Entrepreneurial Finance: The Owner's Perspective

2008-04-04T02:24:00.000-07:00

There are both stark and subtle differences, both in theory and in practice, between entrepreneurial finance as practiced in higher-potential small firms and corporate or administrative finance, which usually occurs in larger publicly traded companies. Students and practitioners of entrepreneurial finance have always been dubious about the reliability and relevance of much of so-called modern finance theory.2 High-potential small businesses need to focus their attention on key aspects of financial management. Consider the following:

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Cash flow and cash. Cash flow and cash are king and queen in entrepreneurial finance. Accrual-based accounting, earnings per share, or creative and aggressive use of the tax codes and rules of the Securities and Exchange Commission are not.

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Time and timing. Financing alternatives for the financial health of an enterprise are often more sensitive to, or vulnerable to, the time dimension. In entrepreneurial ventures, critical financing moves often have a shorter and more compressed time period, have a more rapidly changing optimum timing, and are subject to wider, more volatile swings from lows to highs and back.

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Capital markets. Capital markets for over 95 percent of growth financing for private entrepreneurial ventures are relatively imperfect, in that they are frequently inaccessible, unorganized, and often invisible. Virtually all the underlying characteristics and assumptions that dominate popular financial theories and models (such as the capital asset pricing model) simply do not apply, even up to the point of a public offering for a small company. In reality, there are so many and such significant information, knowledge, and market gaps and asymmetries that the rational, perfect market models suffer enormous limitations.

Exhibit 4.3 Initial Losses by Small New Ventures

Source: Special appreciation is due to Bert Twaalfhoven, founder and chairman of Indivers, the Dutch firm that compiled this summary and that owns the firm on which the chart is based. Mr. Twaalfhoven was also a leader in the Class of 1954 at Harvard Business School and has been active in supporting the Entrepreneurial Management Interest Group and research efforts there.

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Emphasis. While capital is one of the least important factors in the successful growth of higher-potential ventures, it is often a stumbling block for small businesses not used to finding resources for growth. When considering outside investors, you must seek not only the best deal but also the backer who will provide the most value in terms of know-how, wisdom, counsel, and help. Opt for the value added (beyond money), rather than just the best deal or share price (see also about where to invest).

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Strategies for raising capital. Strategies that optimize or maximize the amount of money raised can actually serve to increase risk in emerging companies, rather than lower it. Thus, the concept of "staged capital commitments," whereby money is invested for a three- to eighteen-month phase and is followed by subsequent commitments based on results and promise, is a prevalent practice among venture capitalists and other investors in higher-potential ventures. Similarly, wise entrepreneurs may refuse excess capital when the valuation is less attractive and when they believe that valuation will rise substantially.

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Downside consequences. Consequences of financial strategies and decisions are eminently more personal and emotional for the owners than for the management of large companies. The downside consequences for such entrepreneurs of running out of cash or failing are monumental and relatively catastrophic, since personal guarantees of bank or other loans are common.

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Risk-reward relationships. While the high-risk-high-reward and low-risk-low-reward relationship (a so-called law of economics and finance) works fairly well in efficient, mature, and relatively perfect capital markets (e.g., those with money market accounts, deposits in savings and loan institutions, widely held and traded stocks and bonds, and certificates of deposit), just the opposite occurs too regularly in entrepreneurial finance to permit much comfort with this law. Time and again, some of the most profitable, highest-return venture investments have been quite low-risk propositions from the outset. Yet the way the capital markets price these deals is just the reverse. The reasons are anchored in the second and third points noted above - timing and the asymmetries and imperfections of the capital markets for deals. Entrepreneurs or investors who create or recognize lower-risk, very-high-yield business propositions, before others jump on the Brink's truck, will defy the laws of economics and finance. By proving your business model and articulating growth strategies, you provide an exciting low-risk, high-return scenario (see also about investor).

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Valuation methods. Established company valuation methods, such as those based on discounted cash flow models used in Wall Street megadeals, seem to favor the seller, rather than the buyer, of private emerging entrepreneurial companies. A seller loves to see a recent MBA or investment banking firm alumnus show up with an HP calculator or the latest laptop personal computer and then proceed to develop "the ten-year discounted cash flow stream." The assumptions normally made and the mind-set behind them are irrelevant or grossly misleading for valuation of smaller private firms because of dynamic and erratic historical and prospective growth curves (see also about established business network).

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Conventional financial ratios. Current financial ratios are misleading when applied to most private entrepreneurial companies. For one thing, entrepreneurs often own more than one company at once and move cash and assets from one to another. For example, an entrepreneur may own real estate and equipment in one entity and lease k to another company. Using different fiscal years compounds the difficulty of interpreting what the balance sheet really means and the possibilities for aggressive tax avoidance. Further, many of the most important value and equity builders in the business are off the balance sheet or are hidden assets: the excellent management team; the best scientist, technician, or designer; know-how and business relationships that cannot be bought or sold, let alone valued for the balance sheet (see also about return on investment).

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Goals. Creating value over the long term, rather than maximizing quarterly earnings, is a prevalent mind-set and strategy among highly successful entrepreneurs. Since profit is more than just the bottom line, financial strategies are geared to build value, often at the expense of short-term earnings. The growth required to build value often is heavily self-financed, thereby eroding possible accounting earnings.

Determining Capital Requirements

How much money does my venture need? When is it needed? How long will it last? Where and from whom can it be raised? How should this process be orchestrated and managed? The next two sections provide answers to the vital questions entrepreneurs should ask at any stage in the development of a company.

Financial Strategy Framework

The financial strategy framework shown in Exhibit 4.4 is a way to begin crafting financial and fund-raising strategies. The exhibit provides a flow and logic with which an otherwise confusing, if not befuddling, task can each source has particular requirements and costs - both apparent and hidden - that carry implications for both financial strategy and financial requirements. The premise is that successful entrepreneurs are aware of potentially punishing situations, and that they are careful to "sweat the details" and proceed with a certain degree of wariness as they evaluate, select, negotiate, and craft business relationships with potential funding sources. In doing so, they are more likely to find the right sources, at the right time, and on the right terms and conditions. They are also more likely to avoid potential mismatches, costly sidetracking for the wrong sources, and the disastrous marriage to these sources that might follow.

Defuses of strategic freedom:

Time to 00C Time to close Future alternatives Risk/reward Personal concern

Sources and structure

Equity Other

Financial requirements

Driven by:

Burn rate Operating needs Working capital Asset requirements and sales

Business

Marketing Operations Finance

Value creation

Source: This framework was developed for the Financing Entrepreneurial Ventures course at Babson College and has been used in the Entrepreneurial Finance course at the Harvard Business School.

Certain changes in the financial climate, such as the aftershocks felt after the stock-market crashes of October 1987 and March 2000, can cause repercussions across financial markets and institutions serving smaller companies. These take the form of greater caution by lenders and investors alike as they seek to increase their protection against risk. When the financial climate becomes harsher, an entrepreneur's capacity to devise financing strategies and to effectively deal with financing sources can be stretched to the limit and beyond. But it is exactly at a time like this that existing companies have a capital-markets advantage. Billions of risk-averse dollars retreat to the sidelines in angst. They can't make a return on the sideline but are too afraid to invest, unless they find an existing company with a reasonable track record and a desire to grow.

Investment Capital Inform

Entrepreneurial Finance: The Owner's Perspective