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Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Marie C. Fields/Shutterstock.com Entrepreneurial Finance FOURTH EDITION J. CHRIS LEACH The University of Colorado at Boulder RONALD W. MELICHER The University of Colorado at Boulder Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. This is an electronic version of the print textbook. Due to electronic rights restrictions, some third party content may be suppressed. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. The publisher reserves the right to remove content from this title at any time if subsequent rights restrictions require it. For valuable information on pricing, previous editions, changes to current editions, and alternate formats, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword for materials in your areas of interest. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Entrepreneurial Finance, 4th Edition J. Chris Leach, Ronald W. Melicher Vice President of Editorial, Business: Jack W. Calhoun Publisher: Joe Sabatino Executive Editor: Mike Reynolds © 2012, 2009 South-Western, Cengage Learning ALL RIGHTS RESERVED. 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Macintosh and Power Macintosh are registered trademarks of Apple Computer, Inc. used herein under license. Cengage Learning WebTutor™ is a trademark of Cengage Learning. Library of Congress Control Number: 2010942267 Student Edition ISBN-13: 978-0-538-47815-1 Photo Researcher: Martha Hall/PreMedia Global Student Edition ISBN-10: 0-538-47815-2 Text permissions researcher: Christie Barros/PreMedia Global South-Western Cengage Learning 5191 Natorp Boulevard Mason, OH 45040 USA Cengage Learning products are represented in Canada by Nelson Education, Ltd. For your course and learning solutions, visit www.cengage.com Purchase any of our products at your local college store or at our preferred online store www.CengageBrain.com Printed in the United States 1 2 3 4 5 6 7 15 14 13 12 11 Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. To my wife Martha, our great joys Laura and John, and the Life we share J. CHRIS LEACH To my parents, William and Lorraine, and to my wife, Sharon, and our children, Michelle, Sean, and Thor RONALD W. MELICHER Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Marie C. Fields/Shutterstock.com Brief Contents PART 1 Background and Environment 1 CHAPTER 1 Introduction and Overview CHAPTER 2 From the Idea to the Business Plan PART 3 37 2 Organizing and Operating the Venture 79 CHAPTER 3 Organizing and Financing a New Venture CHAPTER 4 5 Measuring Financial Performance 119 Evaluating Financial Performance 151 CHAPTER PART 81 3 Planning for the Future 187 CHAPTER 6 Financial Planning: Short Term and Long Term CHAPTER 7 8 Types and Costs of Financial Capital 231 Securities Law Considerations When Obtaining Venture Financing CHAPTER PART 189 269 4 Creating and Recognizing Venture Value 313 CHAPTER 9 CHAPTER 10 PART 5 Valuing Early-Stage Ventures 315 Venture Capital Valuation Methods 361 Structuring Financing for the Growing Venture 405 CHAPTER 11 Professional Venture Capital 407 CHAPTER CHAPTER 12 13 Other Financing Alternatives 431 Security Structures and Determining Enterprise Values PART 6 Exit and Turnaround Strategies 457 493 CHAPTER 14 Harvesting the Business Venture Investment CHAPTER 15 Financially Troubled Ventures: Turnaround Opportunities? PART 7 495 529 Capstone Cases 563 CASE 1 Eco-Products, Inc. CASE 2 Coral Systems, Inc. CASE 3 Spatial Technology, Inc. 565 595 621 v Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Marie C. Fields/Shutterstock.com Contents Preface PART xvii 1 Background and Environment 1 CHAPTER 1 Introduction and Overview 3 1.1 The Entrepreneurial Process 5 1.2 Entrepreneurship Fundamentals Who Is an Entrepreneur? Basic Definitions 6 6 6 Entrepreneurial Traits or Characteristics 7 Opportunities Exist But Not Without Risks 1.3 Sources of Entrepreneurial Opportunities Societal Changes 7 9 9 Demographic Changes 10 Technological Changes Crises and “Bubbles” 11 12 1.4 Principles of Entrepreneurial Finance 14 Real, Human, and Financial Capital Must Be Rented from Owners (Principle #1) Risk and Expected Reward Go Hand in Hand (Principle #2) 14 14 While Accounting Is the Language of Business, Cash Is the Currency (Principle #3) 15 New Venture Financing Involves Search, Negotiation, and Privacy (Principle #4) A Venture’s Financial Objective Is to Increase Value (Principle #5) 15 16 It Is Dangerous to Assume That People Act Against Their Own Self-Interests (Principle #6) 17 Venture Character and Reputation Can Be Assets or Liabilities (Principle #7) 1.5 Role of Entrepreneurial Finance 1.6 The Successful Venture Life Cycle Development Stage Startup Stage 22 Survival Stage 22 20 21 Rapid-Growth Stage 22 Early-Maturity Stage 22 Life Cycle Stages and the Entrepreneurial Process 1.7 Financing Through the Venture Life Cycle Seed Financing 18 19 23 23 24 vii Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. viii Contents Startup Financing 25 First-Round Financing 26 Second-Round Financing Mezzanine Financing 26 27 Liquidity-Stage Financing Seasoned Financing 27 28 1.8 Life Cycle Approach for Teaching Entrepreneurial Finance Summary 28 31 CHAPTER 2 From the Idea to the Business Plan 37 2.1 Process for Identifying Business Opportunities 39 2.2 To Be Successful, You Must Have a Sound Business Model Component 1: The Plan Must Generate Revenues Component 2: The Plan Must Make Profits 40 40 41 Component 3: The Plan Must Produce Free Cash Flows 42 2.3 Learn From the Best Practices of Successful Entrepreneurial Ventures Best Marketing Practices Best Financial Practices 42 43 43 Best Management Practices 44 Best Production or Operations Practices Are Also Important 2.4 Time-To-Market and Other Timing Implications 44 45 2.5 Initial “Litmus Test” for Evaluating the Business Feasibility of an Idea 2.6 Screening Venture Opportunities 46 48 An Interview with the Founder (Entrepreneur) and Management Team: Qualitative Screening 49 Scoring a Prospective New Venture: Quantitative Screening Industry/Market Considerations 56 Pricing/Profitability Considerations Financial/Harvest Considerations 57 59 Management Team Considerations Opportunity Screening Caveats 61 62 2.7 Key Elements of a Business Plan 63 Cover Page, Confidentiality Statement, and Table of Contents Executive Summary Business Description 65 Operations and Support 65 65 66 Financial Plans and Projections Risks and Opportunities 67 Business Plan Appendix 68 Summary 63 65 Marketing Plan and Strategy Management Team 51 66 69 Appendix A Applying the VOS Indicator™: An Example 75 Copyright 2010 Cengage Learning. 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Contents PART ix 2 Organizing and Operating the Venture 79 CHAPTER 3 Organizing and Financing a New Venture 81 3.1 Progressing through the Venture Life Cycle 3.2 Forms of Business Organization Proprietorships 84 85 General and Limited Partnerships Corporations 82 87 90 Limited Liability Companies 92 3.3 Choosing the Form of Organization: Tax and Other Considerations 3.4 Intellectual Property 96 Protecting Valuable Intangible Assets 97 What Kinds of Intellectual Property Can Be Protected? 97 Other Methods for Protecting Intellectual Property Rights 3.5 Seed, Startup, and First-Round Financing Sources Financial Bootstrapping 106 Business Angel Funding 108 First-Round Financing Opportunities Summary 93 103 104 111 112 CHAPTER 4 Measuring Financial Performance 119 4.1 Obtaining and Recording the Resources Necessary to Start and Build a New Venture 121 4.2 Business Assets, Liabilities, and Owners’ Equity Balance Sheet Assets 123 Liabilities and Owners’ Equity 4.3 Sales, Expenses, and Profits 4.5 Statement of Cash Flows 125 126 4.4 Internal Operating Schedules 128 131 4.6 Operating Breakeven Analyses Survival Breakeven 122 133 134 Identifying Breakeven Drivers in Revenue Projections Summary 138 140 Appendix A NOPAT Breakeven: Revenues Needed to Cover Total Operating Costs 147 CHAPTER 5 Evaluating Financial Performance 151 5.1 Users of Financial Performance Measures by Life Cycle Stage 5.2 Using Financial Ratios 152 154 Copyright 2010 Cengage Learning. 