hapter 2 From the Idea to the Business Plan Various Types of Firms Salary-replacement firms Lifestyle firms: Entrepreneurial ventures:

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1 Chapter 2 From the Idea to the Business Plan Various Types of Firms Salary-replacement firms: firms that provide their owners with income levels comparable to what they could have earned working for much larger firms Lifestyle firms: firms that allow owners to pursue specific lifestyles while being paid for doing what they like to do Entrepreneurial ventures: entrepreneurial firms that are flows- and performance-oriented as reflected in rapid value creation over time o Growth-driven subset as entrepreneurial ventures A well-designed entrepreneurial venture begins with an idea that survives an analysis of its feasibility and results in a business plan Once conceptualized, a new idea should be examined for its business feasibility Initial feasibility review o This review focuses on whether it is possible to convert the idea into a product or service meeting a lucrative unfilled need Components of a Sound Business Model Sound business model: a plan to generate revenues, make profits, and produce free cash flows o Attract financing and increase the likelihood that the venture will survive and build value over time o Three components Generate Revenues (You must have customers and sell them something) Important component of a venture s perceived present and future value is its current level of revenues (which may be zero, if the venture is in its development stage or at the beginning of its startup stage) the expected growth of those revenues Necessary to generate initial sales and growth in sales over time A venture s management team must develop and market new products and services to increase sales revenue Branding the venture s products and services to facilitate new product introduction and inhibit competitive inroads Make Profits (You must eventually have revenues that exceed the expenses of generating those revenues) Successful venture cannot target sales growth alone. It must target growth in total venture profitability even when prices decrease as sales grow A venture s revenues must be large enough to exceed its costs of production and services, as well as pay the venture s management team, other employees, liabilities owed to its creditors, and tax obligations A venture s management team must be capable of managing the firm s operations efficiently, and of finding and retaining the human resources necessary to carry out production and service functions Seeking a sustainable competitive advantage on any or all of these fronts is an important component of long-term venture viability. A basic principle of market economics and capitalism is that capital providers must be compensated for the venture s use of that capital Capital can be loaned out to others or otherwise employed; consequently, the venture s plan must incorporate a return to capital providers over and above simple profitability Produce Free Cash Flows (You must generate cash inflows that exceed net working capital and capital expenditures) The third component of a sound business model is a future ability to pay accumulated equity capital costs by what many term free cash flow to equity what remains of prof- its after all investment costs have been subtracted A sound business model anticipates the cash flow associated with expansions in the venture s asset investments The venture s value to its owners is determined by the size and timing of its future free cash flows (to equity) However, having to wait to receive those future free cash flows imposes the opportunity cost of not having them now.

2 o o That is, everyone would prefer to have the cash now rather than in the future. The opportunity cost of this delay is Income Statement referred to as the time value of money and is due to the investor s foregone return on current use of the cash. In addition to the time value of money, investors expect to be compensated for risk that is, the risk that the venture will be less successful than anticipated, or even a failure Revenue $ 600,000 $ 1,200,000 COGS (Units x COGS per Unit) 300, ,000 Gross Profit 300, ,000 OE + Tax 200, ,000 Net Profit $100,000 $120,000 Initial specialty equipment and the renovation of an old warehouse building in Lower Downtown, referred to as LoDo, cost $450,000 at the beginning of At the same time, $50,000 was invested in inventories. In early 2011, an additional $100,000 was spent on equipment to support the increased frozen yogurt sales in EXAMPLE: Answer: GPM in 2010 = Gross Profit/Sales = / = 50% NPM in 2010 = Net Profit/Sales = /600000=16.7% GPM in 2011 = / = 50% NPM in 2011 = / = 10% Total Assets 2010 = Warehouse + Inventory = = Total Capital Expenditure = = ROA = Net Profit/Total Assets ROA for 2010 = /500000= 20% ROA for 2011 = /600000=20% Asset Turnover = Revenues/Total Assets Turnover for 2010 = / = 1.20 Turnover for 2011 = / = 2.00 ROA = Net Profit Margin x Asset Turnover ROA for 2010 = 16.67% x 1.2 = 20 ROA for 2010 = 10% x 2.0 = 20 Best Practices of High Growth, High Performance Firms Three Areas: o Marketing Practices o Financial Practices o Management Practices [Note: While Operations/Production practices are not listed separately, they go hand-in-hand with high quality products and services, as well as on-time delivery] Best Practices: Marketing o Deliver high quality products or services o Develop new products or services that are considered to be the best o Offer products or services that command higher prices and margins o Develop efficient distribution channels and superior service support facilities Best Practices: Financial o Prepare detailed monthly financial plans for the next year and annual financial plans for the next five years o Anticipate and obtain multiple rounds of financing as the venture grows o Efficiently and effectively manage the firm s assets, financial resources, and operating performance o Plan an exit strategy consistent with the entrepreneur s objectives and business plan Best Practices: Management o Assemble a management team balanced in functional area coverage and industry/market knowledge o Employ a decision-making style that is viewed as being collaborative o Identify and develop managers that support entrepreneurial endeavors o Assemble a board of directors balanced in terms of internal and external members Time-to-Market and Other Timing Implications Business opportunities exist in real time Most ideas have a relatively narrow window of opportunity to become a successful business venture Sometimes ideas are ahead of their time Of course, being first to market does not necessarily ensure success Time-to-market, particularly when one is first to market, is often important in deter- mining whether an idea becomes a viable business

