Unit 1 Background and Environment people, etc. to reach to an optimum business opportunity.

Once the opportunity has

been decided upon, the next step is to evaluate it.
Entrepreneurial process, Fundamentals, Sources of Opportunities, Venture life cycle,
Evaluating business feasibility An entrepreneur can evaluate the efficiency of an opportunity by continuously asking certain
questions to himself, such as, whether the opportunity is worth investing in, is it sufficiently
Entrepreneurial Process
attractive, are the proposed solutions feasible, is there any competitive advantage, what are
Definition: The Entrepreneur is a change agent that acts as an industrialist and undertakes the risk associated with it. Above all, an entrepreneur must analyze his personal skills and
the risk associated with forming the business for commercial use. An entrepreneur has an hobbies, whether these coincides with the entrepreneurial goals or not.
unusual foresight to identify the potential demand for the goods and services.
2. Developing a Business Plan: Once the opportunity is identified, an entrepreneur
The entrepreneurship is a continuous process that needs to be followed by an entrepreneur to needs to create a comprehensive business plan. A business plan is critical to the success of
plan and launch the new ventures more efficiently. any new venture since it acts as a benchmark and the evaluation criteria to see if the
organization is moving towards its set goals.
Entrepreneurial Process
An entrepreneur must dedicate his sufficient time towards its creation, the major components
of a business plan are mission and vision statement, goals and objectives, capital requirement,
a description of products and services, etc.

3. Resourcing: The third step in the entrepreneurial process is resourcing, wherein the
entrepreneur identifies the sources from where the finance and the human resource can be
arranged. Here, the entrepreneur finds the investors for its new venture and the personnel to
carry out the business activities.

4. Managing the company: Once the funds are raised and the employees are hired, the
next step is to initiate the business operations to achieve the set goals. First of all, an
entrepreneur must decide the management structure or the hierarchy that is required to solve
the operational problems when they arise.

5. Harvesting: The final step in the entrepreneurial process is harvesting wherein, an

entrepreneur decides on the future prospects of the business, i.e. its growth and development.
Here, the actual growth is compared against the planned growth and then the decision
regarding the stability or the expansion of business operations is undertaken accordingly, by
1. Discovery: An entrepreneurial process begins with the idea generation, wherein the an entrepreneur.
entrepreneur identifies and evaluates the business opportunities. The identification
The entrepreneurial process is to be followed, again and again, whenever any new venture is
and the evaluation of opportunities is a difficult task; an entrepreneur seeks inputs
taken up by an entrepreneur, therefore, it’s an ever ending process.
from all the persons including employees, consumers, channel partners, technical

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Who is an Entrepreneur? 3. How confident are you in your mission? An essential trait of entrepreneurs is a
deeply rooted confidence in your own abilities. Especially when you’re starting out,
Plenty of people dream of starting their own business, but few ever take the plunge and
many people are going to doubt you. If you’re easily discouraged, then this may not
actually do it. But if the thought of taking a risk on an idea you think might change the world
be the path for you. Once you’ve gotten your new business off the ground, you’ll be
appeals to you, you might be an entrepreneur.
tasked with making lots of tough decisions that some people aren’t going to like. In
What Is an Entrepreneur? these cases, you’ll need to stick by your choices and avoid second-guessing yourself.

You might think of an entrepreneur as someone who starts or runs a small business, but 4. What is your tolerance for failure? You’re probably familiar with stories of
there’s more to it than that. At a fundamental level, entrepreneurship is about identifying founders who launch a billion-dollar business on their first try but for the majority of
opportunities and taking on risks to fill them. Entrepreneurs as a class tend to be excited by successful entrepreneurs, this isn’t the reality. A key component of entrepreneurship
(rather than afraid of) the challenges that come with solving problems that have never been is a comfort with failing, especially if you can learn from that failure.
solved.
How to Become an Entrepreneur in 7 Steps
You don’t need a business degree—or even that much money in savings—to become a
There’s no one tried-and-true path to becoming an entrepreneur, but there are lots of
successful entrepreneur. Many aspiring entrepreneurs get their start by simply offering a new
resources out there. Networking events can help connect you with fellow entrepreneurs,
solution to a widespread issue.
industry contacts, and potential investors. Incubators or accelerators can help you with the
4 Things to Consider Before Becoming an Entrepreneur basics of developing a product, business plan, and marketing strategy. Here are a few
important things to keep in mind over the course of your entrepreneurial journey:
There’s a lot of romance around the idea of being an entrepreneur. Many people at some
point or another have had a business idea they thought could change the world, or 1. Find your purpose. Write down three things that make you angry. Choose one and
daydreamed about being their own boss. There are certainly advantages to becoming a first- really drill down on what you could do to make that thing less of a problem in your
time entrepreneur, but it’s also an intense, stressful process with a high chance of failure. daily life. Then, write down a plan of action for solving that problem. Or, if you feel
Here are four things to consider before becoming an entrepreneur: like getting creative, come up with a product that could tackle the issue. This doesn’t
necessarily have to be your big invention, so have fun with it.
1. How much do you love your idea? The job of an entrepreneur is hard work, and
failure is a very real (or even the most likely) outcome, so you’ll need to truly love 2. Identify a problem you can solve. You may not have the most experience in an
what you’re doing to get through those challenges. industry, but think about this: Are you a person who knows your niche intimately for
another reason? Might the people making products in your desired industry not have
2. How much stability do you need in your life? Being comfortable with great risk is
your unique knowledge about those products? You may know more about what you
one of the signal characteristics of entrepreneurs. Especially early on in your time as a
want to make than all of the people who are already making products like it. Do
business owner, your product, your schedule, and your income will all be up in the
market research to determine the potential demand for your product.
air. You might work sixty hours a week or more for months on end with no cash flow
and no guarantee of future income. If that doesn’t appeal to you (or it isn’t realistic for 3. Make your first prototype. Prototyping is a two-pronged process: First, it’s bringing
your other life commitments), then quitting your day job to take the plunge might be a your idea into the world to see if it can be made. Then, it’s examining the strengths
mistake. and weaknesses of your product by comparing it to what else is out there. Try your
first few prototypes on yourself. If you wouldn’t buy it and it was your idea in the first

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 place, who would? If it passes the “would I buy it?” test, great—now step it up. Give Six Fundamentals Every Entrepreneur Needs to Succeed
it to some trusted friends and family members to try.
Set realistic expectations.
4. Sell the problem, not the product. You may think that when you’re selling your
While enthusiasm and faith are needed when planning out your business, you do want to
product, you’re selling your product, but that’s not the case. You’ll be selling
temper those thoughts with realism. Your projections for the business should not be wildly
the problem that your product solves. Part one of your pitch should convince your
optimistic so you can manage your expectations and those of any partners. Consider the type
manufacturer, customer, or buyer that there’s an urgent problem that needs solving.
of business and industry. Are you selling a lower margin product that will take time to gain
Appeal to their emotions and get them to either identify or empathize with the
traction? Or are you taking a shot with an app that might attract 100,000 downloads a month?
problem. Ask, “Has this ever happened to you?” If it hasn’t, make them feel for the
Plan for a realistic amount of sales and interest so you can conservatively manage your
people it does happen to: “This is something that my friend has had to cope with their
finances. Are you counting on advertising to bring in customers? Remember that most
whole life.” Part two of your pitch is showing how your product alone is the solution
advertising simply does not work, and you’ll need to attract customers through other channels
to this urgent problem.
and the power of word-of-mouth referrals.
5. Develop your brand story. The story of your brand is what you’re going to want to
Have a clear value proposition.
tell people when you’re marketing your product. That’s what journalists want to write
about, that’s what radio hosts want to talk about. Have you overcome something to Your product or service should offer true value. The value assessment has to go beyond your
start this business? Where do you come from? What was this idea born out of? The own biased opinion. You’re invested in the business, so of course you’ll feel it has value for
more open you’re willing to be about who you are and what you stand for, the more your customers. Gather some outside counsel to be sure the value is clear and easily
likely it is that people will relate to you and therefore your product. explained to your targeted audience. Envision someone referring your service to a colleague,
saying “You need to get Service X because it will help you do A, give you B, and offer you
6. Build a culture of scrappiness. There are two different types of people you have to
insights into C.” If the value proposition is unclear, then you’re likely setting up the business
hire: One will support the strengths you already have, and the other will cover your
for failure.
business blind spots. The more success you get, the more people will start coming out
of the woodwork to get in on that success. In the business world, those people often Offer unique attributes.
come in the form of experts insisting you need their help to grow. In some cases, this
Does your intended service or product bring something new to the consumer? If they already
may be true. Don’t turn your nose up at every expert who offers advice. On the
possess what you are offering, can get it for free, or can an easily acquire it from myriad
flipside, though, you might find that you can perform some of the skills those experts
competitors, then how do you expect to stand out? Will customers be able to identify and
are peddling just fine on your own.
discuss your competitive advantage?
7. Stay connected to your “why.” Starting a successful business is—well, a treacherous
Find your niche in a sizable market.
business. You need to stay focused on something that will keep pushing you forward,
otherwise known as your “why.” Why are you doing this? Why is it important? Turn Knowing your clear value proposition and your unique attributes will help you determine
your “why” into your business’s mission statement. This is as much for you as it is for where you fit in the market.
the people who will be working for you and with you—no matter what sort of
In large and expanding markets, there is always a value proposition to be found with niche
business you’re trying to start, it’s crucial to align yourself and your team on the why
players who can provide a compelling service. In travel, there is always someone looking to
behind the what.

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help research it, track it, or provide services for certain areas or class of travel. As long as the specific to a team or company and undertake specific goals or industry-related operations. A
niche service has a true value proposition and a reasonable market audience, it can pull in corporation may publish its fundamental business principles for its consumers to read, or a
profits. team may publish theirs for other employees to view.

Design a sound business model. 10 fundamental business principles

An entrepreneur can have the most unique product offering, one that offers tremendous value, Here's a list of 10 fundamental business principles to consider:
but if one underlying business plan is not sound then one has nothing. A quality plan is the
1. Know the industry and your competitors
key “how” of a business: how you are going to move forward with your service while
keeping costs down? How do you ensure there will be demand for your product that can be Industry knowledge can be an important aspect of business leadership and may influence
reasonably sustained over the long term? How will you market your product or service to the your standards of business operation and strategy. Consider researching the market you're in
intended audience on a reasonable budget? You need to be a hawk on the bottom line and or collaborating with industry experts in order to improve your understanding of what
ruthlessly manage top line expenses. The hard truth is that most businesses fail, and not consumers expect and care about. Additionally, learning about your competitors' pricing,
always because the idea itself was not sound. A well-constructed economic plan does not of quality and marketing strategies can help ensure that you're offering clients a product that is
course guarantee success, but it is necessary and can turn a failure into a learning experience relevant and adequately priced. This information can help you stand out amongst similar
instead of a catalyst for personal financial ruin. businesses and appeal to the client in a unique way.

A sound model doesn’t mean you can’t deviate from the model and innovate when it is the 2. Build a qualified team
right call.
This fundamental business principle can be beneficial for many work environments,
Pull in customers cost-effectively regardless of your industry. Having team members that are enthusiastic and well-trained can
help ensure that your business strategies and operations are successful. Competent employees
Once you have the product or service and a solid plan lined up, you need to drive customers
can bring innovative ideas or relevant industry knowledge to your company and continually
to make purchases. As I mentioned before, advertising typically does not work. Look at
improve the quality and delivery of your products. Recognizing your team's skills and
inexpensive promotions or contests and your social media strategy as cost-effective ways to
accomplishments can encourage them to continue to perform their best, so training them to
attract consumers. Encourage conversations about your brand by asking for reviews or
do their best can have positive effects on the company and employees overall.
finding a way for consumer-created content that shows off your product’s unique features.
3. Create a high-quality product
While none of this advice may seem particularly surprising, I’m always amazed by how
many entrepreneurs have neglected to do this homework before they launch. If you want to Creating a high-quality product can set your company apart from competitors and motivate
beat the odds, make sure you’ve carefully thought through these non-negotiables before you customers to be loyal to your brand. Successful companies may typically produce well-made
start your business. products or services that address the preferences and desires of the consumer. Focusing on
the quality of your merchandise can improve customer satisfaction by providing them with
What are fundamental business principles?
positive and consistent interactions with your brand. This may help grow your client base and
Fundamental business principles are statements that a company or organization adheres to in brand awareness.
order to identify its priorities and guide future decisions. These principles may address things
like organization and strategy or customer experience and satisfaction. They may also be

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4. Define your goals  Consistency principle

It's typically a good idea to define your goals and business objectives, making this a valuable  Full disclosure principle
fundamental principle. Creating goals can help you track your success and progress, and
 Economic entity principle
identify when to reward employees for their efforts. If you're determined on growing your
business or consumer base, a list of objectives can be a helpful tool. Consider creating a plan  Matching principle
or outline for how to achieve each goal, and consult with other team members to assemble a
 Conservatism principle
manageable list of effective tasks.
8. Understand operational systems and processes
5. Promote your products or services
Understanding operational systems and processes can be a valuable business principle if
Another fundamental business principle is to promote your product or services. Skilled sales
you're trying to grow or scale up the size and reach of your business. There are several
and advertising techniques can improve your revenue and profit and contribute to your
operational systems you can consider, including:
company's success. Consider making a sales plan and a marketing plan in order to have an
effective and sustainable approach. Employees can use a sales plan to promote specific  Managing your customers
products for a designated amount of time in order to yield an ideal amount of profit.
 Communicating with your team and clients
Alternatively, a marking plan grows brand awareness within your industry overall and is less
focused on specific quantifiable measures.  Tracking your sales and marketing techniques

6. Understand organizational structure  Supervising the spread of information through your company

Understanding how successful businesses leaders organize and operate their companies can  Keeping track of your sales and revenue
help you implement similar strategies within your own organization. There are many aspects
Related: The 5-Step Strategic Management Process
of structure within a business, including the management of projects, the allocation of tasks
and the composition of personnel or employees within a department. Mastering effective 9. Use capital strategically
business structures can help you ensure that your company is remaining as productive and
The strategic use of your revenue can be an integral aspect of your business's success.
efficient as possible.
Ensuring that you have sufficient funds to pay all of your employees and allot enough for
7. Know the principles of finance and accounting additional costs that may arise can allow you to continue to operate and grow your company.
Knowing how to allocate your profits can make it possible to continue to produce and
In addition to company structures, understanding key information related to finance and
improve upon your products and merchandise.
accounting may be a fundamental business principle. This can guarantee that your
organization continuously adheres to the laws and regulations of your industry. Finance and 10. Prioritize your customers
accounting information may include the necessary taxes to fill out, permits to apply for and
It can be beneficial for your organization to prioritize your customers and provide them with
deadlines to meet. Some specific accounting principles include:
products that address their interests and desires. You can focus on customer service to ensure
 Accrual principle they feel like you care about their issues and concerns. It may be easier to sell a new product
or upsell existing products to an established customer than to find new clients, so it's

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beneficial for your brand to maintain positive relationships with them so that they continue to job duties. If they know the company as a whole prioritizes customer satisfaction,
purchase or consume your goods and services. they may feel inclined to follow through with this practice.

