INTRODUCTION TO FINANCE FOR ENTREPRENEURS

1 Chapter 1

INTRODUCTION TO FINANCE FOR ENTREPRENEURS

FOCUS

The purpose of this first chapter is to present an overview of what entrepreneurial finance is about. In doing so we hope to convey to you the importance of understanding and applying entrepreneurial finance methods and tools to help ensure an entrepreneurial venture is successful.We present a life cycle approach to the teaching of entrepreneurial finance where we cover venture operating and financial decisions faced by the entrepreneur as a venture progresses from an idea through to harvesting the venture.

LEARNING OBJECTIVES

LO 1.1: Characterize the entrepreneurial process.

LO 1.2: Describe entrepreneurship and some characteristics of entrepreneurs.

LO 1.3: Indicate several megatrends providing waves of entrepreneurial opportunities.

LO 1.4: List and describe the seven principles of entrepreneurial finance.

LO 1.5: Discuss entrepreneurial finance and the role of the financial manager.

LO 1.6: Describe the various stages of a successful venture’s life cycle.

LO 1.7: Identify, by life cycle stage, the relevant types of financing and investors.

LO 1.8: Understand the life cycle approach used in this book.

CHAPTER OUTLINE

1.1 THE ENTREPRENEURIAL PROCESS

1.2 ENTREPRENEURSHIP FUNDAMENTALS

• Who is an Entrepreneur?
• Basic Definitions
• Entrepreneurial Traits or Characteristics
• Opportunities Exist But Not Without Risks

1.3 SOURCES OF ENTREPRENEURIAL OPPORTUNITIES

• Societal Changes
• Demographic Changes
• Technological Changes
• Emerging Economies and Global Changes
• Crises and “Bubbles”
• Disruptive Innovation

1.4 PRINCIPLES OF ENTREPRENEURIAL FINANCE

• Real, Human, and Financial Capital must be Rented from Owners (Principle #1)
• Risk and Expected Reward go Hand in Hand (Principle #2)
• While Accounting is the Language of Business, Cash is the Currency (Principle #3)
• New Venture Financing Involves Search, Negotiation, and Privacy (Principle #4)
• A Venture’s Financial Objective is to Increase Value (Principle #5)

(Entrepreneurial Finance, 7e Chris Leach, Ronald Melicher) (Solution Manual, For Complete File, Download link at the end of this File) 1 / 4

Chapter 1: Introduction to Finance for Entrepreneurs

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• It is Dangerous to Assume that People Act Against Their Own Self-Interests

(Principle #6)

• 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
• Survival Stage
• Rapid-Growth Stage
• Early-Maturity Stage
• Life Cycle Stages and the Entrepreneurial Process

1.7 FINANCING THROUGH THE VENTURE LIFE CYCLE

• Seed Financing
• Startup Financing
• First-Round Financing
• Second-Round Financing
• Mezzanine Financing
• Liquidity-Stage Financing
• Seasoned Financing

1.8 LIFE CYCLE APPROACH FOR TEACHING ENTREPRENEURIAL FINANCE

SUMMARY

DISCUSSION QUESTIONS AND ANSWERS

• What is the entrepreneurial process?

The entrepreneurial process comprises: developing opportunities, gathering resources, and managing and building operations with the goal of creating value.

• What is entrepreneurship? What are some basic characteristics of entrepreneurs?

Entrepreneurship is the process of changing ideas into commercial opportunities and creating value. While there is no prototypical entrepreneur, many are good at recognizing commercial opportunities, tend to be optimistic, and envision a plan for the future.

• Why do businesses close or cease operating? What are the primary reasons why businesses

fail?

Nearly one-half of businesses that fail do so because of economic factors including inadequate sales, insufficient profits, and industry weakness. Many of the economic factors are directly tied to financing concerns (e.g., insufficient profits for investors). Almost 40 percent of business failures not citing economic factors cite specifically financial causes like excessive debt and insufficient financial capital. The remaining cited reasons for failure include a lack of business and managerial experience, business conflicts, family problems, 2 / 4

Chapter 1: Introduction to Finance for Entrepreneurs

3 fraud, and disasters. Many businesses close and fail due to financial trouble which is mostly related to lack of sales and unsatisfactory profits.