3 Time is particularly critical when ideas involve information technology because the difference of a few months may deter- mine success or failure Being first to market does not necessarily ensure success Initial Litmus Test A viable venture opportunity: creates or meets a customer need, provides an initial competitive advantage, is timely in terms of time-to-market, and offers the expectation of added value to investors SWOT analysis: an examination of strengths, weaknesses, opportunities, and threats to determine the business opportunity viability of an idea o The strengths and weaknesses assessment focuses on the internal aspects of the idea; the opportunities and threats focus on the external or competitive environment SWOT analysis considers (S) and (W): o Unfilled customer need o Intellectual property rights o First mover o Lower costs and/or higher quality o Experience/expertise o Reputation value SWOT analysis considers (O) and (T): o Existing competition o Market size/market share potential o Substitute products or services o Possibility of new technologies o Recent or potential regulatory changes o International market possibilities Screening Venture Opportunities Venture opportunity screening: Assessment of an idea s commercial potential to produce revenue growth, financial performance, and value Our approach: o Qualitative screening: Interview with the Founder Using a systematic interview with the entrepreneurial team o Quantitative screening: VOS Indicator Involves applying a more quantitative screen to help determine whether venture investors are likely to fund the metamorphosis Qualitative Screening: Interview o Our qualitative screening takes the form of question-and-answer dialogues While it is possible for the entrepreneur to respond in privacy, we believe that it is much more useful to seek out others to engage in a little role playing o Moreover, if there are other members of the management team in place, each can take the lead responsibility for responding in his areas o o The four individual roles are: Founder Marketing manager Operations manager Financial manager Conclusion of the interview, the interviewer prepares a subjective assessment and indicates one of the following: High commercial potential Average commercial potential Low commercial potential Four Factor Categories Initially Evaluating a Potential Venture s Attractiveness: The Big Picture Know Thy Customer Production and Development Challenges