Related: Steps To Becoming a Manager of Business Operations Sources of Opportunities

Benefits of fundamental business principles 10 Sources of Business Opportunities

Fundamental business principles can have many benefits for your company and help you Many people have interest in business, but most people find it difficult to find the
establish and maintain successful practices. These principles can benefit businesses in the business opportunities. Despite of the fact that many of the individuals have money to
following ways: invest but still they do not know what to do with that money

 Creating a foundation: They can help create a foundation on which all company There is no scarcity of ideas and there are no closed doors for opportunities. Business ideas or
stakeholders build trust and form professional relationships. These stakeholders can opportunities are everywhere in your mind and in your surroundings.
include customers, shareholders, employees and suppliers.
Looking Within Yourself and Examining Skills, Talent, Passion
 Guiding decision-making: A list of appropriate principles can provide management
The very first place to start looking for business ideas and opportunities is to look within
with guidance in decision-making situations. This list can also help them create
yourself. Self-examination is an important thing that can help in reaching to different
strategic plans and navigate what their team can do in order to accomplish given
decisions. It is important to examine your own skills, talent or passion that can fit into the
tasks.
business. Therefore, such businesses, which corresponds according to your skills is the most
 Establishing a company culture: By clearly outlining the fundamental business appropriate and are expected to be successful in future.
principles of your company, you can inform all employees and stakeholders regarding
Keeping Up With Current Events and Ready to Take Opportunities
the expectations, values and standards you intend to uphold. This can create a distinct
and established company culture where employees know how to succeed. Staying updated with social events and modern trend is a great source for getting business
ideas. These events can result in exposure to market trends, industries, new fads
 Distinguishing your company's unique identity: While there are general business
etc. Therefore, resulting in generation of new ideas.
principles that can apply to various companies and industries, identifying a specific
list of what's important to you and your business can help distinguish its identity and Inventing New Product or Service
set yourself apart from competitors in your field.
Another great source of business opportunity is inventing a new product or service. Different
 Improving employee retention: By establishing a list of values and standards that people are creative with a mindset of thinking out of the box and solving problems with the
align with your company, you can attract employees that agree with your vision and best appropriate solution. One need to think like great entrepreneurs such as Steve Jobs, Mark
have a desire to join your team. This means that you may improve your retention rates Zuckerberg etc. However, for winning ideas you need to be specific on your target market
because employees know the expectations ahead of time and believe in your and analyse the problem.
company's mission.

 Influencing staff behavior and practices: Having an outline of the core principles of
the company may influence the way employees behave and how they approach their

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Adding Value to Existing Product particular thing that you could achieve the maximum point of efficiency. This is a highly
acceptable practise and many entrepreneurs work this way. This thinking style can help in
Rather than inventing a product, one can also add a value to existing product. These kind of
getting a lot ideas, which are not just opportunities but are profitable opportunities and worth
innovations can be prove to a great source of business opportunities. Since most of the
investing.
inventions have already taken place, so it is prevailing as innovation.
Venture life cycle
Franchising
What is the Business Life Cycle?
Another investment or business opportunity can also be franchising. By looking on the
demographics and the need for a particular service or product, one can also start business The business life cycle is the progression of a business in phases over time and is most
franchising. It can be really profitable since much of business modelling is not required commonly divided into five stages: launch, growth, shake-out, maturity, and decline. The
because a person uses the rights of another retailer. Franchising can be in several business cycle is shown on a graph with the horizontal axis as time and the vertical axis as dollars or
forms. various financial metrics. Three financial metrics are used to describe the status of each
business life cycle phase, including sales, profit, and cash flow.
Mass Media

Mass media has become comprehensive from past few years. Magazines, TV, Newspapers
etc. are a great source of ideas and opportunities. Different businesses are on sale and
different commercial advertisements are available to choose.

Industrial Surveys

Another important source for a business can be industrial surveys. Since, the main point of a
business is to fulfil the needs of a customer. Therefore, surveying and analysing the
underlying need of a customer can help in reaching a rational decision that addresses the
customer’s problem and result in a profitable business.

Listening Customer Complaints

Complaints are a part of customers’ relationship that led into development of new or
improved products and services. Whenever customers report badly it means that the customer
satisfaction is not being achieved and there is some issue with the product. These things can
help in achieving maximum satisfaction. Similarly, on the other hand they can help in
Image source: CFI
generating new business ideas for addressing problems of customers.
Phase One: Launch
Brainstorming
Each company begins its operations as a business and usually by launching new products or
A creative problem solving technique such as brainstorming is an amazing source of
services. During the launch phase, sales are low but slowly (and hopefully steadily)
generating ideas. The purpose of brainstorming is to think as much possible ways about a
increasing. Businesses focus on marketing to their target consumer segments by advertising

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their comparative advantages and value propositions. However, as revenue is low and initial Phase Five: Decline
startup costs are high, businesses are prone to incur losses in this phase.
In the final stage of the business life cycle, sales, profit, and cash flow all decline. During this
In fact, throughout the entire business life cycle, the profit cycle lags behind the sales cycle phase, companies accept their failure to extend their business life cycle by adapting to the
and creates a time delay between sales growth and profit growth. This lag is important as it changing business environment. Firms lose their competitive advantage and finally exit the
relates to the funding life cycle, which is explained in the latter part. market.

Finally, the cash flow during the launch phase is also negative but dips even lower than the Corporate Funding Life Cycle
profit. This is due to the capitalization of initial startup costs that may not be reflected in the
In the funding life cycle, the five stages remain the same but are placed on the horizontal
business’ profit but that are certainly reflected in its cash flow.
axis. Across the vertical axis is the level of risk in the business; this includes the level of risk
Phase Two: Growth of lending money or providing capital to the business.

In the growth phase, companies experience rapid sales growth. As sales increase rapidly, While the business life cycle contains sales, profit, and cash as financial metrics, the funding
businesses start seeing profit once they pass the break-even point. However, as the profit life cycle consists of sales, business risk, and debt funding as key financial indicators. The
cycle still lags behind the sales cycle, the profit level is not as high as sales. Finally, the cash business risk cycle is inverse to the sales and debt funding cycle.
flow during the growth phase becomes positive, representing an excess cash inflow.

Phase Three: Shake-out

During the shake-out phase, sales continue to increase, but at a slower rate, usually due to
either approaching market saturation or the entry of new competitors in the market. Sales
peak during the shake-out phase. Although sales continue to increase, profit starts to decrease
in the shake-out phase. This growth in sales and decline in profit represents a significant
increase in costs. Lastly, cash flow increases and exceeds profit.

Phase Four: Maturity

When the business matures, sales begin to decrease slowly. Profit margins get thinner, while
cash flow stays relatively stagnant. As firms approach maturity, major capital spending is
largely behind the business, and therefore cash generation is higher than the profit on
the income statement.

Image: CFI’s
However, it’s important to note that many businesses extend their business life cycle during
this phase by reinventing themselves and investing in new technologies and emerging
markets. This allows companies to reposition themselves in their dynamic industries and
refresh their growth in the marketplace.

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Phase One: Launch In Short

At launch, when sales are the lowest, business risk is the highest. During this phase, it is From Startup to Exit: 5 Key Stages of the Financing Lifecycle
impossible for a company to finance debt due to its unproven business model and uncertain
Access to sufficient capital is always a business issue, from the startup stage right through to
ability to repay debt. As sales begin to increase slowly, the corporations’ ability to finance
the exit stage. But the reasons for the financing need – product research and development,
debt also increases.
market validation, operations, growth – and the typical sources of that financing vary
Phase Two: Growth depending on where the business is in its financing lifecycle. Summary of the five key stages
of the financing lifecycle.
As companies experience booming sales growth, business risks decrease, while their ability
to raise debt increases. During the growth phase, companies start seeing a profit and positive Stage 1 Concept Financing: In this beginning stage, the entrepreneur is developing and
cash flow, which evidences their ability to repay debt. completing an initial validation of a business concept. Financial resources will be minimal,
often consisting of self-funding or loans from friends and family members.
The corporations’ products or services have been proven to provide value in the marketplace.
Companies at the growth stage seek more and more capital as they wish to expand their Stage 2 Seed Financing: At the seed stage, the startup will have increased costs as the
market reach and diversify their businesses. entrepreneur incorporates the business and devotes more time to validating the concept,
defining the market and developing the product. Funding options at this stage typically
Phase Three: Shake-out
include government grants and loans and investments from friends, family and close business
During the shake-out phase, sales peak. The industry experiences steep growth, leading to associates, as well as “accredited” angel investors. Startups often attract angel investors by
fierce competition in the marketplace. However, as sales peak, the debt financing life cycle participating in a provincial small business investor tax credit program or raise funds through
increases exponentially. Companies prove their successful positioning in the market, other equity-based funding options, like crowdfunding. To secure angel investments, the
exhibiting their ability to repay debt. Business risk continues to decline. entrepreneur may have to give up some management oversight and control to the new
investors. However, angel investors often provide more than just capital, contributing input
Phase Four: Maturity
and guidance about management and other aspects of running the business.
As corporations approach maturity, sales start to decline. However, unlike the earlier stages
Stage 3 Launch Financing: When the startup is ready to officially launch its product to
where the business risk cycle was inverse to the sales cycle, business risk moves in
market, it will need to ramp up spending to hire personnel and create relationships with
correlation with sales to the point where it carries no business risk. Due to the elimination of
partners, suppliers and customers – with little or no incoming revenue. At this stage, the
business risk, the most mature and stable businesses have the easiest access to debt capital.
startup might begin looking for early stage venture capital funding (typically from venture
Phase Five: Decline capital funds or other institutional investors as opposed to individual investors) or financing
through strategic investors while continuing to raise money from established angel investors.
In the final stage of the funding life cycle, sales begin to decline at an accelerating rate. This
These types of investors spend more time on due diligence before investing, and to attract
decline in sales portrays the companies’ inability to adapt to changing business environments
them, the entrepreneur will have to give up greater control over the business. In exchange, the
and extend their life cycles.
entrepreneur will gain mentorship from experienced business people and access to a broader
Understanding the business life cycle is critical for investment bankers, corporate financial network of partners and investors and help implementing good corporate
analysts, and other professionals in the financial services industry. governance practices to give the business a leg up as it continues to grow.

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Stage 4 Growth Financing: Once a product has been successfully accepted by the market,
the business will be looking to grow and expand its reach. If the business’s revenue stream
isn’t enough to support the targeted growth, it will need to raise more money. Larger venture
capital funding, sometimes in multiple rounds (Series A, B, and so on), is common at this
stage. The company might also use venture capital or angel investor funding at this stage to
bridge to an exit transaction or a public offering.

