to obtain the required physical, financial, and humanresources

While there are caricatures, there is no prototypical entrepreneur Many authors havetried to identify specific characteristics of successful entrepreneurs, but accurate general-izations have eluded them There are numerous myths about entrepreneurs.3 One hearsthat“entrepreneurs are born, not made.” Yet many successful entrepreneurs have been,

or will be, failing entrepreneurs if observed at different times in their lives While fying the fear of failure as a personal motivation propelling them forward, successful en-trepreneurs are not paralyzed by this fear If you see venture bumps as opportunitiesrather than obstacles, perhaps the entrepreneurial lifestyle is right for you

Opportunities Exist But Not Without Risks

If you feel the entrepreneurship bug biting, you are not alone Remember, the annual ber of new U.S business formations runs in the millions Small and growing enterprisesare critical to the U.S economy; small firms provide 60 to 80 percent of net new jobs.4Firms with fewer than 500 employees represent more than 99 percent of all employersand employ over half of the private workforce They are responsible for about half of theprivate gross domestic product During the past century, entrepreneurial firms’ innovations

num-2 Jeffry A Timmons and Stephen Spinelli, New Venture Creation, 8th ed (New York: McGraw-Hill/Irwin, num-2009), p 101.

individual who thinks,

reasons, and acts to convert

ideas into commercial

opportunities and to create

value

3 Timmons and Spinelli address seventeen myths and realities about entrepreneurs and summarize prior efforts to tify characteristics of successful entrepreneurs Ibid., pp 59–60.

iden-4 Small Business Economic Indicators (Washington, DC: U.S Small Business Administration, Office of Advocacy, 200iden-4).

An electronic version of the study including tables is available at http://sba.gov/advo/press/04-26.html.

Chapter 1: Introduction and Overview 7

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included personal computers, heart pacemakers, optical scanners, soft contact lenses, anddouble-knit fabric Entrepreneurial firms have long been major players in high-technologyindustries, where small businesses account for over one-fourth of all jobs and over one-half

of U.S innovations and new technologies Small high-technology firms are responsible fortwice as many product innovations per employee, and obtain more patents per sales dollar,than large high-technology firms One government study suggests that some of the fastestgrowing opportunities for small businesses are in the restaurant industry, medical and den-tal laboratories, residential care industries (housing for the elderly, group homes, etc.),credit reporting, child daycare services, and equipment leasing.5

As much as we would like to encourage your entrepreneurial inclinations, it would beirresponsible for us to imply that starting and successfully operating a business is easy

As a basic financial principle, risk and return go together—the expectation of higher turns is accompanied by higher risks According to the SBA’s Office of Advocacy, for theyears 2005 to 2007 employer firm births were estimated to be 659,093 per year For thesame period, employer firm terminations averaged 578,793 annually In 2008, however,the estimated number of small business starts was below trend at 627,200, while the esti-mated number of closures was above trend at 595,600 Although bankruptcies averagedonly 29,073 per year in 2005 to 2007, they rose to 43,456 in 2008.6

re-Phillips and Kirchhoff, using Dun & Bradstreet data, found that 76 percent of newfirms were still in existence after two years of operation Forty-seven percent of newfirms survived four years, and 38 percent were still operating after six years.7 In a morerecent study of the U.S Census Bureau’s Business Information Tracking Series, BrianHeadd found similar results Sixty-six percent of new employers survived two years,

50 percent were still in existence after four years, and 40 percent survived at least sixyears Headd also studied the U.S Census Bureau’s Characteristics of Business Ownersdatabase, which surveyed owners of closed firms on whether the owners felt their firmswere successful or unsuccessful at the time of closure The evidence suggests that aboutone-third of closed businesses were successful at closure Thus, instead of closing due tobankruptcy, many owners may have exited their businesses by retiring or selling.8Nearly half of business failures are due to economic factors such as inadequate sales,insufficient profits, or industry weakness Of the remainder, almost 40 percent cite finan-cial causes, such as excessive debt and insufficient financial capital Other reasons includeinsufficient managerial experience, business conflicts, family problems, fraud, anddisasters.9

Although the risks associated with starting a new entrepreneurial venture are large,there is always room for one more success Successful entrepreneurs are able to antici-pate and overcome the business risks that cause others to fail While hard work and alittle luck will help, an entrepreneur must be able to finance and manage the venture

Commercial vision, an unrelenting drive to succeed, the ability to build and engage amanagement team, a grasp of the risks involved, and a willingness to plan for the futureare some of the ingredients for success

5 “Small Business Answer Card” and “The Facts about Small Business” (Washington, DC: U.S Small Business Administration, Office of Advocacy, 2000).

6 The Small Business Economy, http://www.sba.gov/advo/research/sb_econ2009.pdf.

7 B Phillips and B.A Kirchhoff, “Formation, Growth and Survival: Small Firm Dynamics in the U.S Economy,” Small Business Economics 1 (1989): pp 65–74.

