Entrepreneurship & Biz. strategy

CC530

Professor. Taeyong Yang

May 30 – June 8, 2005

Resources include (1)People: management team, board of directors, lawyers, accoun

tants, and consultants; (2)Financial resources; (3)Assets: plant and equipment; and (4)Business plan.

The successful entrepreneurs seek to control the resources instead of owning them.

- Need less capital (no dilution of the founder’s equity)- Flexibility (commit and decommit quickly)- Low sunk cost (easier to abort the venture)- Lower fixed costs (favorable for breakeven)- Reduced risk (less obsolescence)

Bootstrapping – Minimizing resources

Using Other People’s Resources

- Money from friends, business associates, or other investors- People, space, equipment, or material loaned, provided inexpen

sively or free by customers or suppliers, or secured by bartering future services, opportunities

- In fact, using other people’s resources: free booklets and pamphlets (published by the Big Six accounting firms), or low-cost educational programs (government funded management assistance programs)

An example of this approach is a company that grew to $20 million in sales in about 10 years with $7,500 cash, a liberal use of credit cards, reduced income for the founders, and hard work and long hours. This company has not had to raise any additional equity capital.

Outside People Resources

(1) Board of Directors;(2) Attorneys; (3) Bankers and Other Lenders; (4) Accountants;(5) Consultants;

Outside People Resources (1) Board of Directors

If the new venture is organized as a corporation, it must have a boardof directors, which must be elected by the shareholders.

Entrepreneurs worry about the wrong thing... that the boards are going to steal their companies or take them over. Though entrepreneurs have many reasons to worry, that’s not one of them. It almost never happens. In truth, boards don’t even have much power. They are less well equipped to police entrepreneurs than to advise them.

A top-notch outside director usually spends at least 9 to 10 days per year on his or her responsibilities.

Fees can range from as little as $500—$ 1,000 for a half- or full-day meeting to $10,000—$30,000 per year for four to six full-day to day-and-a-half meetings, plus accessibility on a continuous basis.

Stock in a startup company, often 2 percent to 5 percent, or options, for 5,000 to 50,000 shares, are common incentives to attract and reward directors.

Outside People Resources (1) Board of Directors (cont.)

• Treat your directors as individual resources.• Always be honest with your directors.• Set up a compensation committee.• Set up an audit committee.• Never set up an executive committee.

* Liability - personally liable for its actions and those of its officers, and, worse, a climate of litigation exists in many areas

* Harassment – from unsatisfied outside stockholders

* Time and risk – more time and intense involvement at an early- stage

Venture Financing: The Entrepreneur’s Achille’s Heel

Three core principles:

1) more cash is preferred to less cash,

2) cash sooner is preferred to cash later

3) less risky cash is preferred to more risky cash.

• What are the financial consequences and implications of crucial business decisions such as pricing, volume, and policy changes affecting the balance sheet? How will these change over time?

• How can we measure and monitor changes in our financial strategy and structure from a management, not just a GAAP, perspective?

• What does it mean to grow too fast in our industry? How fast can we grow without requiring outside debt or equity? How much capital is required if we increase or decrease our growth by X percent?

• What will happen to our cash flow, profitability, return on assets, and shareholder equity if we grow faster or slower by X percent?

• How much capital will this require? How much can be financed internally and how much will have to come from external sources? What is a reasonable mix of debt and equity?

• What if we are 20% less profitable than our plan calls for?• What should be our focus and priorities? What are the cash flow and net

income break-even points for each of our product lines? For our company? For our business unit?

• What about our pricing, our volume, and costs? How sensitive is our cash flow and net income to increases or decreases in price, variable costs, or volume? What price/volume mix will enable us to achieve the same cash flow and net income?

• How will these changes in pricing, costs and volume affect our key financial ratios and how will we stack up against others in our industry? How will our lenders view this?

• At each stage—startup, rapidly growing, stagnating, or mature company—how should we be thinking about these questions and issues?

Figure 18.1 Idealized cash flow diagram for a new enterprise

Cumulative cash flow ($millions)

0Time (months)

-1

-2

-3

3

2

1

10 20 30 40 50

Cash breakeven

The startup stage (first two or three years)

- Entrepreneurial talent of a lead entrepreneur and a key team member or two.

- Critical mass of people, market and financial results, and competitive resiliency are established.