Stage 5 Maturity/Exit Financing: Once the business has matured, additional financing
options will become available for growth and expansion opportunities. For example, the
company might decide to undertake an initial public offering (IPO) to raise money in the
public markets and achieve liquidity for its investors or obtain bank debt financing that isn’t
accessible to earlier stage companies. At this stage, the company might also move forward
Figure: An analysis of organizational feasibility focuses on resource needs and management
with an exit transaction through an acquisition by or a merger with another company.
capabilities. (Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license)
Evaluating Business Feasibility
Resource sufficiency pertains to nonfinancial resources that the venture will need to move
As the name suggests, a feasibility analysis is designed to assess whether your entrepreneurial forward successfully and aims to assess whether an entrepreneur has a sufficient amount of
endeavour is, in fact, feasible or possible. By evaluating your management team, assessing such resources. The organization should critically rank its abilities in six to twelve types of
the market for your concept, estimating financial viability, and identifying potential pitfalls, such critical nonfinancial resources, such as availability of office space, quality of the labor
you can make an informed choice about the achievability of your entrepreneurial endeavour. pool, possibility of obtaining intellectual property protections (if applicable), willingness of
A feasibility analysis is largely numbers driven and can be far more in depth than a business high-quality employees to join the company, and likelihood of forming favourable strategic
plan. It ultimately tests the viability of an idea, a project, or a new business. A feasibility partnerships. If the analysis reveals that critical resources are lacking, the venture may not be
study may become the basis for the business plan, which outlines the action steps necessary possible as currently planned.
to take a proposal from ideation to realization. A feasibility study allows a business to address
Financial Feasibility Analysis
where and how it will operate, its competition, possible hurdles, and the funding needed to
begin. The business plan then provides a framework that sets out a map for following through A financial analysis seeks to project revenue and expenses (forecasts come later in the full
and executing on the entrepreneurial vision. business plan); project a financial narrative; and estimate project costs, valuations, and cash
flow projections.
Organizational Feasibility Analysis

Organizational feasibility aims to assess the prowess (ability) of management and sufficiency
of resources to bring a product or idea to market. The company should evaluate the ability of
its management team on areas of interest and execution. Typical measures of management
prowess include assessing the founders’ passion for the business idea along with
industry expertise, educational background, and professional experience. Founders
should be honest in their self-assessment of ranking these areas.

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Figure: An analysis of financial feasibility focuses on expenses, cash flow, and projected numbers: include an explanation of the underlying assumptions used to estimate the venture’s
revenue. (Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license) income and expenses.

The financial analysis may typically include these items: Projected cash flow outlines preliminary expenses, operating expenses, and reserves in
essence, how much you need before starting your company. You want to determine when you
 A twelve-month profit and loss projection
expect to receive cash and when you have to write a check for expenses. Your cash flow is
 A three- or four-year profit-and-loss projection designed to show if your working capital is adequate. A balance sheet shows assets and
liabilities, necessary for reporting and financial management. When liabilities are subtracted
 A cash-flow projection
from assets, the remainder is owners’ equity. The financial concepts and statements
 A projected balance sheet introduced here are discussed fully in Entrepreneurial Finance and Accounting.

 A breakeven calculation Market Feasibility Analysis

The financial analysis should estimate the sales or revenue that you expect the business A market analysis enables you to define competitors and quantify target customers and/or
to generate. A number of different formulas and methods are available for calculating sales users in the market within your chosen industry by analyzing the overall interest in the
estimates. You can use industry or association data to estimate the sales of your potential new product or service within the industry by its target market. You can define a market in terms
business. You can search for similar businesses in similar locations to gauge how your of size, structure, growth prospects, trends, and sales potential. This information allows you
business might perform compared with similar performances by competitors. One commonly to better position your company in competing for market share. After you’ve determined the
used equation for a sales model multiplies the number of target customers by the overall size of the market, you can define your target market, which leads to a total available
average revenue per customer to establish a sales projection: market (TAM), that is, the number of potential

T×A=ST×A=S users within your business’s sphere of influence. This market can be segmented by
geography, customer attributes, or product-oriented segments. From the TAM, you can
Target(ed) Customers/Users× Average Revenue per Customer=Sales Projection Target(ed)
further distill the portion of that target market that will be attracted to your business. This
Customers/Users× Average Revenue per Customer=Sales Projection
market segment is known as a serviceable available market (SAM).
Another critical part of planning for new business owners is to understand the breakeven
point, which is the level of operations that results in exactly enough revenue to cover costs. It
yields neither a profit nor a loss. To calculate the breakeven point, you must first understand
the two types of costs: fixed and variable. Fixed costs are expenses that do not vary based on
the amount of sales. Rent is one example, but most of a business’s other costs operate in this
manner as well. While some costs vary from month to month, costs are described as variable
only if they will increase if the company sells even one more item. Costs such as insurance,
wages, and office supplies are typically considered fixed costs. Variable costs fluctuate with
the level of sales revenue and include items such as raw materials, purchases to be sold, and
direct labour. With this information, you can calculate your breakeven point—the sales level
at which your business has neither a profit nor a loss. Projections should be more than just

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An analysis of market feasibility examines the overall market and focuses on the anticipated Evaluating the Feasibility of Business Opportunities
share of the target market. (attribution: Copyright Rice University, OpenStax, under CC BY
Table of Contents
4.0 license)
1. Introduction
Projecting market share can be a subjective estimate, based not only on an analysis of
the market but also on pricing, promotional, and distribution strategies. As is the case 2. The Feasibility Analysis Mindset
for revenue, you will have a number of different forecasts and tools available at your
3. Setting Goals
disposal. Other items you may include in a market analysis are a complete competitive
review, historical market performance, changes to supply and demand, and projected growth 4. Establishing Criteria
in demand over time.
5. Stages of Evaluation
ARE YOU READY? for Market Feasibility Analysis
6. Feasibility Process
You’ve been hired by a leading hotel chain to determine the market and financial potential
7. Writing the Business Plan
for the development of a mixed-use property that will include a full-service hotel in
downtown Orlando, located at 425 East Central Boulevard, in Orlando, Florida. The specific 8. Financing the New Enterprise
address is important so you can pinpoint existing competitors and overall suitability of the
9. Summary
site. Using the information given, conduct a market analysis that can be part of a larger
feasibility study. Introduction

Applying Feasibility Outcomes Feasibility analysis is a tool business owners can use to evaluate a proposed change in a
business. This change may involve developing a new product, improving an existing product,
After conducting a feasibility analysis, you must determine whether to proceed with the
changing marketing strategy or expanding or contracting the business.
venture. One technique that is commonly used in project management is known as a go-or-
no-go decision. This tool allows a team to decide if criteria have been met to move forward One dictionary defines feasibility as "capability of being used or dealt with successfully." It is
on a project. Criteria on which to base a decision are established and tracked over time. You that word - successfully - that gives feasibility analysis its real value as a planning and risk
can develop criteria for each section of the feasibility analysis to determine whether to management tool. In business terms, success is usually defined as some measure of profit or
proceed and evaluate those criteria as either “go” or “no go,” using that assessment to make a increased value. An entrepreneur may have other goals, such as expanding the business to
final determination of the overall concept feasibility. Determine whether you are comfortable allow a family member to join the firm. Even in that scenario, the expansion must provide
proceeding with the present management team, whether you can “go” forward with existing sufficient extra income to compensate for the additional cost. If the feasibility analysis
nonfinancial resources, whether the projected financial outlook is worth proceeding, and indicates that the goal may not be met, the entrepreneur can abandon the idea before investing
make a determination on the market and industry. If satisfied that enough “go” criteria are heavily in the expansion. In other words, the feasibility analysis provides a means whereby
met, you would likely then proceed to developing your strategy in the form of a business the entrepreneur can justify whether to proceed with or abandon a business proposal.
plan.
A change in business always involves risk. A thorough feasibility analysis identifies factors
that contribute to the risk, the probability these factors will happen and their effect on the
proposed business opportunity and entrepreneur. This analysis allows the development of an

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advanced plan to mitigate the risk factors and to establish appropriate contingencies, such as minimum acceptable criteria that must exist if an analysis shows the business plan will
insurance or alternate markets. not reach its first goal.

The Feasibility Analysis Mindset Example 2

A feasibility analysis is conducted in several stages. The more complex the business proposal The entrepreneur may decide a new enterprise should gross $50,000 in its first year of
the more stages of analysis is needed. At the end of each stage, the business planner is production, $125,000 in year 2 and $200,000 in year 3. At these rates of return, it would be
required to do two things: expected to lose $50,000 in year 1, break even in year 2 and net $50,000 in year 3.

 Set criteria by which the project will or will not proceed to the next planning phase These financial goals would be reached if the venture could sell 10,000, 25,000 and 50,000
widgets at $5 each respectively in the first 3 years of operation. These are the production
 Make a decision to proceed to the next stage or to abandon the idea at this point
goals for the enterprise.
These criteria depend on the goals set at the beginning.
These goals are specific, measurable and timely. The study will reveal whether they are
Example 1 realistic and achievable.

If the entrepreneur sets a goal to increase profit by $50,000 per year, the criteria may be that Establishing Criteria
profit must increase by at least $25,000 or it is not worth proceeding. But a market
The last activity in each stage of analysis is to set the criteria against which the results of the
assessment shows the business is unlikely to net more than $10,000 extra from added sales,
analysis will be judged. These criteria are based on the goals set for the project, and allow the
so the entrepreneur decides to abandon the project, looking for a different opportunity.
entrepreneur to decide whether to proceed to examine the idea further or to abandon the idea
Setting Goals altogether.

Often, a single goal is set against which the performance expectations of a new enterprise Example 2 continued
may be measured. At times, a long-term goal and one or two shorter-term goals by which
The entrepreneur may decide that returns of $25,000 in year 1, $75,000 in year 2 and break-
start-up performance may be measured are set. These goals should conform to the
even at $150,000 in year 3 are tolerable. These are the minimum acceptable criteria against
S.M.A.R.T. model (Specific, Measurable, Achievable, Realistic, Timely), as the decision to
which the enterprise is evaluated. If the planning process fails to justify these results, the
proceed or abandon will be based on the ability of the proposed enterprise to actually reach
entrepreneur will abandon the project. Minimum marketing criteria would be any
these goals.
combination of sales volume and price that would result in a lower gross income.
The ability to remain objective is imperative in the setting of goals and throughout the
At this point, the entrepreneur should re-examine the methods used to obtain the results. Here
feasibility study. Every step in the process is designed to move the entrepreneur closer to a
are some sample questions to ask in assessing the results.
goal. It is important the goal be clear and remain static, and that the entrepreneur be able to
clearly define whether an activity will meet the objective.  Was the technique used appropriate for getting accurate results?

In a feasibility analysis, two sets of goals are necessary. The first set defines what the  Did the people surveyed accurately represent the customer base?
business is expected to achieve in a given time period, while the second set defines the
 Do these cost figures represent accurately the cost of production and distribution?

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Decision to "Proceed" or "Abandon"

The decision-making activity is easier if "minimum acceptable" criteria for each stage are
established. Either the project meets the minimum criteria or it does not. If it does not, then
the project is abandoned. If the project meets or exceeds the criteria, the entrepreneur can
proceed to analyze the next stage.

This is where it is critical to remain focused and objective. If a "maybe" enters the decision,
the goal or the information is not well defined. It may be necessary to re-define the goals and
start over, or to do the activity more thoroughly.

Stages of Evaluation

Feasibility analysis is a practical process. It forces the entrepreneur to examine the real
circumstances that the venture is likely to encounter. This is where the entrepreneur's
understanding of business management is challenged. The more thoroughly he or she can
Feasibility process flow chart.
examine the various business factors, the more reliable the conclusions of the feasibility
study. The Idea

Stages of Feasibility Analysis Every idea has some merit and drawbacks. At this stage, the entrepreneur will concentrate
mostly on the obvious benefits and limitations.
1. Examine the idea.
 Does the idea appear to meet set goals?
2. Examine the management capabilities of the entrepreneur.
 What factors could prevent it from being successful?
3. Examine the technical capabilities of the organization.
 Is the entrepreneur's family prepared to make the sacrifices necessary for this project
4. Examine the marketing potential for the product or service.
to work?
5. Examine the cost and financing needs.
It is difficult to remain totally objective through this stage. A healthy level of scepticism
These stages are the same as the components of the business plan, so the information allows the entrepreneur to discover the warning signs and pitfalls that can sabotage any good
gathered during the feasibility study can be transferred directly to the business plan, resulting idea.
in a more effective and accurate business plan.
Criteria considerations:
Feasibility Process
 Are the benefits from this idea sufficient to justify the cost in terms of finance,
Figure illustrates a process for conducting a feasibility analysis. It can be altered according to personal stress and family sacrifice?
the complexity of the project and the amount of risk involved, and is adaptable to any
 What is the minimum ratio of benefits to cost that is tolerable?
business development situation.

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Management Capabilities  How much change is required to accommodate this project?

Management experts agree that the most important factor for success in any business is the  At what point is it not worth the effort?
management team that makes the decisions, yet it is the factor most often overlooked in
Market Realities
determining the feasibility of a venture. When beginning a feasibility study, consider the
following: The success of any venture depends on the ability to get the right product into the right
marketplace at the right time and the right price. The marketing world is littered with failed
 What management skills are lacking in order to have effective control over this
products that could have been successful if the formula for success had been different.
enterprise?
Effective market research is the most important activity an entrepreneur can undertake to
 Can these skills be acquired? reduce risk.

 What effect will involvement in this project have on the family and other enterprises? Key areas to research

 Will this new enterprise produce the lifestyle that I want for my family and myself?  features and benefits of the product or service

Criteria considerations:  target market (Who is most likely to buy?)

 What specific skills need to be developed or hired?  distribution options (best way to reach the target buyers)

 At what point does the lack of available skills become an obstacle?  market demand (How many possible buyers, what volume and price?)