• What are five megatrend sources or categories for finding entrepreneurial opportunities?

We identify five megatrend categories. They are: (1) societal changes, (2) demographic changes, (3) technological changes, (4) emerging economies and global changes, and (5) crises and bubbles.

Under societal changes we discuss the gig economy and the sharing economy. The gig economy is where individuals accept short-term job assignments or “gigs” instead of having full-time employment. The sharing economy is where individuals share their assets, such as homes, vehicles, and personal time, with others to provide a new way for distributing goods and services.

• What asset and financial bubbles have occurred recently? How can bubbles and financial

crises lead to entrepreneurial opportunities?

The “dot.com” or Internet bubble burst in 2000. An economic recession that began in 2001 was exacerbated by the 9/11 terrorist attack. The housing asset bubble, fueled by sub-prime mortgages offered to borrowers who could not afford them, burst in 2006. By the second half of 2008, a “perfect financial storm” erupted and possible financial collapse became a reality.

Alternative and renewable energy, accompanied by project credit subsidies, production and investment tax credits, and loan guarantees benefited as a result of the recent financial crisis.These developments and other efforts to stimulate economic activity provided many new entrepreneurial opportunities.

• What is e-commerce? Why are the Internet economy and e-commerce here to stay?

E-commerce involves the use of electronic means to conduct business online. Activities include marketing and selling online and electronic retailing.

The internet economy and e-commerce are here to stay. We will never do business the same way we did before the Internet and the Web. Many business plans were funded with the belief that part of the benefit could be captured by sellers (producers and retailers).However, we now know that the Web so effectively facilitates price competition that it is hard for suppliers and retailers to protect margins. E-commerce may not deliver the margins once conjectured, but the Internet is still one of the most radical innovations in our lifetime.

• What is meant by disruptive innovation? What is the “sharing economy” societal trend?

An innovation involves the introduction of a new idea, product, or process. A disruptive innovation is an innovation that creates a new market or network that disrupts and displaces an existing market or network. 3 / 4

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• Identify the seven principles of entrepreneurial finance.

The seven principles are:

(1) Real, human, and financial capital must be rented from owners (2) Risk and expected reward go hand in hand (3) While accounting is the language of business, cash is the currency (4) New venture financing involves search, negotiation, and privacy (5) A venture’s financial objective is to increase value (6) It is dangerous to assume that people act against their own self-interests (7) Venture character and reputation can be assets or liabilities

• Explain the statement: “The time value of money is not the only cost involved in renting

someone’s financial capital.”

The total cost of renting someone’s financial capital is typically significantly higher than just the time value of money due to the possibility that the venture won’t be able to pay. The rent is risky or uncertain requiring an expected compensation in addition to the time value of money for the renting agreement to be put in place.

• How do public and private financial markets differ?

Public financial markets are markets where standardized contracts or securities are traded on organized securities exchanges. Private financial markets are markets where customized contracts or securities are negotiated, created, and held with restrictions on how they can be transferred.

• What is the financial goal of the entrepreneurial venture? What are the major components

for estimating value?

The venture’s financial goal is to maximize the value of the venture to its owner(s). The major components of estimating value are projected free cash flow (cash generated in a specified time period that exceeds funds needed to operate, pay creditors, and invest in the assets needed to grow the venture) and its risk (including the timing and realized amount).

• From an agency relationship standpoint, describe the possible types of problems or conflicts

of interest that could inhibit maximizing a venture’s value.

There are two basic types of conflicts. Owner-manager (agency) conflicts occur when there are differences between managers’ self-interests and the interests of the owners who hired the managers. There is also the possibility of owner-debtholder conflicts that take the form of a divergence of the owners’ and lenders’ self-interests as the venture gets close to bankruptcy.

Agency relationships arise when “principals” hire “agents” to perform specified activities or services. Businesses are involved in two primary agency relationships: (1) owner-manager conflicts, and (2) manager-debtholder conflicts. The owner-manager agency problem exists

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