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Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. x Contents 5.3 Cash Burn Rates and Liquidity Ratios 156 Measuring Venture Cash Burn and Build Amounts and Rates Beyond Burn: Traditional Measures of Liquidity 158 Interpreting Cash-Related and Liquidity-Related Trends 5.4 Conversion Period Ratios 162 Interpreting Changes in Conversion Times 164 166 Measuring Financial Leverage 166 Interpreting Changes in Financial Leverage 5.6 Profitability and Efficiency Ratios 169 169 Income Statement Measures of Profitability Efficiency and Return Measures 169 171 Interpreting Changes in Profitability and Efficiency 5.7 Industry Comparable Ratio Analysis PART 173 174 5.8 A Hitchhiker’s Guide to Financial Analysis Summary 160 161 Measuring Conversion Times 5.5 Leverage Ratios 157 175 177 3 Planning for the Future 187 CHAPTER 6 Financial Planning: Short Term and Long Term 189 6.1 Financial Planning Throughout the Venture’s Life Cycle 6.2 Surviving in the Short Run 191 192 6.3 Short-Term Cash-Planning Tools 194 6.4 Projected Monthly Financial Statements 199 6.5 Cash Planning from a Projected Monthly Balance Sheet 6.6 Beyond Survival: Systematic Forecasting Forecasting Sales for Seasoned Firms 201 202 203 Forecasting Sales for Early-Stage Ventures 205 6.7 Estimating Sustainable Sales Growth Rates 209 6.8 Estimating Additional Financing Needed to Support Growth The Basic Additional Funds Needed Equation Impact of Different Growth Rates on AFN Estimating the AFN for Multiple Years 213 215 216 6.9 Percent-of-Sales Projected Financial Statements Forecasting Sales 212 216 217 Projecting the Income Statement Projecting the Balance Sheet 217 219 Forecasting the Statement of Cash Flows 220 Financing Cost Implications Associated with the Need for Additional Funds Summary 222 223 Copyright 2010 Cengage Learning. 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Contents xi CHAPTER 7 Types and Costs of Financial Capital 231 7.1 Implicit and Explicit Financial Capital Costs 7.2 Financial Markets 233 233 7.3 Determining the Cost of Debt Capital 235 Determinants of Market Interest Rates 236 Risk-Free Interest Rate 237 Default Risk Premium 238 Liquidity and Maturity Risk Premiums A Word on Venture Debt Capital 7.4 What Is Investment Risk? 241 243 244 Measuring Risk as Dispersion Around an Average Historical Return versus Risk Relationships 7.5 Estimating the Cost of Equity Capital 247 250 Cost of Equity Capital for Public Corporations Cost of Equity Capital for Private Ventures Sources and Costs of Venture Equity Capital 7.6 Weighted Average Cost of Capital 250 252 254 257 A Life Cycle–Based WACC Example Summary 244 257 259 Appendix A Using WACC to Complete the Calibration of EVA 267 CHAPTER 8 Securities Law Considerations When Obtaining Venture Financing 269 8.1 Review of Sources of External Venture Financing 8.2 Overview of Federal and State Securities Laws Securities Act of 1933 271 273 273 Securities Exchange Act of 1934 274 Investment Company Act of 1940 Investment Advisers Act of 1940 274 275 State Securities Regulations: “Blue-Sky” Laws 275 8.3 Process for Determining Whether Securities Must Be Registered Offer and Sale Terms What Is a Security? 276 276 277 8.4 Registration of Securities under the Securities Act of 1933 8.5 Security Exemptions from Registration under the 1933 Act 279 282 8.6 Transaction Exemptions from Registration under the 1933 Act Private Offering Exemption 284 285 Accredited Investor Exemption 286 8.7 SEC’s Regulation D: Safe-Harbor Exemptions 287 Rule 504: Exemption for Limited Offerings and Sales of Securities Not Exceeding $1 Million 287 Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. xii Contents Rule 505: Exemption for Limited Offers and Sales of Securities Not Exceeding $5 Million 289 Rule 506: Exemption for Limited Offers and Sales Without Regard to Dollar Amount of Offering 290 8.8 Regulation A Security Exemption Summary 291 292 Appendix A Schedule A 295 Appendix B Selected SEC Regulation D Materials 299 Appendix C Other Forms of Registration Exemptions and Breaks PART 310 4 Creating and Recognizing Venture Value 313 CHAPTER 9 Valuing Early-Stage Ventures 315 9.1 What Is a Venture Worth? Does the Past Matter? 317 Looking to the Future 317 316 Vested Interests in Value: Investor and Entrepreneur 318 9.2 Basic Mechanics of Valuation: Mixing Vision and Reality Present Value Concept 319 319 If You’re Not Using Estimates, You’re Not Doing a Valuation Divide and Conquer with Discounted Cash Flow 9.3 Required Versus Surplus Cash 321 322 325 9.4 Developing the Projected Financial Statements for a DCF Valuation 9.5 Just-in-Time Equity Valuation: Pseudo Dividends 9.6 Accounting versus Equity Valuation Cash Flow Origins of Accounting Cash Flows 338 338 From Accounting to Equity Valuation Cash Flows Summary 327 331 338 343 CHAPTER 10 Venture Capital Valuation Methods 361 10.1 Brief Review of Basic Cash Flow-Based Equity Valuations 10.2 Basic Venture Capital Valuation Method Using Present Values Using Future Values 367 368 10.3 Earnings Multipliers and Discounted Dividends 10.4 Adjusting VCSCs for Multiple Rounds First Round Second Round 363 364 368 370 371 371 Copyright 2010 Cengage Learning. 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Contents 10.5 Adjusting VCSCs for Incentive Ownership First Round 372 372 Second Round 373 Incentive Ownership Round 373 10.6 Adjusting VCSCs for Payments to Senior Security Holders 10.7 Introducing Scenarios to VCSCs Utopian Approach Mean Approach Summary PART xiii 373 375 375 377 381 5 Structuring Financing for the Growing Venture 405 CHAPTER 11 Professional Venture Capital 407 11.1 Historical Characterization of Professional Venture Capital 11.2 Professional Venture Investing Cycle: Overview 11.3 Determining (Next) Fund Objectives and Policies 11.4 Organizing the New Fund 414 415 11.5 Soliciting Investments in the New Fund 418 11.6 Obtaining Commitments for a Series of Capital Calls 11.7 Conducting Due Diligence and Actively Investing 11.8 Arranging Harvest or Liquidation 419 419 427 11.9 Distributing Cash and Securities Proceeds Summary 409 413 427 428 CHAPTER 12 Other Financing Alternatives 431 12.1 Facilitators, Consultants, and Intermediaries 12.2 Commercial and Venture Bank Lending 433 433 12.3 Understanding Why You May Not Get Debt Financing 12.4 Credit Cards 436 438 12.5 Small Business Administration Programs 439 Overview of What the SBA Does for Small Businesses Selected SBA Loan and Operating Specifics 12.6 Other Government Financing Programs 12.7 Receivables Lending and Factoring 439 441 445 446 12.8 Debt, Debt Substitutes, and Direct Offerings Vendor Financing: Accounts Payable and Trade Notes 448 Mortgage Lending 448 Traditional and Venture Leasing Direct Public Offers Summary 448 449 449 Appendix A Summary of Colorado Business Financial Assistance Options 453 Copyright 2010 Cengage Learning. 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Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. xiv Contents CHAPTER 13 Security Structures and Determining Enterprise Values 457 13.1 Common Stock or Common Equity 459 13.2 Preferred Stock or Preferred Equity 459 Selected Characteristics Convertible Preferreds 460 461 Conversion Value Protection 462 Conversion Protection Clauses 463 Conversion Price Formula (CPF) Market Price Formula (MPF) 13.3 Convertible Debt 464 464 466 13.4 Warrants and Options 467 13.5 Other Concerns about Security Design 472 13.6 Valuing Ventures with Complex Capital Structures: The Enterprise Method Summary PART 473 480 6 Exit and Turnaround Strategies 493 CHAPTER 14 Harvesting the Business Venture Investment 495 14.1 Venture Operating and Financial Decisions Revisited 14.2 Planning an Exit Strategy 498 14.3 Valuing the Equity or Valuing the Enterprise Relative Valuation Methods 14.5 Outright Sale 501 503 504 Family Members Managers 499 500 Dividing the Venture Valuation Pie 14.4 Systematic Liquidation 504 505 An Example 506 Employees 508 Outside Buyers 14.6 Going Public 509 511 Investment Banking 511 Some Additional Definitions 514 Other Costs in Issuing Securities Post-IPO Trading 515 516 Contemplating and Preparing for the IPO Process Summary 497 518 522 Copyright 2010 Cengage Learning. 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Contents xv CHAPTER 15 Financially Troubled Ventures: Turnaround Opportunities? 529 15.1 Venture Operating and Financing Overview 15.2 The Troubled Venture and Financial Distress Balance Sheet Insolvency Cash Flow Insolvency 531 531 533 533 Temporary versus Permanent Cash Flow Problems 15.3 Resolving Financial Distress Situations Operations Restructuring Asset Restructuring 538 540 Financial Restructuring 543 15.4 Private Workouts and Liquidations Private Workouts 535 536 544 544 Private Liquidations 545 Venture Example: Jeremy’s MicroBatch Ice Creams, Inc. 15.5 Federal Bankruptcy Law Bankruptcy Reorganizations 546 Reasons for Legal Reorganizations Legal Reorganization Process Bankruptcy Liquidations Summary PART 545 546 547 549 552 556 7 Capstone Cases 563 CASE 1 Eco-Products, Inc. 565 CASE 2 Coral Systems, Inc. 595 CASE 3 Spatial Technology, Inc. 621 Glossary Index 645 655 Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Marie C. Fields/Shutterstock.com Preface T he 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 ventures require financing—taking investors’ money today and expecting to return a significantly larger amount in the future. Typically the return comes from the venture’s public offering, sale, or merger. In the interim, the venture must manage its financial resources, communicate effectively with investors and partners, and create the harvest value expected by investors. TEXTBOOK MOTIVATION The purpose of the textbook is to introduce financial thinking, tools, and techniques adapted to the realm of entrepreneurship. We believe that, while much of traditional financial analysis may not be ideally suited to the venture context, there is great value in