- Sales typically range between $2M and $20M.

The high growth stage

- Entrepreneur finds it is necessary to let go of power and control.

Managing for Rapid Growth

- require close collaboration of a manager with other people than his or her subordinates

- adept at conflict resolution (e.g., influence without formal power)

- hero making (to make the pie bigger and better)

Entrepreneurial Finance: The Owner’s Perspective

• Cash flow and cash• Time and timing• Capital markets• Emphasis• Strategies for raising capital• Downside consequences• Risk/reward relationships• Valuation methods• Conventional financial ratios• Goals

Determining Capital Requirements

• How much money does my venture need? • When is it needed? • How long will it last? • Where and from whom can it be raised? • How should this process be orchestrated and managed?

These are vital questions to any entrepreneur at any stage in the development of a company.

Table 17.1 Four steps to building a financial plan. 1. Sales forecast Timeframe-two or three years. Assumption about sales per customer, number of customers, and growth rate of sales. Calculation of the sales forecast.

2. Costs forecast Assumption about the costs of doing business in the specified time frame. Calculation of the costs associated with the projected sales of step 1.

3. Income and cash flow forecast Assumption about the timing of cash receivables and payables specified in the time frame. Calculation of the income and cash flow associated with the projected sales and costs on a monthly basis over the timeframe.

4. Balance sheet Assumptions about the starting value of cash and assets. Calculated based on the income and cash flows from step 3.

Free Cash Flow: Burn Rate, OOC, and TTC

The expanded definition can be collapsed into a simpler one:

Earnings before interest but after taxes (EBIAT) - Increase in net total operating capital (FA + WC)

where the increase in net total operating capital is defined as:

Increase in operating working capital (WC)+ Increase in net fixed assets (FA)

Free Cash Flow: Burn Rate, OOC, and TTC

Free cash flow = Earnings before interest and taxes (EBIT)- Tax exposure (tax rate times EBIT)+ Depreciation and other noncash charges- Increase in operating working capital- Capital expenditures

Operating working capital =Transactions cash balances+ Accounts receivable+ Inventory+ Other operating current assets (e.g., prepaid expens

es)- Accounts payable- Taxes payable- Other operating current liabilities (e.g., accrued expe

nses)

Figure 17.1 Assets generate income and liabilities lead to expenses. Net income is income minus expenses.

Figure 17.2 Calculation of the income statement.

Figure 17.3 Cash flow process.

Figure 17.4 Format for a balance sheet.

Table 18.1 Five factors that lead to the different perceptions of investors and entrepreneurs.

Uncertainty of projected outcomes

Asymmetric information

Assigning a value to intellectual property and intangibles

Dynamics of the industry and the financial marketplace

Concentration of wealth in a venture by entrepreneurs while investors will have a diversified portfolio

Table 18.2 Value of real option based on four factors

Increases with the level of uncertainty measured by the standard deviation

Increases with the length of time the person holding the option has to decide whether or not to exercise it

Increases with the ratio of the current stock price to the exercise price. The ratio is P/X.

Increases with the discount rate

Table 18.3 Sources of capital

Founders Family and friends Small biz. Investment

companies Small Biz. Innovation

Research grants Wealthy individuals

(angels) Venture capitalists Banks

Leasing companies Established companies Public stock offering Government grants and

credits Customer prepayments Pension funds Insurance companies

Bootstrapping 77% launched with $50K or less; 46% with $10K or less; 74% with personal savings

1. Start small and probe the market

2. Learn from your customer and adjust the biz model

3. Adjust the revenue and profit engine

4. Keep cost to a minimum

5. start expanding the company

e.g., Estee Lauder ($100 in 1930; $3B in 99; $6.945B in 2003;

$9.47B on 10/5/04)

Walt Disney Co. ($290 in 1923; $16B in 99; $37.396B in 2003

$49.06B on 10/5/04)

AuctionWeb → eBay (p395)

Table 18.4 Advantages and disadvantages of bootstrap financing

Low pressure on valuation

Easy terms on ownership Control by founders Little time spent on

finding investors

Unable to fund growth phase

Lack of funding commitment for future

Loss of advice from professional investors

Table 18.5 Criteria for angel investments

Within the industry in which the angel has experience

Located within a few hours’ driving distance of the angel

Recommended by trusted biz. associates

Entrepreneurs with attractive personal characteristics such as integrity and coachability