 On a scale of 10, how much support is there from family for pursuing this  competition (What products and companies compete?)
opportunity?
 trends (What is the expected life of the product?)
Technical Realities
 expected price (highest, lowest and most often prices)
An assessment of the idea must consider the question, "Can it be done?" In other words, are
 expected sales (volume and market conditions)
the entrepreneur and organization capable of producing the product and taking it to the
marketplace? Specific questions might include: It is important to understand that customers rule the marketplace. They alone determine
whether the product will sell in sufficient numbers and price to be viable. Market research
 Is there access to the required raw materials?
can reveal the probability of product success.
 What technology, equipment and processes are required?
Criteria Considerations:
 Do staff understand the required technology, equipment and processes?
 What are the minimum values on sales volume and price needed to be viable?
 Does it appear that the production system is workable and affordable?
 Is the potential for growth in sales adequate?
Criteria considerations:
 Is this product the best option available?
 How much time can be devoted to this project at the expense of other enterprises?

Page 15 of 46
 investor is willing to place at risk. These risks may be financial or social. In either case, they
can have a significant effect on the entrepreneur and his or her family.
Cost and Financial Realities
Managing risk is a function of controlling the factors that contribute to possible losses against
Each of the previous analyses generated information on anticipated costs and expected
the investment. Feasibility analysis is a risk-management tool because it helps the
returns. Once this information is transferred to a ledger, three statements can be created:
entrepreneur identify the risk factors involved in the project. Other risk management tools are
 pro forma (projected) income and expense statement those practices that contribute to consistent quality and safety of the product being sold or
that contribute to a low unit cost of production.
 cash flow statement
The feasibility analyst might ask these questions:
 opening balance sheet
 What can go wrong with this project?
These statements are essential to creating a solid business case to justify the proposed
venture. In the original goals, return on investment (ROI) might have been stated. It is  Is there a way to prevent any of these from happening?
possible to calculate a projected ROI.
 What is the probability that any of these factors will go wrong?
The entrepreneur is seeking answers to the following questions:
 What is the probability that two or more of these will go wrong?
 Does the profit level meet or exceed stated goals?
 What will be the effect on the project and the family if they do?
 Are the set-up costs within the range of financial options?
 Can the effect of these risks be reduced through insurance and at what cost?
 Will this proposal provide sufficient return on investment?
 How able and willing is the entrepreneur to assume these risks?
 How will this investment affect net worth?
Risk control is the utilization of systems that minimize the effect of a negative occurrence.
Criteria considerations:
 Quality control and safety programs - reduction of the risk of injury or harm to
 Is the cost of sales acceptable relative to the product price? customers

 Does the venture meet or exceed the profit goals?  Production efficiencies - competitive advantage through low cost of production

 Does the expected return meet or exceed the minimum acceptable level?  Thorough market research - improved chance of marketplace success

 Is there a better way to reach my financial goals?  Accurate cost estimates - improved accuracy of estimating profit and return

Risk Realities Criteria Considerations:

Investments are made in the expectation of a return to the investor. In general, the greater the  Do the risks involved in this venture exceed the benefits?
return expected, the more willing the investor will be to invest. People vary in their ability
 What specific risks need to be avoided or controlled?
and their willingness to take risks. The ability varies with the extent of the cost and the wealth
or asset value of the investor. The willingness varies with the amount of those assets that the  Is the cost of risk abatement through prevention and insurance affordable?

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  What is the maximum amount of risk that can be handled? Conduct a Feasibility Study: Feasibility studies are a great way to answer your own
questions, and questions investors will have about your business. For example, a marketing
Writing the Business Plan
feasibility study looks at the market to assess competition, find niches, and will help you
The information that has been collected to this stage is sufficient to allow the entrepreneur to identify who might buy your products or services.
write a complete business plan. Business plan forms and electronic business plans are
A technical feasibility study: addresses how you will get your product to market (i.e., how
available wherever business books and software are sold. These may come in a variety of
your business will produce, store, deliver, and track its products or services.) A financial
different formats, but all require essentially the same information.
feasibility study projects how much start-up capital is needed, sources of capital, returns on
Financing the New Enterprise investment, and other financial considerations. It looks at how much cash is required, where
it will come from, and how it will be spent.
The business plan is a key tool for obtaining financing for a new business venture, but it is
not a guarantee a financial institution will lend the necessary money to finance the capital and The more you know about your own business needs upfront, the fewer problems you will
operating costs of the enterprise. The information acquired during the feasibility study will have in raising capital and getting started when you are ready to launch.
make the business plan more attractive to investors and lending institutions.
A Economic Feasibility study:
There will be one more "proceed or abandon" decision to be made at this stage. If several
Economic feasibility is the cost and logistical outlook for a business project or
financing sources reject the business plan, the entrepreneur must re-examine the business
endeavour. Prior to embarking on a new venture, most businesses conduct an economic
case and decide whether to proceed with the proposal. One option is to review all sections of
feasibility study, which is a study that analyzes data to determine whether the cost of the
the feasibility analysis and determine whether improvements can be made. Another is to
prospective new venture will ultimately be profitable to the company. Economic feasibility is
reject the idea completely and look for a better idea.
sometimes determined within an organization, while other times companies hire an external
Criteria Considerations: company that specializes in conducting economic feasibility studies for them.

 How much funding is needed to operate the enterprise effectively?

 Should the business case be improved in order to keep trying?

 Does this proposal put too much at risk?

Summary

Feasibility analysis can be conducted on any business proposal, from growing a new variety
of sweet corn to the building of a processing plant. The amount at risk determines the
intensity and thoroughness with which it is conducted. The quality of the information and
analysis determines the accuracy of the resulting business case.

Page 17 of 46
Unit 2 What factors lead to advantages of a particular form? What intellectual property is involved?

Financial Performance What methods of protection are available? What are the available sources of early-stage
financing?
Organizing and financing new venture, measuring financial performance, and
evaluating financial performance. The first question addresses legal forms of organization.2 We specifically consider:

Organizing and financing new venture  Sole proprietorships

 Partnerships (general and limited)
Sole Proprietorships
 Corporations (regular and subchapter S)
Partnerships  Limited liability companies3

General summary of financial, legal, and tax characteristics one should consider when structuring a
new venture. More specifically, these characteristics are:
Limited
 Number of owners
Corporations
 Ease of startup
Limited Liability Companies (LLCs)  Investor liability
 Equity capital sources
FORMS OF BUSINESS ORGANIZATION  Firm life
Venture opportunities are diverse. Consider three examples.1 First, suppose you have an idea  Liquidity of ownership
for a new and different board game. You grew up playing Scrabble and Pictionary and now  Taxation
you have an idea for a board layout where, depending on which squares you land on, one of
several card decks will be activated that requires either “left-brained” (quantitative) or “right-
brained” (qualitative) activities. You plan to use colorful character icons that you will protect Proprietorships
with trademarks. For reference purposes, we will call this venture idea the BrainGames
Company. A proprietorship is a business venture owned by an individual who is personally liable for the
venture’s debts and other liabilities. The owner or proprietor contributes equity capital and
Suppose your second venture idea is to manufacture and sell home safety products, including can contract, incur debt, sell products or provide services, and hire employees just like other
an escape ladder. The ladder will be lightweight, sturdy enough to support someone weighing businesses. A proprietor also has sole responsibility for venture decision making. The
200 pounds, and folds down to the size of a small briefcase. You are considering taking a primary advantage of a proprietorship is that it allows an entrepreneur to conduct the full
college-level product development course so that you can create a prototype. Once you have range of business activities with almost no additional expense to the organization.
a viable prototype, you hope to file for any relevant trademarks and patents. We will call your
second venture idea the EasyWayOut Company. In other little time is required to organize a proprietorship, and the associated legal fees are
low. The owner also determines the life of the proprietorship. For example, the proprietor can
Your third idea involves making miniature devices that can be embedded in athletes’ helmets choose to close down or cease operating the venture at any time.
for an unprecedented “up close” view of the action. During a game, the devices will collect
and transmit performance data in real time to a central computer. The computer will One drawback of a proprietorship is that the personal financial risk is high because the
transform the raw data into new types of statistics and digital images. For example, you proprietor has unlimited liability, a personal responsibility for the venture’s obligations. In
envision a gauge that records the force of a hit or tackle and a stamina gauge that records the event that the venture’s debts or other obligations cannot be paid from the venture’s
changes in the speed of a player’s movements during a game. The technology is in the late assets, creditors have recourse to the proprietor’s personal assets, including cash, bank
stages of development, and you have applied for two patents. We will call this venture accounts, ownership interests in other businesses, automobiles, and real estate.
concept the Virtual SportsStats Company. The proprietor of a failed venture with outstanding obligations may be forced into personal
We explore questions faced by all new ventures as they move through their startup stages: bankruptcy to protect personal assets from the venture’s creditors.
That are the legal organizational forms available when forming a new venture?

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BUSINESS ORGANIZATIONAL FORMS AND SELECTED FINANCIAL, LEGAL, (LLC) no membershi and equity often difficult owners;
limit; long p offerings to taxed at
AND TAX CHARACTERISTICS time and interests to owners transfer personal tax
high legal ownership rates
ORGANIZATION NUMBE INVESTO EQUITY FIRM LIFE TAXATIO costs
AL R OF R CAPITAL AND N
FORM OWNER LIABILIT SOURCE LIQUIDITY
S AND Y S OF General and Limited Partnerships
OWNER’ OWNERSHI
S EASE P The term partnership refers to a general partnership, which is a business venture owned by
OF two or more individuals, called partners, who are each personally liable for the venture’s
STARTU liabilities. Because there are multiple owners, a partnership agreement spells out how
P
business decisions are to be made and how profits and losses will be shared. If the partnership
Proprietorship One; little Unlimited Owner Life Personal tax
time and determined rates agreement does not state otherwise, each general partner has complete managerial discretion
low legal by owner; over the conduct of business.
costs often difficult
to transfer Much like proprietorships, equity capital sources for general partnerships are restricted to
ownership funds supplied by partners. The costs associated with forming a general partnership are
General partnership Two or Unlimited Partners, Life Personal tax usually moderate in terms of time and legal fees. The partners determine the partnership’s
more; (joint and families, determined rates life. If one or more partners decide to transfer their ownership positions to others, the process
moderate several and friends by may be a difficult one. All partners must agree to replace an existing partner with a new
time and liability) partners; partner, and all partners must agree to a sale of a partnership.
legal costs often difficult
to transfer A general partner’s personal financial liability for the venture’s obligations mirrors that of the
ownership sole proprietor—unlimited. In cases of joint liability, legal actions must treat all partners as a
Limited partnership One or Limited General Life Personal tax
group. If the relevant law allows subsets of partners to be objects of legal action related to the
more partners’ and limited determined rates
general liability partners by partnership, the partners have joint and several liability. Joint liability is the norm for
and one or limited to general partnership debt and contract obligations, although some states hold partners jointly and
more their partner; often severally (separately) liable for these. If the conduct of a partnership business has wrongfully
limited investments difficult to harmed another party, partners are typically jointly and severally liable. Although a partner’s
partners; transfer personal liability cannot be altered by the partnership agreement, the agreement can spell out
moderate ownership how partners can recover funds from each other.
time and
legal costs Partnership
Corporation One or Limited to Venture Unlimited Corporate
more, with shareholder investors life; usually taxation; Business venture owned by two or more individuals who are jointly and personally liable for
no limit; s’ and easy to
dividends the venture’s liabilities.
long time investments common transfer subject to
and high shareholde ownership personal tax Partnership Agreement
legal costs rs rates An agreement that spells out how business decisions are to be made and how profits and
Subchapter S Fewer Limited to Venture Unlimited Income losses will be shared
corporation than 75 shareholder investors life; often flows to
owners; s’ and difficult to shareholder Joint Liability
long time investments subchapter transfer s; taxed legal action treats all partners equally as a group joint and several liability subsets of partners
and high S ownership at personal can be the object of legal action related to the partnership
legal costs investors tax rates
Limited liability One or Limited to Venture Life set by Income Limited Partnership
company more, with owners’ investors owners; flows to Certain partners’ liabilities are limited to the amount of their equity capital contribution

Page 19 of 46
Corporations finance. Other important sources of short term finance are trade credit, installment credit, and
A corporation is a legal entity that separates the personal assets of the owners, called customer advances.
shareholders, from the assets of the business. In a more detailed definition, Chief Justice John
Marshall stated: 2. Medium term finance- The period of one year to five years may be regarded as a medium
A corporation is an artificial being, invisible, intangible, and existing only in the term. Medium term finance is usually required for permanent working capital, small
contemplation of law. Being the mere creature of the law, it possesses only those properties expansions, replacements, modifications etc. Medium term finance can be raised by;
which the charter of its creation confers upon it, either expressly, or as incidental to its very
existence. These are such as are supposed best calculated to effect the object for which it was  Issue of shares
created. Among the most important are immortality, and, if the expression may be allowed,  Issue of debentures
individuality; properties by which a perpetual succession of many persons are considered the  Borrowing from banks and other financial institutions
same, and may act as a single individual  Plaguing back of profits by existing concerns.