applying venture adaptations. This entrepreneurial finance text introduces the theories, knowledge, and financial tools an entrepreneur needs to start, build, and harvest a successful venture. Sound financial management practices are essential to a venture’s operation. The successful entrepreneur must know how and where to obtain the financing necessary to launch and develop the venture. Eventually, that same successful entrepreneur must know how and when to interact with financial institutions and regulatory agencies to take the venture to its potential 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 ventures typically begin with an initial development stage where the entrepreneurial team generates ideas and assesses the associated business opportunities. Most entrepreneurs realize that a business plan can greatly improve the chance that an idea will become a commercially viable product or service. Startup stage ventures focus on the formulation of a business model and plan. As marketing and selling products and services begins, survival stage ventures often refocus or restructure. Rapid growth stage ventures increase their momentum, and begin to demonstrate value creation. Maturity stage ventures typically look for ways to harvest the value created and provide a return to their investors. Each stage in the life cycle requires a specific understanding of the financial management tools and techniques, potential investors and their mindset, and the financial institutions supporting that venture stage. During the early stages of a venture’s life, cash management tools and survival planning are the dominant forms of financial analysis. Cash burn rates are very high and additional sources of financing are usually limited, making it critical for the successful venture to project and accommodate necessary operating costs. The need to measure and adjust investment in working capital and property, plant, and equipment is evident. The process of anticipating and xvii Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. xviii Preface accommodating costs and asset investments begins with the analysis of historical financial experience and then projects future financial positions using projected financial statements or their proxies. Successful ventures emerging from their survival stages can concentrate more on value creation and calibration. Consequently, our financial management emphases for this stage are valuation tools and techniques. Equally important as sound financial management practices is the need for the entrepreneur to understand the types and sources of financial capital and the related investment processes. During the development stage, seed financing usually comes from the entrepreneur’s personal assets and possibly from family and friends. Business angels and venture capitalists are important financing sources during the startup stage. First-round financing from business operations, venture capitalists, suppliers, customers, and commercial banks may be initiated during the survival stage. The rapid growth stage involves second-round, mezzanine, and liquidity stage financing from business operations, suppliers, customers, commercial banks, and investment bankers. Once a venture enters its maturity stage, seasoned financing replaces venture financing. Seasoned financing takes the form of cash flow from business operations, bank loans, and stocks and bonds issued with the assistance of investment bankers or others. Our approach is to introduce the types and sources of financial capital that become available as we progress through a successful venture’s life cycle. The successful entrepreneur must understand the legal environment regulating financial relationships between the venture, investors, and financial institutions including venture capital funds and investment banks. We cover the basic securities laws and regulatory agencies, particularly the Securities and Exchange Commission (SEC), relevant to the entrepreneur when considering how to obtain financial capital at each stage. To summarize, we take a comprehensive three-pronged stage-sensitive approach to entrepreneurial finance. Our coverage of entrepreneurship-adapted financial analysis and relevant institutional details provides a relevant financial analysis base for the entrepreneur 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 identify and explain the types and sources of financing available during the various stages and introduce the relevant legal and regulatory environment the entrepreneur must consider 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 property issues demonstrates important issues and concepts for the earliest stage ventures. Raising External Funds: Chapter 8’s (Securities Law Considerations When Obtaining Venture Financing) treatment of securities law introduces readers to the 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 and external 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 Valuation Methods) introduces representative multi-stage venture capital valuation methods Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Preface • • • xix and interprets them relative to more traditional procedures. It provides a unified example of traditional pre-money and post-money valuations and the shortcuts employed by many venture capitalists. Professional VCs: Chapter 11 (Professional Venture Capital) explores the historical development of venture capital and describes the professional venture investing cycle from determining the next fund objectives and policies to distributing cash and securities proceeds to investors. Harvest: Chapter 14 (Harvesting the Business Venture Investment) considers a wide range of venture harvest strategies including private sales (to outsiders, insiders, and family), transfers of assets, buyouts, and initial public offerings. Turnaround Opportunities: Chapter 15 (Financially Troubled Ventures: Turnaround Opportunities?) introduces important aspects of financial distress and alternative restructuring 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 course can 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. Recently, entrepreneurial finance cases have been available individually from the usual providers and in collected form in entrepreneurial case books. The second, or what we term the venture capital approach, emphasizes the money management aspects of financing entrepreneurial ventures. For this approach, we recommend supplementing the text treatments 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 executive MBA, we recommend concentrating on the text and using our capstone cases as focal points for integrating the venture financing perspective. We have also used this text for semester-long upper division (junior/senior-level) undergraduate courses involving finance and non-finance business majors. Most academic business programs require students to take basic background courses in both accounting and finance prior to upper division courses such as entrepreneurial finance. Chapters 9, 10, and 13 present a rigorous and conceptually advanced approach to financial valuation. Our experience is that these chapters provide the greatest intellectual challenge and require relatively sophisticated spreadsheet skills. The fourth edition of this textbook has been written to support two different approaches to the undergraduate entrepreneurial finance course. The more rigorous approach challenges undergraduate students by covering all 15 chapters including 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 or covered in a descriptive (no modeling or calculations) manner. For application, while the included 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 been covered in prerequisite courses or in instances when a review of the materials is warranted. The remainder of the text can be used without explicit coverage of this review material. Additionally, for some adopters, it may be advantageous to alter the sequencing and coverage of the securities law and investment banking material, depending on student backgrounds and other course offerings. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. xx Preface 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 Headlines” feature is provided in the end of chapter material. 