Good market and growth potential

Seeking an investment of $100K~1M that offers minority ownership of about 40%

Table 18.6 Investment stages

1.Seed or start-up stage

2.Development stage (Series A)

3.Growth stage (Series B or C, and others as required)

4.Competitive or maturity stage (Initial public offering)

Table 18.8 U.S. venture capital investments for 1995~2003

Table 18.9 Characteristics of an attractive venture capital investment

Potential to become a leading firm in a high-growth industry with few competitors

Highly competent and committed management team and high human capital (Talent)

Strong competitive abilities and a sustainable competitive advantage

Viable exit or harvest strategy Reasonable valuation of the

new venture

Outstanding opportunity Founders’ capital invested in the

venture Recognizes competitors and has

a solid competitive strategy A sound BP showing how cash

flow turns positive within a few years

Demonstrated progress on the product design and good sales potential

Table 18.10 Five steps for a venture capital ideal

1. Determine the amount of cash needed and its use

2. Locate appropriate venture capital investors and secure a referral to them

3. Determine which risks are to be reduced in this financing round

• Team risk – people• Capital risk – finance• Technology risk – innovation• Market risk – industry and competitors

4. Agree on valuation and ownership structure

5. Agree on a contract (term sheet) describing the deal and its terms

Figure 18.4 Potential for the flow of funds to a new biz. firm

Angels

Friends And

families

Venture capital firms

Investment Banks• IPO• Private placement

NewBiz.firm

• pension funds• private investors• Corporations

Flow of funds

IPO

Private placement

Seed funds

Series A,B,C

Seed or series A

Table 18.11 Projected cash flow and profit for ABC Inc.

year 1 2 3 4 5 6

Sales 0 1,000 2,500 5,000 8,000 10,000

Profit -600 -10 400 650 1,000 1,200

Cash flow

-1,100 0 500 1,200 1,500 1,800

Valuation of ABC Inc. CR = (1+G)N I = M I At 45% annual expected return

M = (1 + 0.45)5 = 6.41

CR = M I = 6.41 1.1 = 7.05 PO = CR / MV 100% MV = PE EN

Expecting growth rate of earnings of 20% for several years, then PE 16

EN at year 5: $1M MV = 16 $1M = $16M

PO = CR / MV 100% = 7.05/16 100% = 44.0%

Table 18.12 Netscape valuation at four stages

Stage DatePrice per

share

New investment ($millions)

Seed 4/94 $0.75 $3.1

Series A 7/94 $2.25 $6.4

Series B 6/96 $9.00 $18.0

IPO 8/96 $28.00 $160.0

Table 18.13 Financial stages of EZY Inc.

Stage Investors Price per

share

Ownership by FFF

Ownership by venture capitalists

Seed FFF $0.10 100% -

Series AVenture

capital group$0.90 60.0% 40.0%

Series BVenture

capital group$0.50 34.0% 66.0%

Table 18.14 Venture capital financing of FedEx

Stage Dateinvestment ($millions)

share price ($ per share)

Seed 9/1973 $12.25 -

Series A 3/1974 $6.40 $7.34

Series B9/1974

$3.88 $0.63

IPO 1978 - $6.00

Table 18.15 Issues to be resolved within the terms of the deal

Percent ownership for the investor group

Timing of investment Control exerted by investor Vesting periods for ownership

by the entrepreneur team Rights to require an IPO and

registration rights

Type of security Reservation of ownership for em

ployees (stock option pool) Antidilution provisions Milestones of achievement, if the

re are multiple stages or steps to the investment

Stock option plans

Table 18.16 Advantages and disadvantages of issuing an IPO

Raising new capital with the possibility of later, additional offerings

Liquidity : Ability to convert ownership to cash, potential of harvest for investors and founders

Visibility : Build brand and reputation

Offering costs and effort required Disclosure requirements and

scrutiny of operations Perceived pressures to achieve

short-term results Possible loss of control to a

majority shareholders

Advantages disadvantages

Table 18.17 IPO offerings for selected years in the US

year 1971 1976 1981 1986 1991 1996 2001

Number of issues 253 40 347 693 365 864 111

Total proceeds ($billions)

1.1 0.3 3.1 17.7 16.3 56.1 36.3

Rich Dad and Poor Dad

가난한 사람의 현금흐름 중산층의 현금흐름

Poor person Rich person

Yahoo! 1995:

First Round Financing

“I guess, three and a half years ago, if we were looking to start a business and make a lot of money, we wouldn’t have done this.”