8 Brian Headd, “Redefining Business Success: Distinguishing Between Closure and Failure,” Small Business Economics

21 (2003): pp 51–61.

9 “Small Business Answer Card” and “The Facts About Small Business.”

CONCEPT CHECK Q What percentage of new businesses survive four years of operation?Q What are some of the major reasons why small businesses fail?

SECTION 1.3SOURCES OF ENTREPRENEURIAL OPPORTUNITIES

Entrepreneurs are the primary engine of commercial change in the global economy

Entrepreneurial opportunities are ideas that have the potential to create value throughnew, repackaged, or repositioned products, markets, processes, or services One study ofInc magazine’s 500 high-growth firms suggests that about 12 percent of founders feel theirfirms’ successes are due to extraordinary ideas, whereas the remaining 88 percent feel theirfirms’ successes are due to exceptional execution of ordinary ideas.10In a separate survey,Amar Bhide found that Inc 500 founders often make use of existing ideas originating intheir prior work experiences Only 6 percent of his responding founders indicate that“nosubstitutes were available” for their products or services In contrast, 58 percent say theysucceeded even though competitors offer“identical or close substitutes.”11

Megatrends are large societal, demographic, or technological trends or changes thatare slow in forming but, once in place, continue for many years In contrast, fads arenot predictable, have short lives, and do not involve macro changes Of course, thereare many degrees between fads and megatrends that provide entrepreneurs with businessopportunities However, while entrepreneurial opportunities can come from an almostunlimited number of sources, we give special focus to the following three megatrendcategories:

Q Societal trends or changes

Q Demographic trends or changes

Q Technological trends or changes

Q Crises and“bubbles”

Societal ChangesMany entrepreneurial endeavors are commercial reflections of broader societal changes

In 1982, John Naisbitt identified several major or megatrends shaping U.S society andthe world.12Naisbitt recognized that the U.S economy, by the early 1980s, centered onthe creation and distribution of information He argued that successful new technologieswould center on the human response to information Many of the commercial opportu-nities in the past two decades have capitalized on information creation and organizationand its central role in human decision support

entrepreneurial

opportunities

ideas with potential to create

value through different or

10 J Case, “The Origins of Entrepreneurship,” Inc., June 1989, p 51.

11 Amar V Bhide, The Origin and Evolution of New Businesses (New York: Oxford University Press, 2000).

12 John Naisbitt, Megatrends (New York: Warner Books, 1982) Although only two are presented here, Naisbitt identified six additional megatrends For a follow-up look at the megatrends shaping our society, see John Naisbitt and Patricia Aburdene, Megatrends 2000 (New York: Morrow, 1990) In a 2007 article in Entrepreneur magazine, five forces that shaped the face of entrepreneurship over the past three decades were identified as technology (the computer), the Internet (a network to link computers), globalization (everyone can sell worldwide), baby boomers (question-authority attitudes), and individualism (corporate restructurings forced individuals to look out for themselves) See Carol Tice,

“Change Agents,” Entrepreneur (May 2007), pp 65–67.

Chapter 1: Introduction and Overview 9

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Naisbitt also recognized that the United States was increasingly affected by a globaleconomy and that Americans were rekindling the entrepreneurial spirit It is now clearthat almost all businesses face international competition and that the pace of entrepre-neurial innovation is increasing throughout the world To succeed in such an environ-ment requires an understanding of current megatrends and the anticipation of newones While many possible trends are candidates for spawning entrepreneurial innova-tion, two that will undoubtedly influence future commercial opportunities are thedemographic shifts associated with the baby boom generation and our increasinglyinformation-oriented society.

Social, economic, and legal changes may occur within pervasive trends Social changesare reflected in important changes in preferences about clothing styles, food (e.g., gluten-free diets), travel and leisure, housing, and so forth An anticipation of social change isthe genesis of many entrepreneurial opportunities as innovators position themselves tosatisfy the demand for the related new products and services Economic shifts—the rise

of two-career families, higher disposable incomes, changing savings patterns—also gest entrepreneurial opportunities Changes in our legal environment can introduce im-portant economic opportunities by eliminating existing barriers to entry For example,deregulation in the banking, transportation, and telecommunications industries has al-lowed entrepreneurs to provide cost-efficient, demand-driven alternatives

Demographic ChangesOne major demographic trend continuing to shape the U.S economy is the aging of theso-called “baby boom generation.” In 1993, Harry Dent documented major generationwaves in the United States during the twentieth century.13By far, the most important gen-eration wave is the baby boom After World War II, from 1946 to 1964, an unprecedentednumber of babies, approximately 79 million, were born in the United States As this gen-eration has aged, it has repeatedly stressed the U.S infrastructure In the 1950s and 1960s,

it overloaded public school systems from kindergarten through high school By the 1970sand early 1980s, a period sometimes referred to as their innovation wave, boomers wereheavily involved in developing, innovating, and adopting new technologies