Limited Liability Companies

A limited liability company (LLC) provides the owners with limited liability (like a 3. Long term finance- Period exceeding 5 years are usually regarded as long term. Long
corporation) and passes its income before taxes through to the owners (in a similar manner to term finance is required for procuring fixed assets, for the establishment of a new business,
a partnership or S corp). for substantial expansion of existing business, modernization etc.
Forming an LLC requires organizational time and legal costs roughly comparable to those of
organizing as a corporation. An LLC typically requires the preparation of two documents. The important sources of long term finance are;
The certificate of formation (Delaware) or the articles of organization (California) lay out the
LLC’s name, address, a formal agent for receiving legal documents, the duration of the firm,  Issue of shares
and whether members or their appointees will govern the LLC. The operating agreement  Issue of debentures
plays the role of the partnership agreement in specifying in more detail how the LLC will be  Loans from financial institutions
governed, the financial obligations of members, the distribution of profits and losses, and  Plaguing back of profits by existing concerns.
other organizational details. Boilerplates for organizing an LLC are widely available, but
competent legal advice is critical in the decision to form an LLC. As these structures are
relatively new, the courts are still working out various areas of law related to LLCs, including Sources of Finances
how they are treated in states other than their formation state.
1. Equity financing- Equity is capital invested in a business by its owners, and it is ‘at risk’
on a permanent basis. Because it is permanent, equity capital creates no obligation by an
Financing the New Venture entrepreneur to repay investors, but raising equity requires sharing ownership.
2. Venture capital- Venture capital is an alternative form of equity financing for small
businesses. Venture capitalists focus on high-risk entrepreneurial businesses. They
Sources of Financing provide start-up (seed money) capital to new ventures, development funds to businesses
Financial Requirements in their early growth stages, and expansion funds to rapidly growing ventures that have
Finance is a key input of production. It is a pre requisite for accelerating the process of the potential to “go public” or that need capital for acquisitions.
industrial development. Financial resources are essential for business, but particular 3. Personal sources- Entrepreneurs must look first to individual resources for start-up
requirements change as an enterprise grows. Obtaining those resources in the amount needed capital. These include cash and personal assets that can be converted to cash. Family
and at the time when they are needed can be difficult for entrepreneurial ventures because members and close friends become involved as informal investors.
4. Commercial banks- Most commercial loans are made to small businesses. Commercial
they are generally considered more risky than established enterprises.
banks provide unsecured and secured loans. An unsecured loan is a personal or signature
Types of finance loan that requires no collateral; the entrepreneur is granted the loan on the strength of his
reputation. Secured loans are those with security pledged to the bank as assurance that the
Depending upon the nature of the activity, the entrepreneurs require three types of finances; loan will be repaid.
i.e. short term, medium term and long term finances. 5. Finance companies- There are three types of finance companies, and although all are
asset-based lenders, each serves a different clientele. These are sales finance companies,
1. Short term finance- Short term finance refers to the funds required for a period of less consumer finance companies, and commercial finance companies.
than one year. Short term finance is usually required to meet variable, seasonal or temporary  Sales finance companies- focus on loans for specific purchases like automobiles and
farm machinery. Most of the customers are end users such as individuals who have
working capital requirements. Borrowing from banks is a very important source of short term their new cars financed through finance companies.

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  Consumer finance companies- focus on short term loans secured by personal assets, business are sold.
and most consumer loans are for small amounts at high rates of interest. These loans
are typically negotiated directly between finance companies and consumers for The financial life cycle of a small firm
purchases such as furniture, appliances, vacation trips and home repairs.
 Commercial finance companies- are focused predominantly on small business and
agricultural lending. Their primary business is making loans on commercial, industrial
and agricultural equipment. Cash flow-debtors and stock
6. Leasing
Financial management is a small firm starts with the management of the cash flow. It is easy
Leasing allows a small firm to obtain the use of equipment, machinery or vehicles without
for cash resources of a small business to become ‘locked up’ in unproductive areas such as
owning them. Ownership is retained by the leasing company, although in many cases there is
a purchase option at the end of the lease period. debtors, work in progress and finished stocks.

Debtors can hurt small business in two major ways;

7. Hire purchase
Hire purchase provides the immediate use of the asset and also ownership of it, provided that
1. They absorb cash and effectively increase the funding requirement of a small firm.
payments according to the agreement are made. 2. The longer a debt is alive, the greater the risk of a bad debt.
Stock represents a poor investment for a small firm’s financial resources. Stock surpluses
8. Factoring
earn no money and the risk of deterioration if not used quickly. Stock management is about
Factoring is a specialist form of finance to provide working capital to young, undercapitalized
balances, and the optimization of resources. Stocks need controlling in three areas- raw
businesses. A small firm, which grants credit to its customers, can soon have considerable
material stock, work-in-progress, finished stock.
sums of money tied up in unpaid invoices. Factoring is a method of releasing these funds; the
factoring company takes responsibility for collection of debts and pays a percentage (Usually Costs and profits
80%) of the value of invoices of the issuing company.
Profits and losses are theoretical figures representing the difference between total earnings
Control of Financial Resources and total expenditures, incurred by a small firm in achieving those earnings. Profits or losses
Financial problems should be translated into cash surpluses or deficits. Profitability can be improved by;
Fast growing small businesses have particular problems in controlling their finances. Growth
brings frequent changes to the internal structures and external environment of a small firm. It  Reduction of costs
is often difficult to ensure that financial control systems keep pace with the changing  Increase of prices
circumstances. The small business is likely to be confronted by a variety of financial  Increase of sales volume
problems as it advances through its life cycle. Costs are classified as fixed or variable. Fixed costs remain unchanged in the short term.
These costs will not vary with the volume of goods or services sold. They are the overheads
of a business. Fixed costs do vary in the long term. Variable costs are operational expenses
that change according to the volume of production.
Stage Likely sources of finance Financial issues
Financial analysis
Conception Personal investment Under capitalization, because of inability
to raise finance. Small firms differ greatly in their approach to the provision of accounting information, and
the use of forecasts and budgets for planning and controlling of business. The three most
Introduction Bank loans, overdrafts Control of costs and lack of information.
widely used financial summaries are;

Development Hire purchase, leasing ‘Over trading’, liquidity crisis.  Profit and loss account or income statement
 Cash flow, and
Growth Venture capital ‘Equity gap’ appropriate information  The balance sheet.
systems.

Maturity All sources Weakening return on investment The profit and loss account, also commonly called as income statement shows how a
business is doing in terms of sales and cost- and the difference between them of profit or
Decline Sale of business/ liquidation Finance withdrawn. Tax issues of losses.

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The cash flow summary indicates the movement of cash into and out of the business. It differs 5 key indicators
in the important respect of reflecting credit given to customers and received from suppliers,
as well as the amount of money invested in a business, or borrowed by it. Henao says key financial indicators fall into these categories:

 Growth—Are your sales and profits increasing or decreasing year-over-year? Is there

The balance sheet represents a summary of what money has been spent by a business, and
what it has been spent on. It is usually an annual summary of the use and source of funds in a a trend?
company.  Profitability—Is your business making enough profit compared to other similar
companies?
Measuring Financial Performance
 Liquidity—Can the company meet its short-term obligations?
After deciding how to organize your business, it is important that you maintain a record of
operations. This record provides ongoing feedback for internal decision making and gives  Leverage—Is the company taking advantage of financing to operate and grow?
creditors and investors necessary information for making sound financial decisions. Every
entrepreneur should have a basic understanding of how financial records reflect the venture’s  Activity—Are you managing the assets of the company effectively?
initial and developing assets and ownership. An entrepreneur should understand how proper
Moreover, it’s critical for entrepreneurs to project and monitor cash flow, Henao adds. Even a
accounting procedures record sales and costs and how this determines whether the venture is
company that is generating profits can quickly find itself in trouble if it doesn’t have enough
making a profit. By using these records to prepare financial statements, the entrepreneur
cash to operate. Thus, you should know your financing needs in advance in order to manage
develops an understanding of how cash is generated and depleted. This understanding leads
your business proactively.
to an ability to interpret important measures of the venture’s financial situation (building or
burning cash) and project when the venture will reach operating breakeven. "If the business is growing, you are most likely going to require financing for receivables,
inventory, machinery and equipment to hire more people, etc. If you wait until you need the
Perhaps the easiest way to measure entrepreneurial success is with money. How much has
funds, you’re putting the company in jeopardy."
your wealth and the wealth of your business(es) grown? Money is a quick measure of success
because it's easy to track your financial growth through financial statements, balance sheets, Benchmark your financial performance
and cash flow statements.
Henao recommends that entrepreneurs benchmark the financial performance of their business
Five financial indicators every entrepreneur should monitor against that of similar companies in the same industry. Results that are below the average
may highlight areas for improvement.
Proper financial management is crucial because it allows you to make timely, well-informed
decisions in response to changing conditions. For instance, a subpar gross profit margin might indicate faulty pricing based on an
inaccurate reading of costs. To solve the situation, you will likely have to reduce costs,
Surprisingly, many entrepreneurs look at financial reports only at year-end or even a few
increase prices or a combination of the two.
months later when financial statements become available. That lack of attention is putting
their business at risk, says Jorge Henao, a BDC Business Consultant specialized in financial "Entrepreneurs often work on intuition," Henao says. "But having the right information at the
management and strategy. right time will help entrepreneurs make more educated decisions."
Review your indicators every month Measuring financial performance majorly covers:
You have to be disciplined in reviewing financial data at least on a monthly basis and • Financial statement quantifies: – marketing – distribution – manufacturing – management.
conducting more thorough analysis every quarter, Henao says.
• It is built on a foundation of assumptions.
You want to compare your company’s performance to objectives set out at the beginning of
the year, based on a long-term strategic plan. You then make adjustments as necessary • It is composed of OR Evaluating Financial Performance:
throughout the year to accomplish the objectives.
• Balance sheet
"You want to make decisions at the right time," he says, "If you wait until year end to address
• Income statement
issues, it will probably be too late."
• Operating and cash-flow budgets

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• Pro-forma statements • If the equation is not in balance, the work should be rechecked.

Balance sheet Capital budgeting

The balance sheet is divided into : – financial resources owned by the firm – claims against Entrepreneurs must make investment decisions with three techniques of capital budgeting.
these resources Current Assets both ‘Plus’ and ‘Minus’ Current liabilities Why the balance
sheet always balances Payback period (PB), Internal Rate of Return (IRR), Net Present Value (NPV)

• Assets = Liabilities + Owners’ equity Break-even analysis

• If something happens that increases or decreases one side of the balance sheet, it is offset by Break-even analysis estimates expected product profitability. that is to know
something on the other side. • How many units must be sold to break even?
Understanding the balance sheet • What contribution does a product make to the margin?
Income statement P&L: The income statement AKA (As Known As) ‘profit and loss BEP helps to understand how a particular product contributes to the overall profit.
statement’ or ‘P&L’ shows the change that has occurred in a firm’s position as a result of its
operations over a specific period. Compared to balance sheet, which reflects the company’s Financial ratio analysis
position at a particular point in time.
Ratios are generally considered to be for owners, managers or creditors.
Understanding the income statement (P&L)
• Vertical analysis – Look ‘up and down’ a single statement to see strengths and weaknesses
Balance and P&L
• Horizontal analysis – Look at financial statements and ratios over time
• What different things can the Balance Sheet and the Income Statement (also known as
Performance tools for sustainable entrepreneurs • Life cycle assessment (LCA) – Track
Profit & Loss) tell you about a business?
costs from idea product death • Design for the environment (DFE) – ‘Wastes’ are ‘designed
• Which category is most important to you? Which line do you first look at? out’ • Factor X – Doubling output while halving impact • EMS ISO 14000 and clean
production – Managing environmental affairs through continuous improvement •
Cash-flow statement: Shows the effects of operating, investing and financing activities on its Environmental impact assessment (EIS) – Assess positive and negative impacts of a project
cash balance. on the natural environment • Material flow analysis (MFA) – Strategies to improve the
– How much cash did the firm generate from operations? material flow systems • ME T (materials, energy and toxicity) Matrix – Impacts of a product
over its life cycle
– How did the firm finance fixed-capital expenditures?
Triple bottom line • Sustainable development performance looks at three areas: people
– How much new debt did the firm add? (social), planet (environment) and profits (economic).

Preparing financial budgets Sales Footprint analysis • You can calculate your carbon footprint. • Expressing all business
activities in CO2 equivalent emissions • Service businesses: taxis, transport, flights and
Forecast using linear regression estimating the expected value of sales versus ad outsourcing. • Manufacturing businesses: aluminium, cement, iron and steel, pulp and paper,
expenditures. refrigeration, semiconductors, wood products Environmental impact of aviation
Pro forma statements
Measuring and evaluating entrepreneur performance
The final step is the preparation of pro forma statements - projections of a firm’s future
• One constant preoccupation for the entrepreneur is measuring of economic performance
financial statements. After preparing the pro forma balance sheet, the entrepreneur should
verify the accuracy of their work with the application of the traditional accounting equation: • Increasingly, stakeholders and the public are expecting entrepreneurs to show that they are
not merely delivering economic value, but also following socially and environmentally
• Assets = Liabilities + Shareholders’ equity
responsible paths.

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We measure six kinds of resources • Tangible resources – Financial – Physical – Planning for Future
Environmental • Intangible resources – Organisational – Relational – Human
Financial Planning: Short Term and Long Term, Systematic Forecasting of Sales, Types and
Costs of Financial Capital, Weighted Average Cost of Capital

Financial Planning: Short Term and Long Term

Short-term financial planning is important for virtually all businesses – from small startups to
large established businesses. Even large businesses with seemingly healthy income
statements have gone bankrupt, simply because they couldn’t meet their current obligations.