4 Financial Fortune-Telling Quantitative Screening: o A more quantitative approach to assessing a proposed new venture s viability or feasibility also can be developed o Factors often considered important in evaluating a new venture s feasibility include: market size potential industry barriers to entry size of expected profit margins accounting-based rates of returns expected investment returns potential for a future public offering quality of management team o These groups can be grouped into the following areas: Industry/Market Pricing/Profitability Financial/Harvest Management Team o VOS TM Indicator: checklist of selected criteria and metrics used to screen venture opportunities for potential attractiveness as business opportunities o Supplement to, rather than replacement of, basic qualitative Q&A approach EXAMPLE: Jen Liu and Larry Mestas are seeking venture investors to help fund the expected growth in their Frozen Yogurt venture. Use the VOS IndicatorÔ guidelines to score Jen and Larry s frozen yogurt venture in terms of the items in the pricing/profitability factor category. Comment on the likely attractiveness of this business opportunity to venture investors. ANSWER: Gross Margin: 55% - Year #1; 55% - Year #2 (HIGH) After-Tax Margin: 16.7% - Year #1; 10 % - Year #2 (AVERAGE) Asset Intensity: 1.2 Year #1; 2 Year #2 (AVERAGE) ROA: 20% - Year #1; 20% - Year #2 (HIGH) Overall Pricing/Profitability - AVERAGE **Factor Category: Industry/Market o Market Size Potential Average: $20-$100 million o Venture Growth Rate Average: 10%-30% o Market Share (Year 3) Average: 5%-20% o Entry Barriers Average: Timing/Size Factor Category: Pricing/Profitability o Gross Margins Average: 20%-50% o After-Tax Margins Average: 10%-20% o Asset Intensity Average: turnover o Return on Assets Average: 10%-25% Cost of Goods Sold: direct costs of producing a product or providing a service Gross Profit: revenues less the cost of goods sold Gross Profit Margin: gross profit divided by revenues Net Profit: dollar profit left after all expenses, including financing costs and taxes, have been deducted from the firm s revenues Return on Assets (ROA) Model o Net Profit Margin (NPM): net profit divided by revenues o Asset Intensity: total assets divided by revenues, the reciprocal of asset turnover (so ATO = Revenues/Total Assets) o Return on Assets (ROA): net after-tax profit divided by total assets o ROA Model: ROA = NPM x ATO ROA Model Considerations

5 o Case 1: High Profit Margins & Low Asset Turnovers Examples: products and services based on technological innovations o Case 2: Low Profit Margins & High Asset Turnovers Examples: commodity-type products and services Operating Cash Flow: cash flow from producing and selling a product or providing a service Free Cash Flow to Equity: cash remaining after operating cash outflows, financing and tax cash flows, investment in assets needed to sustain the venture s growth, and net increases in debt capital Internal Rate of Return (IRR): compound rate of return that equates the present value of the cash inflows received with the initial investment EXAMPLE: Company C has a basic earnings power (BEP) ratio of 15 %, and has a times interest earned (TIE) ratio of 6. Total assets are $100,000. The tax rate is 40 %. What is C's return on assets (ROA)? SOLUTION: BEP = EBIT/TA =.15 à EBIT =.15 x = $ TIE = EBIT/I = 6 à I = 15000/6 = $2 500 NI = (EBIT-I) x (1-T) = )(1-.4) = 7500 ROA = NI/TA = 7500/ =.075 = 7.5% Factor Category: Financial/Harvest o Cash Flow Breakeven Average: 2-4 years o Rates of Return Average: 20%-50% per year o IPO Potential Average: 2-5 years o Founder s Control Average: High Minority Factor Category: Management Team o Experience/Expertise Average: General/General o Functional Areas Average: Most Covered o Flexibility/Adaptability Able to Adapt o Entrepreneurial Focus Average: Founder VOS Indicator Average Scores o High Potential (average scores of ) ideas that have the potential to become high-growth, high-performance ventures or home runs o Average Potential (average scores of ) o Low Potential (average scores of ) Key Elements of a Business Plan Business Plan: written document that describes the proposed product or service opportunity, current resources, and financial projections Cover Page: should identify the venture and provide the name, address, and phone number of the entrepreneur or other contact person Confidentiality Statement: o Example: This business plan contains information that (the firm) considers proprietary. By accepting this business plan the recipient acknowledges the proprietary nature of this information contained herein and agrees to keep confidential all such information. A Typical Business Plan Outline Executive Summary Business Description o Description of the product/service o Industry background o Venture or firm background o Goals and milestone objectives

6 Marketing Plan and Strategy o Target market and customers o Competition and market share o Pricing strategy o Promotion and distribution Operations and Support o Quality targets o Technology requirements o Service support Management Team o Experience and expertise o Organizational structure o Intellectual property rights Financial Plans and Projections o Income statements & balance sheets o Statements of cash flows o Break-even analysis o Funding needs and sources Risks and Opportunities o Possible problems and risks o Real option opportunities Appendix o Detailed support for financial forecasts o Timeline and milestones Summary An inspiring idea is not the same as a viable business opportunity Successful implementation involves making right decisions in the areas of marketing, finance, management, and production There exist various ways of identifying potentially viable opportunities A promising opportunity should be clearly formulated in a business plan