- Jerry Yang, 1997

David Filo Tulane, CE (class of 1988); Stanford, EE; Yang’s TA

Jerry Yang Stanford (class of 1990); PhD candidate

Michael Moritz: Right now, the biggest risk that you guys run is not making a decision, because if you don’t someone else is going to run you over.

Sequoia – Cisco, Oracle and Apple

Yahoo! – hierarchically organized list of links to sites on

the World Wide Web. Jerry Yang

“NOT just a directory but a media property” “Primarily we’re a brand. ····· The focus of the

business deals we are doing right now is not on revenues but on our brand”

Mosaic and the WWW: In 1993, U of IL, UC introduced Mosaic. Easy to use browser for navigating the Internet.

Estimated to have 2M users worldwide in just over one year. Jerry’s Guide to the WWW:

Filo and Yang’s bookmarks grew large and unwieldy. Earliest versions of Mosaic were unable to sort bookmarks in any

convenient manner. Filo and Yang wrote software that allowed them to group their boo

kmarks into subject areas. They tried to visit and categorize at least 1,000 sites a day. Subject category; sub; subsub…

The hierarchy made it easy for even novices to find websites quickly.

Filo: “No technology could beat human filtering.” – labor intensive.

Yahoo!: “Yet Another Hierarchical Officious Oracle” Growing Popularity

Spread by word of mouth and e-mail. Yahoo!’s network resource requirements increased exponenti

ally. Stanford provided them with sufficient bandwidth to the Interne

t, but bottlenecks came from limitations in the number of TCP/IP connections.

Time required to maintain the site was unmanageable Classes and research fell behind.

Potential Competing Services Architext (Stanford; renamed Excite) Webcrawler (U of Washington) Lycos (Carnegie Mellon) The WWW Worm Inforseek AOL and Microsoft in 1995 represented larger competit

ors who could enter the market either by building their own or acquiring one of the other startups.

Uniqueness and genius A guide with human discretion and judgment built into

it. The sites that they link to are deliberately chose. Yahoo! Is able to build intuitive paths that might be

singularly, or even temporarily important to the people seeking it.

Leaving Stanford and Starting the Business Yang and Filo had been in Silicon Valley long enough t

o realize that what they really wanted to do was to start their own business.

The number of hits jumped from thousands to hundreds of thousands daily. By fall of 1994, the two received over 2M hits a day on their site.

Their Ph.D. adviser Giovanni De Micheli told them to move their hobby off campus.

Abandoning their academic careers. Three main potential options to explore: 1) sell Yahoo!;

2) partner with a corporate sponsor; 3) start an independent business using VC financing.

Search for Funding Reuters (John Taysom, VP Marketing)

Since Yahoo! did not generate revenues, it was in a poor negotiating position; talks progressed very slowly.

ISN (Randy Adams, founder, the first online retailer in the world)

Netscape (Jim Clark and Marc Andressen) By early 1995, Yahoo! was running on four Netscape workstat

ions. Netscape offered to purchase Yahoo! outright. The offer was a potentially lucrative one. Netscape’s company culture was more in tune with what the t

wo were looking for.

Corporate Partnerships:

AOL, Prodigy, Compuserve If Yahoo! did not partner with them, as large players th

ey could develop their own competing services that would cause Yahoo! to fail.

Disadv 1: Yahoo started as a grass-roots effort, free of commercialization.

Disdav 2: The lack of control that the two founders would have over their creation.

Jerry and Dave were worried that selling to AOL would have most likely killed Yahoo in the end.

Sequoia Capital, Michael Moritz Journalistic background His contacts with publications and knowledge about

how to manage context. The total MC for Sequoia backed companies exceeded

that of any other VC firm. Modus operandi: funding successful companies using

only a small amount of capital. Offer: $1M investment for 25% share of the company. Only 24 hours to accept the deal.

The Decision Sequoia’s Offer

Giving up too much; need money desperately; invaluable resources at Sequoia

Corporate Sponsorship Get the funding with retaining 100% ownership Tainting Yahoo’s image (non-commercial free site)

M&A A lot of money; but have to give up primary control

Look for better terms with another VC firm