Short term planning helps answer important questions like:

 How much cash should you have available in the bank to pay bills?

 How much inventory should you keep on hand?

 How much credit should you extend to customers?

Short-Term Finance Defined

The main difference between short-term and long-term finance is the timing of cash flows.
Usually, short-term financial decisions are defined as those that involve cash flows within the
next 12 months. The long-term is usually defined as longer than one year.

Operating Cycle and Cash Cycle – Unsynchronized!

A common reason firms get into cash flow problems is because of the timing of cash flows
during short-term operating activities.

To illustrate, we can look at some typical short-run operating activities of a manufacturing

firm:

1. Buying raw materials

2. Paying for raw materials → cash out

3. Manufacturing the product.

4. Selling the product

5. Collecting cash → cash in

The operating cycle is the time between the arrival of inventory and the date when cash is
collected from receivables. As we can see, cash is usually paid out before it is collected.

The cash cycle starts when cash is paid out for materials and ends when cash is collected
from accounts receivable.

Imagine a company could buy inventory, sell its product, collect payment, and pay suppliers
all in one day. The company would have a cash cycle of zero days. It’s hard to think of many

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examples of this type of firm because most companies have a positive cash cycle. The longer Finally, the quarterly cash balance is found by subtracting the quarterly cash inflows with the
the cash cycle, the more the need for financing. cash outflows. Financing arrangements have to be made for quarters with a net cash outflow.

Strategies for Reducing Cash Flow Problems Larger companies often go beyond the “best guess” outlined above and use multiple “what if”
scenario analysis, and sensitivity analysis.
Decrease cash cycle time
Common sources of short-term borrowing
Decreasing cash cycle time can help significantly reduce the chances of cash flow problems.
This is why companies frequently try to decrease their inventory and receivables time Operating loans
periods. Cash cycle time can be decreased further if payments to suppliers can be delayed.
Operating loans from banks are the most common way to finance temporary cash deficits. It’s
Cash reserves an agreement where the company can borrow up to a certain amount for a given period –
almost like a credit card. Operating loans can be unsecured or secured by collateral.
Keeping cash reserves and few short-term liabilities can go a long way to help avoid financial
distress. However, this comes at a cost. Having idle cash that is not put to work or invested Interest is charged on the loan and is set by the bank. It’s usually the bank’s prime lending
means future revenue is foregone. rate plus an additional percentage. The bank may increase the rate over time as it assesses the
borrower’s risk.
Maturity hedging
Banks lend mainly to low-risk borrowers. This is why they often decline risky business loans.
Maturity hedging is a fancy term that simply means paying for short-term costs, like Many loan requests that banks turn down come from small businesses, particularly startups.
inventory, with short-term loans. It is usually better to avoid financing long-lived assets (such
These startups then often turn to alternative financing sources.
as machinery) with short-term borrowing. That type of maturity mismatching requires
frequent refinancing, and is riskier because short-term interest rates are more volatile than Financial institutions may require collateral (called security) for a loan, such as property,
long-term rates. Maturity mismatching also increases risk because short-term financing may accounts receivable, or equipment. These are called secured loans. For secured loans, the
not always be available. interest rate charged is often less than with unsecured loans.

It’s important to note that short-term interest rates are normally lower than long-term rates. Letter of credit
This means that it’s generally more expensive to use long-term borrowing than short-term
borrowing. Letters of credit allow borrowers to pay off a balance and borrow funds as needed. This
differs from a short-term loan where the borrower receives a lump sum of cash and can
Cash Budgeting borrow more only after the short-term loan is repaid.

The primary tool for short-term financial planning is the cash budget. It gives managers a Other sources
“heads-up” about when short-term financing may be needed. A cash budget simply records
Larger companies use a variety of other sources of short-term funds. Commercial paper are
estimates of cash receipts and payments.
short-term notes issued by highly rated firms. Banker’s acceptances are similar to
Cash budgeting starts with a sales forecast, usually by the quarter, for the upcoming year. By commercial paper except that they are guaranteed by a bank in exchange for a fee charged by
using the sales forecast and factoring in the receivables period, we can get an estimate of the the bank.
timing of cash collections by quarter.
Long-Term Financial Planning
Next, cash payments are taken into account. Cash payments are often put into four categories:
Once short-term goals have been established, it’s time to create a five- or ten-year plan that
 Payments of accounts payable will see your company’s mission realized. Where will your company be in a decade? It’s
okay if you don’t have the answer to that question just yet. That’s what long-term financial
 Capital expenditures (cash payments for long-term assets) planning is for.
 Long-term financing costs (interest, dividends etc.) What is long-term financial planning? According to the Government Finance Officers
 Salaries, taxes and other expenses Association (GFOA), long-term financial planning is “the process of projecting revenues and
expenditures over a long-term period, using assumptions about economic conditions, future

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spending scenarios, and other salient variables.” Although the GFOA deals with government What is Financial Planning
agencies, the principles of their long-term financial planning definition apply to businesses as
well. Essentially, financial professionals are meteorologists who forecast budgetary needs Firms must plan for both the short term and the long term. Short-term planning rarely looks
further ahead than the next 12 months. It seeks to ensure that the firm has enough cash to pay
instead of the weather.
its bills and that short-term borrowing and lending is arranged to the best advantage
To plan for these needs effectively, businesses should have SMART long-term financial
goals. As outlined in Forbes, SMART stands for: specific, measurable, attainable, relevant, In long-term planning, where a typical planning horizon is 5 years, although some firms look
and time-bound. It may be tempting to keep a long-term financial goal broad—remain out 10 years or more. For example, it can take at least 10 years for an electric utility to
profitable, for example—but your long-term goals should be as well defined as your short- design, obtain approval for, build, and test a major generating plant.
term goals. If your company has a short-term goal to generate $1,000,000 in net income in Long-term financial planning focuses on the firm’s long-term goals, the investment that will
one year, you may also want to consider a long-term five-year goal of generating $5,000,000 be needed to meet those goals, and the finance that must be raised. However, you cannot
in net income annually. think about these things without also tackling other important issues. For example, you need
To achieve these long-term goals, you’ll need a financial plan that includes the following to consider possible dividend policies, for the more that is paid out to shareholders, the more
the external financing that will be needed. You also need to think about what is an
elements:
appropriate debt ratio for the firm. A conservative capital structure may mean greater reliance
 Income statement: a statement used to determine profits and losses in a fiscal quarter on new share issues. The financial plan is used to enforce consistency in the way that these
or year. questions are answered and to highlight the choices that the firm needs to make. Finally, by
establishing a set of consistent goals, the plan enables subsequent evaluation of the firm’s
 Cash flow projection: a prediction of how cash is expected to flow in and out of a
performance in meeting those goals.
business.
Financial Planning Focuses on the Big Picture
 Balance sheet: a summary of a business’s assets, liabilities, and equity.
Many of the firm’s capital expenditures are proposed by plant managers. However, the final
Where do you get the data and information for these elements of a financial plan? By using budget must also reflect strategic plans made by senior management. Positive-NPV
the same processes established to achieve your short-term goals. When you build upon the opportunities occur in those businesses where the firm has a real competitive advantage.
lessons learned in a single year, you set the stage for achieving your long-term goals. You’ll Strategic plans need to identify such businesses and look to expand them. The plans also seek
still have to balance optimism with realism, but short- and long-term goals should both be to identify businesses to sell or liquidate as well as businesses that should be allowed to run
part of your overall financial plan. down.
Beyond the annual budget cycle and multi-year capital plan, governments need to identify Strategic planning involves capital budgeting on a grand scale. In this process, financial
long-term financial trends. Long-term financial planning involves projecting revenues, planners try to look at the investment by each line of business and avoid getting bogged down
expenses, and key factors that have a financial impact on the organization. Understanding in details. Of course, some individual projects are large enough to have significant individual
long-term trends and potential risk factors that may impact overall financial sustainability impact. For example, the telecom giant Verizon recently announced its intention to spend
allows the finance officer to proactively address these issues. Going through a long-term billions of dollars to deploy fiber-optic-based broadband technology to its residential
financial planning process allows decision makers to focus on long-term objectives, customers, and you can bet that this project was explicitly analyzed as part of its long-range
encourages strategic thinking, and promotes overall awareness for financial literacy in an financial plan. Normally, however, financial planners do not work on a project-by-project
organization. Long-term financial planning creates commitment and motivation to provide a
basis. Smaller projects are aggregated into a unit that is treated as a single project.
guide for decision-making.
At the beginning of the planning process, the corporate staff might ask each division to
Long-term financial planning relates to strategic planning, developing financial policies,
submit three alternative business plans covering the next 5 years:
capital improvement planning, and budgeting, but it is inherently different. Each process
fulfills a different combination of planning purposes. As such, long-term financial planning is 1: A best-case or aggressive growth plan calling for heavy capital investment and rapid
most valuable when accompanied by these other planning processes and often communicated growth of existing markets.
together.
2: A normal growth plan in which the division grows with its markets but not significantly at
the expense of its competitors.

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3: A plan of retrenchment if the firm’s markets contract. This is planning for lean economic There are three types of financial capital: equity, debt, and specialty. There's also sweat
times. equity, which can be harder to gauge but is still helpful to keep in mind, especially when
you're looking at a small or startup business.
The plan will contain a summary of capital expenditures, working capital requirements, as
well as strategies to raise funds for these investments. Learn more about the three main types of capital and how they can help you assess your own
business or someone else's.
Sales forecast in entrepreneurship
Type One: Equity Capital
Sales forecasting is the process of estimating future revenue by predicting the amount of
product or services a sales unit (which can be an individual salesperson, a sales team, or a Also known as “net worth” or “book value," this portrays a company's assets minus its
company) will sell in the next week, month, quarter, or year. liabilities. Some businesses are funded with equity capital alone. This may come in the form
of cash invested by the shareholders or owners into a company that has no offsetting
BEYOND SURVIVAL: SYSTEMATIC FORECASTING liabilities.
Forecasting for firms with operating histories is generally much easier than forecasting for This is the favored form of capital for most businesses, because they don't have to pay it
early-stage ventures. Difficulty, however, is no defence for new ventures; forecasts are a back, but it can be very costly. It can also demand massive amounts of work to grow an
necessary ingredient in business plans, particularly if the venture wishes to attract external
enterprise that's been funded this way.1
financing. There is something to be said for taking a small step in the light before leaping into
the darkness that is new venture forecasting. Accordingly, we begin with the forecasting for a Microsoft is an example of this type of operation. It makes high enough returns to justify a
seasoned firm and use the insights it offers as guideposts for a useful approach to new venture pure equity capital structure.
forecasting so, Forecasting Sales for Early-Stage Ventures is necessary.
Type Two: Debt Capital
Estimating Sustainable Sales Growth Rates
This type is money given as a loan with the understanding that it must be paid back by a
To increase value, most ventures need to increase their scales. Revenue growth in isolation, certain date. The owner of the capital is often a bank, bondholder, or wealthy person. They
however, does not assure increasing value. Incremental sales must lead to incremental overall agree to accept interest payments in exchange for you using their money.2
profits and free cash flows. There are several potential impediments to a lockstep relationship
between incremental sales and incremental cash flows. First, the incremental sales must be Think of interest expense as the cost of “renting” the money to expand your business. It's
often known as the "cost of capital." About 80% of U.S. small businesses are said to rely on
sold at prices that cover all incremental costs (capacity and variable costs).
credit at least in part.3
This may not be so easy if the venture, like most firms, faces downward-sloping demand
(with lower prices required to sell more units). Second, the revenues from additional unit The Small Business Administration (SBA) administers many venture capital programs to
sales must cover increases in working capital investments (inventory and accounts start-ups and small businesses. These include long-term loans and loan-guaranty programs;
receivable) required to support those incremental sales. Only when sales revenues cover all of these help small businesses obtain funding from other sources.4
these costs are there free cash flows that can give rise to an increase in venture value. Debt can be an easy way to expand for many young businesses. It's fairly easy to access and
When a venture requires external funds to support expansion, the venture must consider understand.
whether its margins allow it to pay its costs and still provide the type of return demanded by The profit for a business owner is the difference between the return on capital and the cost of
venture investors. Some ventures will conclude that slower growth from internal funding is a capital. For instance, a profit of 5% or $5,000 wouldn't exist without the debt capital
better way to go. Others will seek out external capital in a costly but total commitment to borrowed by the business if it borrowed $100,000 and paid 10% interest yet earned 15% after
rapid growth. taxes.

Type Three: Specialty Capital

This is the gold standard, and it's something you would do well to find as a business
owner. There are a few sources of capital that have almost no economic cost and can take the
Types and Costs of Financial Capital

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limits off growth. They include the negative cash conversion cycle or vendor financing, and The cost can actually be negative in certain cases, such as when you're paid to invest other
insurance floats. people’s money and you get to keep the income.

Negative Cash Conversion Other types of businesses can develop forms of float, but it might not be easy.