Dent estimates that the boomers’ spending wave started in the early 1990s and peaked

in the late 1990s and the first part of the twenty-first century The tremendous expansion

in the stock and bond markets during the 1980s and 1990s was, in part, due to the theseanticipated innovation and spending waves Dent projects that the organization, orpower, wave, where boomers dominate top managerial positions and possess the accu-mulated wealth to influence corporate America, will peak sometime in the 2020s

For the entrepreneurially inclined, the good news is that the boomers continue tospend at record levels;“consumer confidence” is a key ingredient to America’s continuedprosperity and expansion Financing continues to be available for solid business oppor-tunities Venture investing, although initially reeling after the decline at the turn of thiscentury and the subsequent recession, is recovering The aging boomers, with their earn-ing and consumption power, continue to provide enduring business opportunities Many

of the successful entrepreneurial ventures will provide goods and services tailored to thisaging, and wealthy, generation There will undoubtedly be other business opportunities

13 Harry S Dent, Jr., The Great Boom Ahead (New York: Hyperion, 1993) Also see Harry S Dent, Jr., The Roaring 2000s (New York: Simon & Schuster, 1998).

relating to as-yet unlabeled subsets of consumers Entrepreneurs with the ability to derstand demographic shifts, and see the resulting new business opportunities, will writetheir own success stories.

Technological ChangesTechnological change may be the most important source of entrepreneurial opportu-nities.14While the accurate dating of the arrival of major technological innovations is dif-ficult, it is reasonable to say that the genesis of our information society was in the mid tolate 1950s and early 1960s Transatlantic cable telephone service began The Soviet Unionlaunched Sputnik, suggesting the possibility of global satellite communications Transistorsreplaced vacuum tubes in computers Compilers opened the door to higher-level program-ming languages, and the development of the computer“chip” was under way

Perhaps the most important invention in shuttling us from an industrial society to aninformation society was the computer chip.15Such chips are the backbone of all moderncomputing and enable the telecommunications applications and information systems thathave changed the way almost everyone lives The worldwide distribution of computer chips(and the software systems running on them) has paved the way for what may be the mostsignificant innovation in global commerce since the merchant ship: the Internet The Inter-net is an incredibly diffuse collection of computers networked together It is hard to think

of anything else in history that parallels the level of international coordination (individualsand entities) that the Internet has almost painlessly achieved, and in a remarkably shorttime.16 When the Internet’s ability to provide nearly instant worldwide communicationwas combined with rapid transfer of graphic images, the Internet became the infrastructurefor the “World Wide Web,” a user-friendly and commercially attractive foundation formany new ways of doing business, including retail and wholesale operations through elec-tronic commerce In addition to the Web’s commercial applications, the Internet has dra-matically changed the way almost everyone goes about daily business Internet functionalityaffects modern life in almost uncountable ways, including such common things as elec-tronic mail (e-mail), remote access, large file transfer (including pictures, music, andvideos), instant messaging, and, more recently, cell phone–Web cross-functionality

14 For example, see Scott Shane, “Explaining Variation in Rates of Entrepreneurship in the United States: 1899–1988,”

Journal of Management 22 (1996): pp 747–781; and Scott Shane, “Technology Opportunities and New Firm Creation,”

Management Science 47 (2001): pp 205–220.

15 The U.S Patent Office appears to recognize Jack Kilby and Robert Noyce as the computer chip’s co-inventors Kilby conducted research at Texas Instruments during the 1950s and filed for the first “computer chip” patent Noyce filed after Kilby, but supposedly had a more useful design Noyce later cofounded the Intel Corporation See Lee Gomes,

“Paternity Suits Some Better Than Others in the Invention Biz,” Wall Street Journal, June 18, 1999, pp A1, A10.

16 The Internet had its beginning in late 1969 when researchers at UCLA, including Professor Leonard Kleinrock and uate students Stephen Crocker and Vinton Cerf, linked two computers for purposes of exchanging data This initial network project, supported by the Department of the Defense (DOD), was given the name Arpanet for Advanced Re- search Projects Agency Network Other milestones include the inventing of network e-mail in 1971 and the use of the “@” symbol in 1972 Cerf and Robert Kan invented the TCP protocol used in transporting data via the Internet in

grad-1974 In 1982, the “Internet” was defined as a series of TCP/IP networks that were connected In 1990, Tim Lee invented the World Wide Web, and Arpanet ceased to exist The commercial explosion really began after the cre- ation of modern server software, hypertext markup language (HTML), and browsers (such as Mosaic, Netscape, and Internet Explorer) See Anick Jesdanun, “Happy Birthday to the Internet,” Daily Camera, August 30, 2004, pp 1B, 5B.

Berners-The appendix in this chapter provides further information on the Internet’s structure and the various constituent tries that provide goods and services to support the Internet.

indus-Chapter 1: Introduction and Overview 11

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