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 or problem. Chapter 1 (Introduction and Overview) was substantially rewritten to reflect the current focus on environmentally friendly products and “clean tech” and “clean energy” 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 venture opportunities was added. Chapter 3 (Organizing and Financing a New Venture) includes updated personal and corporate income tax information and reorganized problems to follow chapter topics. Chapter 5 (Evaluating Financial Performance) was edited to improve the clarity of the cash burn discussion. We added new financial ratio problems and restructured the mini-case. Chapter 6 (Financial Planning: Short Term and Long Term) includes addition of problem 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 multiple approaches to free cash flow valuation methods. Some of the materials were moved into a Learning Supplement. Chapter 13 (Security Structures and Determining Enterprise Values) includes a substantially rewritten section on “Valuing Ventures with Complex Capital Structures: The Enterprise Method” with the focus on presenting one method consistent with Chapter 9. An alternative enterprise valuation method is now presented as Learning 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 requirements data. New Capstone Case: Eco-Products, Inc. We added a new case for a company that produces and sells environmentally sound food service products from renewable resources. The related early-stage financing decisions involve: (a) raising funds through a private placement memorandum, and (b) a proposed private placement with an investment firm utilizing a term sheet. Excerpts from the private placement memorandum and the term sheet are provided for student review and analysis. SUPPLEMENTS Instructor’s Manual with Test Bank Written by the text authors, the Instructor’s Manual includes short answers to endof-chapter questions and answers to end-of-chapter problems. The Test Bank includes true/false and multiple choice questions, as well as short test problems. Both Instructor’s Manual and Test Bank are available on the text Web site for instructors only. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Preface xxi PowerPoint Lecture Slides Created by the text authors, the PowerPoint slides present a point-by-point lecture outline, including graphics and equations, for instructors to use in the classroom. They are available on the text Web site for instructors only. Excel Solutions Excel Solutions to end-of-chapter problems requiring Excel are provided for instructors on the text Web site. Text Web Site The text Web site at www.cengagebrain.com provides access to these supplements. Acknowledgments During the several years we spent developing and delivering this material, we benefited from interactions with colleagues, students, entrepreneurs, and venture capitalists. We thank the numerous sections of students who became the sounding board for our presentation of this material. We also thank the members of the Venture Capital Association of Colorado who opened their professional lives and venture capital conferences to our students. Additionally, we have benefited from detailed valuable comments and input by Craig Wright and Michael Meresman. Clinton Talmo and Robert Donchez contributed to the preparation of the Instructor’s Manual. We recognize the moral support of the Deming Center for Entrepreneurship (Bob Deming, and directors Dale Meyer, Denis Nock, Kathy Simon, Steve Lawrence and Paul Jerde). We thank the Coleman Foundation for research support for the Coral Systems, Inc. and Spatial Technology, Inc. cases and the Educational Legacy Fund for research 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 enough to publish it; Mike Reynolds, our current Cengage Learning executive editor, and Adele Scholtz our developmental editor. Also, we’d like to thank our production manager, Tamborah Moore and our marketing manager, Nate Anderson. We also thank Martha Leach for research assistance behind the “From the Headlines” stories and for proofreading a complete version of this fourth edition. We thank Andre Gygax, Hardjo Koerniadi, and Cody Engle who provided several important corrections to previous materials. For their patience and insights offered during the process, we thank our colleagues who reviewed materials for this fourth edition or earlier editions of the text: Brian Adams, University of Portland MJ Alhabeeb, University of Massachusetts Olufunmilayo Arewa, Northwestern University David Choi, Loyola Marymount University Susan Coleman, University of Hartford David Culpepper, Millsaps College John Farlin, Ohio Dominican David Hartman, Central Connecticut State University William C. Hudson, St. Cloud State University Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. xxii Preface Narayanan Jayaraman, Georgia Tech Jeffrey June, Miami University Miranda Lam, Salem State College Michael S. Long, Rutgers University Michael Owens, University of Tennessee Chattanooga Robert Patterson, Westminster College Charles B. Ruscher, University of Arizona Steven R. Scheff, Florida Gulf Coast University Gregory Stoller, Boston College Srinivasan Sundaram, Ball State University Michael Williams, University of Denver Finally, to our families for their patience through four editions, we offer our sincere thanks. J. Chris Leach Ronald W. Melicher Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Marie C. Fields/Shutterstock.com About the Authors J. Chris Leach is Professor and Chair of the Finance Division and the Robert H. and Beverly A. Deming Professor in Entrepreneurship at the Leeds School of Business, University of Colorado at Boulder. He received a finance Ph.D. from Cornell University, began his teaching career at the Wharton School and has been a visiting professor at Carnegie Mellon, the Indian School of Business, and the Stockholm Institute for Financial Research (at the Stockholm School of Economics). His teaching experience includes courses for undergraduates, MBAs, Ph.D. students, and executives. He has been recognized as Graduate Professor of the Year and has received an award for MBA Teaching Excellence. His research on a variety of topics has been published in The Review of Financial Studies, Journal 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 in the 1970s. During his transition to the University of Colorado, he was the chairman of a New Mexico startup and later, as an investor and advisor, participated in a late 1990s Silicon Valley startup that subsequently merged into a public company. His consulting activities include business and strategic planning advising, valuation, and deal structure for early stage and small businesses. He is a faculty advisor for the Deming Center Venture Fund and a member of the Deming Center Board of Directors. MBA teams Chris has sponsored have qualified for six international championships of the Venture Capital Investment Competition. Ronald W. Melicher is Professor of Finance in the Leeds School of Business at the University of Colorado at Boulder. He earned his undergraduate, MBA, and doctoral degrees from Washington University in St. Louis, Missouri. While at the University of Colorado, he has received several distinguished teaching awards and was designated as a universitywide President’s Teaching Scholar. He also has held the William H. Baugh Distinguished Scholar 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 the Academic Chair of the three-campus Executive MBA Programs. Ron has taught entrepreneurial finance at both the MBA and undergraduate levels. He also teaches corporate finance and financial strategy in the MBA and Executive MBA programs and investment banking to undergraduate students. While on sabbatical leave from the University of Colorado, Ron has taught at the INSEAD Graduate School of Business in Fontainebleau, France and at the University of Zurich in Zurich, Switzerland. He has delivered numerous university-offered executive education non-credit courses and has taught in-house finance education materials for IBM and other firms. He has given expert witness testimony on cost of capital in regulatory proceedings and has provided consulting expertise 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 published in major finance journals including the Journal of Finance, Journal of Financial and Quantitative Analysis, and Financial Management. He is the co-author of Introduction to Finance: Markets, Investments, and Financial Management, Fourteenth Edition (John Wiley & Sons, 2011). xxiii Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. PART Background and Environment 1 Chapter 1 Introduction and Overview Chapter 2 © Marie C. Fields/Shutterstock.com From the Idea to the Business Plan 1 Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER Introduction and Overview 1 FIRST THOUGHTS Only those individuals with entrepreneurial experience can say, “Been there, done that!” With aspiring entrepreneurs in mind, we start at the beginning and consider how entrepreneurial finance relates to the other aspects and challenges of launching a new venture. Our goal is to equip you with the terms, tools, and techniques that can help turn a business idea into a successful venture. LOOKING AHEAD Chapter 2 focuses on the transformation of an idea into a business opportunity and the more formal representation of that opportunity as a business plan. Most successful ideas are grounded in sound business models. We present qualitative and quantitative screening exercises that can help determine an idea’s commercial viability. We provide a brief discussion of a business plan’s key elements. CHAPTER LEARNING OBJECTIVES This chapter presents an overview of entrepreneurial finance. We hope to convey the potential benefit of embracing standard entrepreneurial finance methods and techniques. We consider an entrepreneur’s operating and financial decisions at each stage, as the venture progresses from idea to harvest. After completing this chapter, you will be able to: 1. 