Suppose you own a retail store. You need $1 million in capital to open a new location in Sweat Equity
order to expand. Most of that money will be spent on buying or renting the property, product
"Sweat equity" is built when an owner, and sometimes key employees, bootstrap operations.
displays, equipment, inventory to stock your shelves, and new workers.
They may put in long hours at a low rate of pay per hour, or they may not get any pay at
You open your doors and hope that customers come in and buy the items you're selling. In all. This makes up for the lack of capital necessary to hire the employees needed to do the
the meantime, your capital is tied up in the form of inventory. That capital may be either debt job.
or equity capital, or both.
Sweat equity is largely intangible, and it doesn't count as financial capital. However, it can be
Now, suppose that you could get your customers to pay you before you have to pay for your estimated as the cost of payroll saved as a result of excess hours worked by the owners.
items. This would allow you to carry far more products than your capitalization
The hope is that the business will grow rapidly enough to make up for the low-pay, long-hour
structure would otherwise allow. It can be done through vendor financing.
sweat equity they put into the company.
An Example of Vendor Financing
Cost of Financial Capital
Suppose ABC company convinced its vendors to put their products on its shelves and retain
ownership until the moment a customer walks to the front of the store and pays for the Cost of financial capital of an investor, in financial management, is equal to return, an
goods. The vendor sells them to ABC at that precise moment. In turn, ABC sells them to the investor can fetch from the next best alternative.
customer. It is the opportunity cost of investing the same money in different investment having similar
This allows ABC locations to expand far more quickly and return more money to the owners risk and other characteristics.
of the business in the form of share repurchases. Cash dividends would also be an option.
They don’t have to tie up hundreds of millions of dollars in inventory.

The increased cash in the business as a result of more favorable vendor terms and/or getting
customers to pay sooner allows the business to generate more income than equity or debt
capital alone would permit.

Vendor financing can be measured by looking at the percentage of inventories to accounts

payable. The higher the percentage, the better. You'll also need to analyze the cash
conversion cycle. In this case, more days “negative” is better.

Generating Float
Weighted Average Cost of Capital
Insurance companies are a good example when it comes to understanding the concept of
A firm uses various sources of finance to finance its projects. Each source of finance will be
float. They collect money and generate income by investing those funds before paying
benefits out to their clients. They hold on to the money and use it until a car is wrecked, a having a specific cost. So in order to determine the overall cost of capital of the firm, the
home is destroyed by a storm, or an office is flooded. weighted average cost of individual sources of finance should be determined with the weights

"Float" is money that a company holds but doesn't own. It has all the benefits of debt equity being the proportion of each type of capital used.
but none of the drawbacks. The most important consideration is the cost of capital: how much The Weighted Average Cost of Capital (WACC) is defined as the weighted average of
money it costs the owners of a business to generate float. the cost of various sources of finance, weights being the book value or market values of each
source of finance.

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If ko represents the weighted average cost of capital or overall cost of capital then, Cost of Preference :
ko = wdkd + wpkp + wtkt + weke + wrkr Redeemable: Kp = PDiv + 1/n(Pn –Po )
Ko = Overall cost of capital
½(Pn + Po)
Wd = Weight of debt
Wp = Weight of preference share of capital
Wr = Weight of retained earnings Irredeemable: Kp = PDiv/Po
We = Weight of equity share capital where,
Kd = Specific cost of debt
PDiv = Preference Dividend
Kp = Specific cost of preference share capital
Pn = redemption price
Kr = Specific cost of retained earnings
Ke = Specific cost of equity share capital Po = issue price

n = maturity period
WACC (Ko) = KdWd + KpWp + KeWe + KrWr Dividend is calculated on Face Value and floatation cost is to be deducted after allowing for
Cost of Debt : premium or discount ie Po = Po ( 1-f)

The cost of debt refers to interest rates paid on any debt, such as mortgages and bonds.
Interest expense is the interest paid on current debt.
Cost of Equity:
Redeemable : Kd = Int (1- T) + 1/n (Bn – Bo)
The cost of equity is the cost of using the money of equity shareholders in the operations.
½ (Bn +Bo) The formula:
𝑫
Ke = +g
𝑬𝒐
Irredeemable: Kd = Int( 1-f )

Bo
where,
where,
D = dividend
Bn = redemption price
Eo = market price of shares
Bo=issue price
g = growth rate in dividend
n = maturity period

Int = amt of interest

T = tax rate

Further, company incurs floatation cost and floatation cost should be deducted after
allowing for premium or discount ieBo = Bo (1-f)

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Unit 4 1. Understanding The Purpose of The Valuation

Creating and Recognizing Value

The reason for doing the valuation will determine the standard of value to use, and in turn,
Basic Mechanics of Valuation, Venture Capital Valuation using present value and future the valuation approach and the assumptions made in calculating the valuation. Each of these
value, Adjusted valuation methods business valuation factors has an impact on the ultimate assessment.

The Basic Mechanics of a Business Valuation

There are a variety of reasons for valuing a business or business assets:

Understanding the basic elements to a business valuation exercise can put you in a better
 Sale of the business or a share of the business
position to assess proposals for your business, and for potential future transactions where its
value is involved.
 Business merger or acquisition

There is a wide range of reasons why you may need to attach a value to your business. While
 Litigation
a simple web search for “how to value a business” will produce plenty of methodologies,
approaches, tips and “rules of thumb”, the bad news is that only some of these will be
 Tax purposes
appropriate to value your business.

 Insolvency/bankruptcy
Business valuation follows a complex set of rules and requires knowledge of valuation
techniques, factors driving value in the industry, laws and accounting standards, and a good
 Financial reporting
understanding of the subject company; it also requires professional experience and good
judgement, some of the basics of business valuation—the “rules of thumb” most important in
 Marital dissolution
compiling an accurate valuation.

The purpose for the valuation will determine the standard of value to apply. For example, in a
The important elements of business valuation.
marital dissolution case, some states use a fair market value standard, while others use fair
value—a statutory standard that is not determined by the current market. To further
Business Valuation:
complicate matters, the fair value standard used for financial reporting purposes under
Generally Accepted Accounting Practices (GAAP) varies slightly from the fair value
Though business valuation guidelines are straightforward, valuation of business assets or
standard used for other purposes; under GAAP guidelines, fair value is based on participants
enterprises requires a great deal of detailed information, as well as a number of judgements
in the most advantageous market—rather than the open, unrestricted market—which tends to
calls on the part of the evaluator. An accurate, defensible valuation relies on all of the
result in higher values. A valuation for U.S. tax purposes, on the other hand, requires
following valuation basics.
application of the fair market value standard.

Identifying the purpose for the valuation and selecting the proper standard of value to use is
critical to arriving at a fair, reasonable, and defensible value.

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 2. Determining The Basis Of Value understanding of these factors allows comparison of the subject company’s performance to
the business valuation data of others in the same industry of similar size and age.
The basis of value is a consideration of the type of value being measured and the perspectives
of the parties to a transaction. Is the basis of value defined as the value between a willing By comparing the price-to-earnings (P/E) ratio, sale prices for recent transactions involving
buyer and a willing seller, or as the investment value to the current owner? The basis of value similar companies, price-to-book, and price-to-free cash flow of comparable businesses to the
is often specified by law, regulation, or contract, and may be the reason for pursuing the same metrics for the Subject Company, performance of the subject company relative to
valuation. Thus, the purpose for the valuation and the basis of value are directly linked, and similar companies can be established.
the basis of value will have an impact on the valuation approach used and the assumptions
made in the valuation. 5. Determining The Future Outlook For The Business

3. Determining The Premise Of Value Future outlook is the primary concern for an investor or purchaser; value, in their eyes,
derives from the future prospect of creation of additional value. To determine future value,
The premise of value is determined by the purpose for the valuation and the basis of value. it’s necessary to first understand the company’s current strategy and how it has performed to
Generally, it will fall into one of the following categories: date. From this understanding, it’s possible to make projections and forecasts of future
revenues, market share, operating expenses, taxes, capital requirements, and cost of capital.
 Going concern premise: This premise of value assumes continued use of the business Comparison of these metrics to those of other companies in the industry offer additional
assets and continuing operation of the company. insight into the Subject Company’s future prospects.

 Orderly or forced liquidation premise: In this valuation premise, the assumption is To derive reasonable forecasts from this data, it’s also necessary to understand management’s
that the business assets will be operated or sold individually or as a group; the plan for ongoing value creation in the Subject’s business and assess whether it is plausible.
company will not continue operation. Does it rely on repeating strategies that have been successful in the past, or on taking a new
strategic direction? Will it be generated organically, or through acquisitions? These plans
In addition, a business or asset might be of greater value to a particular buyer; this is often the must be carefully scrutinized to determine whether or not they are realistic; business
case in mergers and acquisitions. In these types of transactions, acquisition of the business expectations that deviate significantly from past performance should signal the need for
may allow the purchaser to expand into new markets or achieve some type of synergy that additional scrutiny to determine their plausibility. For example, if management projects a rate
offers value above and beyond the fair market value of the acquired business. A random of growth that exceeds the rate of growth of the overall economy for the infinite future, that is
buyer on the open market would not realize these benefits, so for that buyer, the value of the not a realistic assumption.
business would be less. The premise of value for a merger or acquisition might be
substantially higher as a result. Determining The Valuation Approach To Use

4. Reviewing The Historic Performance Of The Business Once the purpose and proper standard of valuation, the premise of value, and the business’
historic performance and future outlook are established, the best approach for calculating
Understanding the company’s history, ownership structure, and past financial performance is value can be selected. In all valuations, there are three basic business valuation approaches:
crucial for establishing how the business has performed relative to similar businesses. A solid the market approach, the income approach, and the cost approach.

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1. Market Approach 2. Income Approach

Two market approaches can be used in valuing a business. The income approach is a classic approach to valuation—but it requires extensive detail and
analysis and relies on many assumptions. However, it will often result in a more accurate
The first approach involves finding comparable companies and analyzing their value value, particularly when combined with other valuation methods, due to the extensive
indicators (multiples), averaging the value indicators of the comparable companies, and analysis and detail that goes into its calculation. It allows value to be calculated using a
applying those averages to the Subject Company. It’s an imprecise measurement, since the variety of scenarios and thus can offer a range of values based on tweaks in the assumptions
market may over or under value the companies used for comparison, and because the used for forecasting.
difference in multiples between similar companies may be due to company-specific factors.
The value premise of the income approach is that the company’s current full cash value
The second approach is analogous to the use of comparables in real estate appraisal. Sales equals the present value of future cash flows it will generate over its remaining lifecycle.
analysis of similar businesses provides a ballpark value; by analyzing recent sales or asking
prices and making adjustments from those to account for differences from the Subject The steps to applying the income approach are as follows:
Company, a value for the company can be determined.
 Estimate annual cash flows
Limitations of this approach include limited data; the market may not provide many examples
of comparable sales or offerings and independent verification of value may not be available.  Convert estimated cash flows to their current cash value equivalent
In addition, this approach becomes very complicated when it involves valuation of large or
complex companies—there are likely to be even fewer of these to use for comparison  Estimate residual value at the end of the forecast period
purposes, and value for the comparable companies may include intangibles such as
intellectual property, contracts, and customer relationships.  Convert residual value to its current cash equivalent

For comparison purposes, the price of the comparable company needs to be broken down into  Add current value of estimated cash flows to current value of residual value to
its components—tangible assets, intangible assets, real property, personal property, taxable calculate enterprise value
assets, and non-taxable assets. Obtaining or determining the different elements of value is
complicated, and even if they can be established, making value adjustments between the  Deduct working capital, intangible assets, and other excluded assets of the enterprise
comparables and the Subject Company is a subjective judgement call. value to calculate tangible assets

As a result, the market approach provides useful data points, but often will not adequately While the income approach can produce a fair and defensible enterprise value, it has
reflect the Subject Company’s actual value. It is most often used in a merger or acquisition limitations. It does not allow separation by type of asset, so it is inappropriate for use in
transaction, where the purchasing company hopes to realize a business synergy through the situations such as establishing value for property taxes. Another major limitation is that the
acquisition and thus is less concerned with establishing an exact value for the subject value derived is very sensitive to assumptions about the forecast period; small changes in key
company. This approach is also commonly used in valuations for finance purposes. assumptions such as the cost of capital can have a big impact on the calculated value.
Projections are just that—guesses about what the future holds—and they may or may not be

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accurate. As a result, income-based valuations tend to be most accurate for companies with made for marketability, which reflects the inability to quickly convert an interest in the
predictable, stable cash flows. business to cash, and control, to account for lack of complete operational and financial
control, if there are minority stakeholders whose approval is required in making decisions.
The income approach can be combined with the cost approach outlined in the following
section, allowing for direct valuation of tangible assets and indirect valuation of intangible These basics are the foundation of an accurate and defensible business valuation. Everything
assets. This combined approach provides a fair and defensible value for many valuation from the purpose of the valuation, the basis and premise of value assumed, and past
purposes. performance and future outlook of the subject company must be taken into consideration
before any of the valuation approaches are applied. The challenge in achieving a fair and
3. Cost Approach accurate valuation is in selecting the most appropriate valuation approach (or approaches),
accurately weighting the calculated values, and using good judgement in making adjustments.
The basis of the cost approach is the logic that investors will not pay more for an asset than While the valuation approaches are straightforward and calculating value may appear to be
they would for a substitute asset of equal utility. In the cost approach, the Subject Company is simply a matter of plugging the right numbers into the right formulas, in reality, professional
replicated from the ground up to determine the cost of this substitute asset. judgement is crucial to obtaining an accurate estimation of value for the subject assets.