2. 3. 4. 5. 6. 7. 8. Characterize the entrepreneurial process. Describe entrepreneurship and some characteristics of entrepreneurs. Indicate three megatrends providing waves of entrepreneurial opportunities. List and describe the seven principles of entrepreneurial finance. Discuss entrepreneurial finance and the role of the financial manager. Describe the various stages of a successful venture’s life cycle. Identify, by life cycle stage, the relevant types of financing and investors. Understand the life cycle approach used in this book. 3 Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 4 Part 1: Background and Environment From the Headlines Small Wind Gets a Gust from CLEANtricity Power According to a recent poll, 89% of U.S. voters, including 84% of Republicans, 88% of Independents, and 93% of Democrats, believe 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 increase 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, complete with landscape photos of rows of towering wind turbines sporting massive propellers. Less in the limelight, but every bit as much in the game, are ventures targeting small-scale wind turbine electricity generation. Like their cousins in other renewable energy categories, including those working with micro biofuel and solar energy production, small-scale wind energy generation ventures are contributing to the debate on viable paths forward in the renewable energy markets. CLEANtricity Power, located in Broomfield, Colorado, is one of the new players in the “small wind market.” The American Wind Energy Association characterizes that Small Business Administration (SBA) ............................ established by the federal government to provide financial assistance to small businesses market by the target customers and the rated capacity of the generating technology: Small wind turbines are electric generators that utilize wind energy to produce clean, emissions-free power for individual homes, farms, and small businesses. With this simple and increasingly popular technology, individuals can generate their own power and cut their energy bills while helping to protect the environment. The United States leads the world in the production 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 through the next decade.3 CLEANtricity’s intent is to manufacture small-scale wind turbines that “enable individuals, businesses, and communities to generate 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 electricity 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 depending 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.”4 Given 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 2 3 4 American Wind Energy Association press release, April 22, 2010, citing poll conducted by Neil Newhouse of Public Opinion Strategies and Anna Bennett of Bennett, Petts & Normington; press release available at http://www.awea.org/newsroom/ releases/04-22-10_Poll_Shows_Wind_Works_for_ Americans.html visited on 4/25/2010. American Wind Energy Association, “Wind, A Leading Source of New Electricity Generation,” http://www.awea.org/pubs/documents/Outlook_ 2009.pdf., visited on 4/25/2010. http://www.awea.org/smallwind/visitedon4/25/2010. Coloradobiz, December 2009, Tech Startup of the Month, pg. 58. This article is also available at http://www.cobizmag.com/articles/tech-startup1/. I t 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 Business Administration (SBA) documents that “employer firm births” have exceeded 600,000 annually in recent years.1 Reasonable estimates place non-employer (e.g., single person or small family) businesses started each year at a similar number. In addition to these formally organized startups, countless commercial ideas are entertained and abandoned without the benefit of a formal organization. The incredible magnitude of potential entrepreneurial opportunities is a clear reflection of the commercial energy fostered 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 you make. .............................. 1 The Office of Advocacy of the Small Business Administration (SBA) was created in 1976 by Congress to be an independent voice for small business within the federal government. Small business statistics are available at http:// www.sba.gov/advo/research/dyn_b_d8906.pdf. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 1: Introduction and Overview 5 SECTION 1.1 THE ENTREPRENEURIAL PROCESS entrepreneurial process ............................ developing opportunities, gathering resources, and managing and building operations with the goal of creating value FIGURE 1.1 The entrepreneurial process comprises: developing opportunities, gathering resources, and managing and building operations, all with the goal of creating value. Figure 1.1 provides a graphical depiction of this process. Many entrepreneurship students have formulated ideas for possible new products and services. However, prior to committing significant time and resources to launching a new venture, it can really pay to take the time and effort to examine the feasibility of an idea, screen it as a possible venture opportunity, analyze the related competitive environment, develop a sound business model, and prepare a convincing business plan. The second aspect of a successful entrepreneurial process involves gathering the physical assets, intellectual property, human resources, and financial capital necessary to move from opportunity to entrepreneurial venture. The venture should organize formally and legally, the process of which also provides an opportunity for founders to build consensus for the new venture’s boundaries of authority and basic ethical framework. Every startup needs “seed” financing and must have a strategy for acquiring it. The third piece of the entrepreneurial process is managing and building the venture’s operations. An effective business model must generate revenues to cover operating costs in the foreseeable future. Eventually, a growing venture will also need to provide enough cash flow to cover planned expansion and reinvestment. Additional financing rounds, possibly including those available through public securities offerings, may be necessary for growth in later years. Figure 1.1 depicts an intersection of all three components—creating value. Each of the components contributes to the overall value. As a reminder of the wider context, we place the components and their intersection in the context of the venture’s economic, legal, and social environment. THE ENTREPRENEURIAL PROCESS Economic, Legal, and Social Environment Developing Opportunities Creating Value Managing and Building Operations Gathering Resources Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 6 Part 1: Background and Environment CONCEPT CHECK Q What are the components of the entrepreneurial process? SECTION 1.2 ENTREPRENEURSHIP FUNDAMENTALS Successful entrepreneurs recognize and develop viable business opportunities, have confidence 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 difficulty focusing. 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 exceeds your limited personal resources. How much external financing do you need to make a credible attempt with the new venture? How much of the venture’s ownership will you have 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 unprecedented commercial exploration of the market for Halloween crafts. Her firm has experienced phenomenal growth and is seeking financing for this season’s inventory stockpiling. Do her options differ from yours? Do the possible investors for your startup and her later-stage venture move in the same circles? Your neighbor is the chief executive officer (CEO) of a large firm founded twenty years ago. He has accumulated enormous paper wealth and, before retirement, wishes to diversify his investments. How do your neighbor’s investment goals and your financial needs relate to one another? Is your neighbor a reasonable prospect for startup funding, or is he more likely to spend the money he has allocated for earlier-stage investing on his own idea for a new product? Does he see himself as an entrepreneur or as one who wants to enable and profit from other entrepreneurs? Who will succeed? Who will fail? Who is an entrepreneur? Your pumpkin-carving friend? 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 a Fortune 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 entrepreneurial gene. Even if we had such a test, rest assured that for many who test positive, the news might not be welcome, particularly to friends and family. The ups and downs of the entrepreneurial lifestyle are difficult for those supporting the entrepreneur financially and emotionally. Nonetheless, we believe that the tools and techniques we introduce can help entrepreneurs and others anticipate venture challenges, navigate through shortfalls, and achieve important milestones. Fortunately for the entrepreneur, employees, backers, and their families, these tools and techniques can help smooth out an inevitably bumpy ride. Basic Definitions While the academic definition of “entrepreneurship” has evolved, it is useful to formalize our context for the term. Jeffry Timmons and Stephen Spinelli suggest that “entrepreneurship 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 Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 1: Introduction and Overview entrepreneurship ............................ process of changing ideas into commercial opportunities and creating value CONCEPT CHECK 7 capture.”2 We adopt a somewhat shorter definition: Entrepreneurship is the process of changing ideas into commercial opportunities and creating value. An entrepreneur is an individual who thinks, reasons, and acts to convert ideas into commercial opportunities and to create value. Whether entrepreneurial efforts succeed or fail, an entrepreneur’s mission is to find economic opportunities, convert them into valuable products and services, and have their worth recognized in the marketplace. Q What is the meaning of entrepreneurship? Q Who is an entrepreneur? entrepreneur ............................ Entrepreneurial Traits or Characteristics individual who thinks, reasons, and acts to convert ideas into commercial opportunities and to create value While we want to avoid most generalizations about entrepreneurial traits or characteristics, there are three we consider important. First, successful entrepreneurs recognize and seize commercial opportunities, frequently before others even have an inkling of their potential. Mark Twain once said, “I was seldom able to see an opportunity, until it ceased to be one.” Second, successful entrepreneurs tend to be doggedly optimistic. The glass 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 with the present. Their optimism is conditional. They know that certain events need to take place 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 there and begin to construct paths to obtain the required physical, financial, and human resources. While there are caricatures, there is no prototypical entrepreneur. Many authors have tried to identify specific characteristics of successful entrepreneurs, but accurate generalizations have eluded them. There are numerous myths about entrepreneurs.3 One hears that “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 identifying the fear of failure as a personal motivation propelling them forward, successful entrepreneurs are not paralyzed by this fear. If you see venture bumps as opportunities rather than obstacles, perhaps the entrepreneurial lifestyle is right for you. CONCEPT CHECK Q What are some general traits or characteristics of entrepreneurs? Opportunities Exist But Not Without Risks If you feel the entrepreneurship bug biting, you are not alone. Remember, the annual number of new U.S. business formations runs in the millions. Small and growing enterprises are critical to the U.S. economy; small firms provide 60 to 80 percent of net new jobs.4 Firms with fewer than 500 employees represent more than 99 percent of all employers and employ over half of the private workforce. They are responsible for about half of the private gross domestic product. During the past century, entrepreneurial firms’ innovations .............................. 2 Jeffry A. Timmons and Stephen Spinelli, New Venture Creation, 8th ed. (New York: McGraw-Hill/Irwin, 2009), p. 101. 3 Timmons and Spinelli address seventeen myths and realities about entrepreneurs and summarize prior efforts to identify characteristics of successful entrepreneurs. Ibid., pp. 59–60. 4 Small Business Economic Indicators (Washington, DC: U.S. Small Business Administration, Office of Advocacy, 2004). An electronic version of the study including tables is available at http://sba.gov/advo/press/04-26.html. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 8 Part 1: Background and Environment included personal computers, heart pacemakers, optical scanners, soft contact lenses, and double-knit fabric. Entrepreneurial firms have long been major players in high-technology industries, 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 for twice 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 fastest growing opportunities for small businesses are in the restaurant industry, medical and dental 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 be irresponsible 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 returns is accompanied by higher risks. According to the SBA’s Office of Advocacy, for the years 2005 to 2007 employer firm births were estimated to be 659,093 per year. For the same 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 estimated number of closures was above trend at 595,600. Although bankruptcies averaged only 29,073 per year in 2005 to 2007, they rose to 43,456 in 2008.6 Phillips and Kirchhoff, using Dun & Bradstreet data, found that 76 percent of new firms were still in existence after two years of operation. Forty-seven percent of new firms survived four years, and 38 percent were still operating after six years.7 In a more recent study of the U.S. Census Bureau’s Business Information Tracking Series, Brian Headd 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 six years. Headd also studied the U.S. Census Bureau’s Characteristics of Business Owners database, which surveyed owners of closed firms on whether the owners felt their firms were successful or unsuccessful at the time of closure. The evidence suggests that about one-third of closed businesses were successful at closure. Thus, instead of closing due to bankruptcy, many owners may have exited their businesses by retiring or selling.8 Nearly 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 financial causes, such as excessive debt and insufficient financial capital. Other reasons include insufficient managerial experience, business conflicts, family problems, fraud, and disasters.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 anticipate and overcome the business risks that cause others to fail. While hard work and a little 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 a management team, a grasp of the risks involved, and a willingness to plan for the future are 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.” Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 1: Introduction and Overview CONCEPT CHECK 9 Q What percentage of new businesses survive four years of operation? Q What are some of the major reasons why small businesses fail? SECTION 1.3 SOURCES OF ENTREPRENEURIAL OPPORTUNITIES entrepreneurial opportunities ............................ ideas with potential to create value through different or new, repackaged, or repositioned products, markets, processes, or services Entrepreneurs are the primary engine of commercial change in the global economy. Entrepreneurial opportunities are ideas that have the potential to create value through new, repackaged, or repositioned products, markets, processes, or services. One study of Inc. magazine’s 500 high-growth firms suggests that about 12 percent of founders feel their firms’ successes are due to extraordinary ideas, whereas the remaining 88 percent feel their firms’ successes are due to exceptional execution of ordinary ideas.10 In a separate survey, Amar Bhide found that Inc. 500 founders often make use of existing ideas originating in their prior work experiences. Only 6 percent of his responding founders indicate that “no substitutes were available” for their products or services. In contrast, 58 percent say they succeeded even though competitors offer “identical or close substitutes.”11 Megatrends are large societal, demographic, or technological trends or changes that are slow in forming but, once in place, continue for many years. In contrast, fads are not predictable, have short lives, and do not involve macro changes. Of course, there are many degrees between fads and megatrends that provide entrepreneurs with business opportunities. However, while entrepreneurial opportunities can come from an almost unlimited number of sources, we give special focus to the following three megatrend categories: Q Q Q Q Societal trends or changes Demographic trends or changes Technological trends or changes Crises and “bubbles” Societal Changes Many entrepreneurial endeavors are commercial reflections of broader societal changes. In 1982, John Naisbitt identified several major or megatrends shaping U.S. society and the world.12 Naisbitt recognized that the U.S. economy, by the early 1980s, centered on the creation and distribution of information. He argued that successful new technologies would center on the human response to information. Many of the commercial opportunities in the past two decades have capitalized on information creation and organization and its central role in human decision support. .............................. 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. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 10 Part 1: Background and Environment Naisbitt also recognized that the United States was increasingly affected by a global economy and that Americans were rekindling the entrepreneurial spirit. It is now clear that almost all businesses face international competition and that the pace of entrepreneurial innovation is increasing throughout the world. To succeed in such an environment requires an understanding of current megatrends and the anticipation of new ones. While many possible trends are candidates for spawning entrepreneurial innovation, two that will undoubtedly influence future commercial opportunities are the demographic shifts associated with the baby boom generation and our increasingly information-oriented society. Social, economic, and legal changes may occur within pervasive trends. Social changes are reflected in important changes in preferences about clothing styles, food (e.g., glutenfree diets), travel and leisure, housing, and so forth. An anticipation of social change is the genesis of many entrepreneurial opportunities as innovators position themselves to satisfy the demand for the related new products and services. Economic shifts—the rise of two-career families, higher disposable incomes, changing savings patterns—also suggest entrepreneurial opportunities. Changes in our legal environment can introduce important economic opportunities by eliminating existing barriers to entry. For example, deregulation in the banking, transportation, and telecommunications industries has allowed entrepreneurs to provide cost-efficient, demand-driven alternatives. CONCEPT CHECK Q What are megatrends, and how do they introduce new commercial opportunities? Demographic Changes One major demographic trend continuing to shape the U.S. economy is the aging of the so-called “baby boom generation.” In 1993, Harry Dent documented major generation waves in the United States during the twentieth century.13 By far, the most important generation wave is the baby boom. After World War II, from 1946 to 1964, an unprecedented number of babies, approximately 79 million, were born in the United States. As this generation 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 1970s and early 1980s, a period sometimes referred to as their innovation wave, boomers were heavily 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 these anticipated innovation and spending waves. Dent projects that the organization, or power, wave, where boomers dominate top managerial positions and possess the accumulated wealth to influence corporate America, will peak sometime in the 2020s. For the entrepreneurially inclined, the good news is that the boomers continue to spend at record levels; “consumer confidence” is a key ingredient to America’s continued prosperity and expansion. Financing continues to be available for solid business opportunities. Venture investing, although initially reeling after the decline at the turn of this century and the subsequent recession, is recovering. The aging boomers, with their earning and consumption power, continue to provide enduring business opportunities. Many of the successful entrepreneurial ventures will provide goods and services tailored to this aging, 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). Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 1: Introduction and Overview 11 relating to as-yet unlabeled subsets of consumers. Entrepreneurs with the ability to understand demographic shifts, and see the resulting new business opportunities, will write their own success stories. CONCEPT CHECK Q What is meant by the term “baby boom generation”? Technological Changes Technological change may be the most important source of entrepreneurial opportunities.14 While the accurate dating of the arrival of major technological innovations is difficult, it is reasonable to say that the genesis of our information society was in the mid to late 1950s and early 1960s. Transatlantic cable telephone service began. The Soviet Union launched Sputnik, suggesting the possibility of global satellite communications. Transistors replaced vacuum tubes in computers. Compilers opened the door to higher-level programming languages, and the development of the computer “chip” was under way. Perhaps the most important invention in shuttling us from an industrial society to an information society was the computer chip.15 Such chips are the backbone of all modern computing and enable the telecommunications applications and information systems that have 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 most significant innovation in global commerce since the merchant ship: the Internet. The Internet 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 (individuals and entities) that the Internet has almost painlessly achieved, and in a remarkably short time.16 When the Internet’s ability to provide nearly instant worldwide communication was combined with rapid transfer of graphic images, the Internet became the infrastructure for the “World Wide Web,” a user-friendly and commercially attractive foundation for many new ways of doing business, including retail and wholesale operations through electronic commerce. In addition to the Web’s commercial applications, the Internet has dramatically changed the way almost everyone goes about daily business. Internet functionality affects modern life in almost uncountable ways, including such common things as electronic mail (e-mail), remote access, large file transfer (including pictures, music, and videos), 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 graduate 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 Research 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 1974. In 1982, the “Internet” was defined as a series of TCP/IP networks that were connected. In 1990, Tim BernersLee invented the World Wide Web, and Arpanet ceased to exist. The commercial explosion really began after the creation 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. The appendix in this chapter provides further information on the Internet’s structure and the various constituent industries that provide goods and services to support the Internet. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 12 Part 1: Background and Environment e-commerce ............................ the use of electronic means to conduct business online CONCEPT CHECK Electronic commerce, or e-commerce, involves the use of electronic means to conduct business online. Although many of the simple “dot.com” and “e-commerce” business models of the late 1990s did not work, the Internet economy and e-commerce are here to stay. Simply put, we will never do business the same way we did before the Internet. It has become too easy to compare various suppliers’ prices or check on the latest offer from our competitors to return to conducting business in the “darkness” tolerated only a few years ago. A simple example is online package tracking. Now, instead of using the phone to say a package is “in the mail,” the sender is expected to provide a tracking number to be used on the Web so that the sender and the receiver can ascertain the veracity of this claim and follow the package along its route. Attention continues to shift from the age-old strategy of owning and controlling natural resources (tangibles), to a strategy of owning and controlling information (intangibles). Even Internet entrepreneurs who started their ventures intending to sell products and services have sometimes found themselves giving their products and services away in order to monitor their “users” and sell user demographic information. Information is central in the modern global economy. While new technologies suggest business opportunities, profitable commercial application of the new technologies often occurs after trial and error. Many attempts to exploit the Internet commercially were proposed, tried, and funded. Eventually, there was a wave of potentially appealing applications—and the vision was contagious. We are still trying to determine the winners. That is, we know the Internet provides significant efficiency improvements for commercial interaction; we’re just not sure whether the winners are buyers, sellers, or both. The Web lets suppliers compete for consumers’ business, putting the consumer in an advantageous position. It is not clear whether this benefits suppliers in the long run. It is fair to say that many e-commerce business plans were funded with the belief that part of the benefit could be captured by sellers; that is, producers and retailers. We now know that the Web so effectively facilitates price competition that it is hard for suppliers and retailers to protect margins. Much of the efficiency gains go to the buyers (in what economists call consumer surplus), making for a less-than-attractive seller business model. Although such a plan might have received funding a few years ago, building an e-commerce site to sell nondifferentiated goods at lower prices than are currently available is now a nonstarter. An important characteristic of the Internet is that physical barriers to entry are very low. That is, it is easy and relatively low cost to launch a competing Web e-commerce site. If your business model doesn’t have a sustainable purchasing cost advantage, the Internet may help defeat your business model because it allows scores of other retailers to quickly monitor and replicate whatever you’re doing and drive everyone toward aggressive price competition and diminishing margins. E-commerce may not deliver the margins once conjectured, but the Internet is still one of the most radical innovations in our lifetime. Expect it to provide profitable new venture opportunities for many years to come—consumers are probably hooked forever. Q What innovations drove our move from an industrial society to an information society? Why? Q Why is e-commerce here to stay? Crises and “Bubbles” The first decade of the twenty-first century was characterized by extreme economic swings accompanied by, among other things, the bursting of several asset and financial Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 1: Introduction and Overview 13 “bubbles,” the 9/11 terrorist attack on the United States, and the 2007–2009 financial crisis. Cost-cutting coupled with economic growth during the 1990s led to the availability of excessive amounts of financial capital as the twentieth century came to an end. Venture investors were chasing poorer investment opportunities than those to which they had become accustomed. Stock prices of Internet or “tech” firms rose much faster than those firms’ abilities to generate earnings and cash flows. As a result, the “dot.com” or Internet bubble burst in 2000.17 Venture funding dried up to at a mere trickle relative to the amounts flowing during the dot.com era. Many entrepreneurs with good potential opportunities were unable to find funding. When the dot.com economy was faltering, an economic recession that began in 2001 was exacerbated by the 9/11 terrorist attack. In response, the Federal Reserve moved quickly to increase liquidity and lower interest rates. Government spending was increased, and tax cuts were implemented in 2002. Government officials encouraged lenders to make mortgage loans to a wider range of potential home buyers, resulting in sub-prime mortgages being offered to borrowers who could not afford the loans. Economic expansion and rapidly rising home prices culminated in the bursting of the housing asset bubble in 2006. This was followed by a peak in stock prices in 2007 and an economic recession that began in mid-2008. By the second half of 2008, a “perfect financial storm” had been created, and many worried about the possibility of financial collapse. Several major financial institutions were on the verge of failing. Some financial institutions were merged into, or acquired by, stronger institutions (e.g., Merrill Lynch was acquired by Bank of America), the Lehman Brothers investment bank was allowed to fail, while AIG (American International Group) was “bailed out” by the Federal Reserve and the U.S. government. Venture funding virtually dried up. Even entrepreneurs with good opportunities were stymied by a lack of venture capital. For the second time in the decade, the availability of venture funds collapsed. The U.S. government in October, responded by passing the Economic Stabilization Act of 2008, which provided funds to the U.S. Treasury to purchase “troubled” financial assets held by institutions. The American Recovery and Reinvestment Act (ARRA) was passed in February 2009 and provided for tax incentives, appropriations, and increased government spending in an effort to stimulate economic expansion. Importantly for aspiring entrepreneurs, these dark and cloudy times almost always come with a silver lining. For this most recent financial crisis, it appears that one nascent sector that benefitted dramatically during the time of crisis was alternative and renewable energy. Subsidies abounded with project credits, production and investment tax credits, and loan guarantees. Additionally, even in the absence of crisis-related government favoritism for certain sectors, while many entrepreneurs suffer dearly as their ventures fail, others benefit from consolidation and the resulting lower level of competition due to the shakeout. Many aspiring entrepreneurs and investor connections are made during the fallout from major economic crises. CONCEPT CHECK Q What asset and financial “bubbles” have occurred recently? Q What kinds of entrepreneurial opportunities have occurred as a result of government efforts to stimulate the economy after the 2007–2009 financial crisis? .............................. 17 For an example of the extreme developments see: “10 Big Dot.Com Flops,” http://money.cnn.com/galleries/2010/ technology/1003/gallery.dot_com_busts/index.html, accessed 3/14/2010. Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 14 Part 1: Background and Environment SECTION 1.4 PRINCIPLES OF ENTREPRENEURIAL FINANCE Entrepreneurial finance draws its basic principles from both entrepreneurship and finance. New ventures require financial capital to develop opportunities, start business ventures, and create value. It takes time to build value. Investors expect to be compensated for the use of their capital and for the risk that they might not get it back. Developing a successful entrepreneurial venture is best accomplished without the sacrifice of individual character and reputation. As th...
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Running head: ECO-PRODUCTS INC. CASE STUDY

ECO-PRODUCTS INC. CASE STUDY
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ECO-PRODUCTS INC. CASE STUDY

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Part A
Eco-Products Inc. was established in the year 1990 by Steve and his father, Kent. During
this time, the company was established as an entrepreneurial venture and was growing steadily
and slowly. An entrepreneurial venture is an organization founded based on innovation and
opportunism with the main aim of creating social value. Together they founded Eco-Products
Inc. to make high-quality, competitively priced, and environmentally sustainable products more
widely accessible. The company was set up in their hometown of Boulder, Colorado, a
community known for its support of environmental initiatives and natural products. In the early
years of operation, profits were slim to none. It was at this same time that Kent used his house as
a warehouse for their products while Steve delivered orders in his Subaru station wagon. Longterm planning, fiscal discipline, and a customer base committed to buying recycled products kept
the company going.
In 1996, Kent and Steve launched the building division and continually expanded it to
accommodate Janitorial and paper products. There was a steady demand for these products, and
this marked the first significant growth period the company experienced since it was established.
Eco-Products employed three people to primarily sell janitorial and paper supplies, including
copy paper, cups, and toilet paper. The company ended 1997 with revenues of $1.2 million,
yearly growth of 60%, and five employees.
Part B
The company continued to market green janitorial paper and building supplies up to 2004
when Eco-products was put to a new line of both business supply and building supply divisions.
Its managerial team was multiplied, and sales in the business supply division grew fast as a
consequence of focusing on brand and Internet strategies.

ECO-PRODUCTS INC. CASE STUDY

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a) In 2004-05 Eco-Products continued to primarily be a distributor of eco-friendly products like
biodegradable disposable drinking cups, among others, acquired from a range of manufacturers.
As the business focus altered from retail sales to wholesale distribution, pressure increased to
come up with their brand of eco-friendly products. Product distributors were chosen in China and
Taiwan.
b) Steve Savage reiterated the development of a key Eco-Products line from a Polylactide (PLA)
resin sourced from renewable sources such as sugarcane crops. This gave the firm a chance to
offer a full, uniquely designed line of environmentally friendly products.
c) As wholesale supply advanced, co-existing product manufacturers limited Eco-Products'
ability to sell a variety of products in wholesale. After pinpointing Asian manufacturers, the
"Eco-Products" branded commodities of disposable cups and food containers stroke the market
in March 2007.
Part C
Many businesses and governments are encouraging greener and environmentally friendly
products. (Chen & Chai, 2010). There is a large market for foodservice disposable packaging
ranging from a variety of customers, from Google cafeterias to Major League Baseball stadiums,
and End-customers or individual consumers purchasing small quantities through the website or
by telephone. The global demand for foodservice disposable packaging is close to $30 billion
dollars in sales per yea...


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Excellent resource! Really helped me get the gist of things.

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