Once the replacement cost of the company is calculated, that cost is adjusted for depreciation In short or summarized form the different methods / approaches of valuation are as
to arrive at the replacement value, less depreciation, of the subject company. under:

Generally, this will yield a value much lower than the Subject Company’s book value, 1. Income Approach: The income valuation method is based on concept of valuing the
because “ghost assets”—assets which exist on the company’s books, but are not used—are present value of future benefits. This approach estimates business value by considering the
eliminated, as are obsolete assets. future income accruing over a period of time. The methods most commonly used by business
valuation professionals include the Capitalization of Earnings Method and the Discounted
The cost approach yields a solid capital valuation supported by current market costs and Earnings Method (Discounted Cash Flow Method).
conditions; it also provides a clear value for tangible assets. When used with the income
approach, intangible assets can be indirectly valued, by subtracting the value of tangible 2. Market Approach: Market Approach refers to the notion of arriving at the value of a
assets calculated in the cost approach from the enterprise value derived through the income company by comparing it to the market value of similar publicly listed companies. The
approach. market business valuation approach is also based on the principle 5 of substitution. The
business valuation expert identifies business entities that have transacted as a way to compare
The biggest drawback to the cost approach is the amount of data required for this method of the subject business. Sold businesses in comparison to the subject is a way to calculate value
business valuation. Data on the cost of materials, equipment, labor—and sometimes more—is of an equally desirable company from an ownership or investment standpoint. The methods
required to arrive at the value, making the cost approach data and labor intensive. most commonly used for the market business valuation approach are the Guideline Public
Company Method, Guideline Company Transactions Method, Multiple of Discretionary
Arriving At A Conclusion Of Value Earnings Method, and Gross Revenue Multiple Method.

Often, the value will be calculated using more than one approach; the resulting values are 3. Asset Approach: The asset business valuation approach is based on the principle of
then evaluated and weighted as appropriate. Additional adjustments (discounts) are then substitution that a prudent buyer will not pay more for a property than the cost of acquiring a

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substitute property of equivalent utility. All assets and liabilities are adjusted to reflect the property space. Businesses that are heavily dependent on a single key person are at higher
business as a going concern entity or the company in liquidation, depending on the premise of risk and tend to attract lower valuations. Business projections and forecasts that depict 200%
value appropriate for the valuation. An asset-based approach is a type of business valuation growth in profits, but do not match that with increased sales, support staff or office space are
that focuses on a company’s net asset value (NAV), or the fair-market value of its total assets immediately questionable and weaken the valuation position.
minus its total liabilities, to determine what it would cost to recreate the business. There is
some room for interpretation in the asset approach in terms of deciding which of the ■ A business story that makes sense.
company’s assets and liabilities to include in the valuation, and how to measure the worth of
each. Company valuations are about more than just the numbers. Valuations should capture both
the quantitative and qualitative aspects of the business, as well as the context in which it
Common elements to all valuations operates. Forecasting sales growth in an objectively shrinking industry, planning for zero bad
debts across a book of a thousand clients and assuming that the current staff complement is
Generally speaking, business valuations aim to place a fair value on a business. Just like there sufficient to service 4-5 times the business volume are common mistakes that many business
are many different types of businesses, there are many different valuations methodologies owners make. These assumptions have a positive impact on the valuation numbers, but taking
and approaches. However, they all share some common elements and underlying principles. a step back and thinking through these statements rationally, it is clear that the business does
not have a consistent, reasonable and well thought out plan for the future with the valuation
■ Cash is king. impact applying as a consequence.

A valuable business is one that demonstrates healthy, reliable cash generative ability. This is Forward-looking versus backward-looking valuations
often referred to as Free Cash Flow (“FCF”) and is broadly a measure of the cash that is
available to investors in the business. FCF is itself quite a broad topic, but the common thread Most methods will fall into one of these two buckets. Each method has its pros and cons, and
is consistency: businesses that generate consistent cash flows tend to attract higher valuations some methods are better suited to some businesses than others. However, regardless of the
than those that don’t. approach, one should always test whether backwards and forwards looking measures are
illustrating similar results. Nevertheless, even though they will almost never match, there
■ The past does inform the future…to some extent. should be a sensible explanation for drastic differences between the two.

Historical business performances (sales, expenses, profits) is not a perfect indicator for future Backward-looking valuations rely on historic business performance as a means of estimating
projected performance. The future is unknown, and the business itself grows and matures. future performance. These methods include revenue and earnings multiples, cost to replicate,
However, while there are plenty of good reasons for a business to lift its margins from 10% to balance sheet and NAV (Net Asset Value) based methods as well as extra earning potential
25% one year to the next, and unless drastic changes to improve these margins are clearly and and return on investment measures. They are typically simple to calculate, as they are derived
defensibly justifiable, it is possible that a business valuer will ignore such fanciful upswings. primarily from information that is available, such as annual financial statements and
management accounts.
■ Is the business adequately resourced to deliver?
Forward-looking methods tend to be more complex to carry out. They are built on forecasts
This is particularly critical for growing businesses, but remains just as valid for established of future sales, expenses and profitability, and as a result are reliant on the assumptions that
ones. Resourcing refers to staff, key persons and experts, supplier lines, funding and even are made about the business. These methods allow for additional detail about the business to

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be accurately captured in the valuation price, such as the recent introduction of a large client, Business owners that make the effort to obtain regular valuations for the business will have a
significant periods of planned growth, new product lines and changes to the business capital far better chance at growing and building their business over time in such a way to optimise
structure. Common forward-looking methods include discounted cash flow methods, of their selling price. The same way that one may maintain and service a car in order to preserve
which there are a wide range of variants available. its sale value, business owners should use valuation exercises as a means of ensuring that
they are continuously building a saleable asset.
Be clear about the purpose of the valuation
When to DIY your valuation
There are many reasons why a valuation needs to be undertaken. These include buy/sell
discussions, introducing a new partner or shareholder, succession and estate planning, capital The internet presents all of us with an abundance of information and resources at the click of
raising and even for tax and divorce calculations. a button. It is therefore relatively straight forward for any business owner to carry out a
valuation exercise themselves. Indeed, many online tools exist where business owners can
Understanding the purpose of the valuation is critical. In each case, the parties that will be obtain a free report in a matter of minutes and this can be a good way for business owners to
reviewing and engaging with the valuation differ and their motives will differ substantially. get a handle on the different methodologies and approaches available.
Buyers would push for lower prices while sellers would push for higher prices; succession
and buy/sell planning is more about equitable treatment of shareholders, and estate planning However, just as one would ask a doctor to step in when symptoms get a bit too serious to be
will place greater focus on the tax and inheritance implications for the business owner. safely addressed by a web search, business owners should seek the right input and advice
when they find themselves with transaction discussions and material decisions involving their
However, business valuations are not silver bullets. There is no single right price for a business. Some of the key benefits of hiring a professional to carry out a business valuation
business, and invariably, different parties will almost always arrive at different valuation include:
results. The key to arriving at a conclusion to any discussion (whether it be with the tax man
or a new investor) is understanding the objectives of each party and selecting the approach ■ Objectivity and independence. Business owners are notoriously (and justifiably) biased
and valuation basis that is best suited to achieving those objectives effectively. when it comes to their own business, and tend to overestimate potential, underestimate
expenses and exaggerate sales potential. This is a negative to a potential buyer that
Using valuations in buy/sell discussions necessarily needs an objective and pragmatic view for potential performance.

A quality valuation report can be an invaluable tool for any party entering into buy or sell ■ Blind spots. A fresh set of eyes will typically highlight areas or aspects that business
discussions. For a business owner looking to sell their business (or a part thereof), a detailed owners are too close to see or choose not to see. This can assist the business owner in
valuation exercise will highlight the aspects of the business that contribute positively to the identifying weak spots in the value proposition, as well as helping them justify and validate
valuation and will allow the seller to motivate for the highest price. the value that they have built.

Conversely, a well-equipped buyer will have a better understanding of how the business has ■ Experience. Valuation professionals have typically valued a range of businesses across a
delivered results and the assumptions/expectations that would need to be play out in order for range of industries and can provide a view of the business that business owners simply cannot
the buyer to realise a suitable return on their investment. achieve themselves.

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 valuation, evaluate its sales, expenses, profits, and gross profits from the past three years.
The right valuation partner
These figures help you predict the future and give your business a value today.

The right valuation partner can be a tremendous asset to your business. Much like a trusted 5. Discount Cash Flow Valuation
mechanic, they can assist business owners in ensuring that their business is managed and If profits are not expected to remain stable in the future, use the discount cash flow valuation
grows in a way that accrues maximal value over time. When looking for a valuation partner method. It takes your business’s future net cash flows and discounts them to present day
for your business, test their backgrounds and ask to see some previous valuation reports. values. With those figures, you know the discounted cash flow valuation of your business and
There may be a premium to be paid, but this should be comfortably offset by an enhanced how much money your business assets are expected to make in the future.
outcome to any future discussions. 6. Adjusted Present Value (APV) (Adjusted Valuation Method)

A business valuation is the process of determining a company’s economic value. Professional The adjusted present value uses the Net Present Value (NPV), which calculates on the basis
evaluators are typically brought in to determine the value of the business, using one or more of being financed only by equity. After the NPV is determined, APV then factors in the
valuation methods to arrive at an objective number. benefits of financing by taking into account the present value (PV) of any financing benefits
Common Business Valuation Methods like tax shields such as those provided by deductible interests.
Below are five of the most common business valuation methods: The NPV formula is:
1. Asset Valuation
Your company’s assets include tangible and intangible items. Use the book or market value
of those assets to determine your business’s worth. Count all the cash, equipment, inventory,
real estate, stocks, options, patents, trademarks, and customer relationships as you calculate
the asset valuation for your business.

2. Historical Earnings Valuation

A business’s gross income, ability to repay debt, and capitalization of cash flow or earnings
determines its current value. If your business struggles to bring in enough income to pay bills,
its value drops. Conversely, repaying debt quickly and maintaining a positive cash flow
improves your business’s value. Use all of these factors as you determine your business’s
historical earnings valuation.
3. Relative Valuation
With the relative valuation method, you determine how much a similar business would bring
if they were sold. It compares the value of your business’s assets to the value of similar assets
and gives you a reasonable asking price.
4. Future Maintainable Earnings Valuation
The profitability of your business in the future determines its value today, and you can use
the future maintainable earnings valuation method for business valuation when profits are
expected to remain stable. To calculate your business’s future maintainable earnings

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 shares. However, to receive the investor’s capital, new shares must be issued. This means that
the overall number of shares increases, which then dilutes the original shareholders portion of
the pie.
For example, if there were initially 100 shares worth 10 dollars each and an investor offers
$500, then the investor will receive 50 shares ($500/$10). Then, there would be 150
outstanding shares with the original shareholders owning its 100 shares and the new investor
owning its 50 shares. This means that the original shareholders’ portion is reduced from
100% to 67%. But, if things go well and more money is invested down the line, the value of
the shares should begin to increase as well as the post-money valuation of the company.
Thus, even though investors may own a smaller percentage, they do so at a higher value per
share.
Then adjust for debt and compare the differences with and without the debt shield. How Frequently Does a Business Valuation Need to be Performed?
A business valuation may be performed at different points in a company’s existence for
For the best and most accurate results, compare two or more methods so you’re prepared for various reasons, most often related to investment decisions, exit planning strategy, a potential
the merger and acquisition process and can confidently stand by the value of your business. sale or buyout, or due to an impending IPO.
Pre-Money vs. Post-Money Valuations Because it is recommended to hire a reputable valuation service, the process can be costly to
Here is a brief look at pre-money and post-money valuation methods, and the similarities and carry out. It’s also a time-consuming process given the amount of information that needs to
differences between the two. be collected and analyzed. For larger businesses, the time and complexity involved often
Pre-Money serves as a deterrent to engaging in regular valuation assessments.
In the simplest of terms, pre-money valuation is the financial figure used to describe the However, the economic climate is frequently in flux, influencing the financial status of
overall value of a company prior to any capital investments. This type of valuation is virtually every company, which is why many companies find an annual valuation analysis to
generally calculated by evaluating factors such as assets, liabilities, revenue, profits, and a be desirable. Although there is no hard and fast answer as to how frequently a business
series of other pertinent financial factors, which is often dependent upon the nature of the valuation should be performed, here are a few ways to approach the process.
business and the segment of the economy in which it resides. In addition, the analysis will Very Rarely or Never
likely include an examination of the company’s business plan and marketing strategy, the For smaller companies that do not plan to seek capital infusions or sell their businesses at
relevant market, competitors in the space, and other external economic factors that will some point down the road, it may be possible to avoid going through the valuation process
ultimately influence the company’s ability to grow and thrive. This assessment is based on altogether. Granted, this seems like an unlikely scenario, but there are entrepreneurs who are
the company’s standing before there are any fundraising rounds. quite territorial when it comes to their hard won creations, so this certainly could happen. But
Post-Money even if a company does not intend to engage in any large scale investments or transactions, it
Post-money valuation looks at the value of a business subsequent to the investment of capital, could end up being helpful to determine a company’s valuation for strategic planning
often through some form of fundraising. With post-money valuation, an investor offers a sum purposes and driving up profitability. As a result, learning the business’s valuation one time
of money based on a stated post-money valuation. Of course, this means that there is also an or perhaps every five to ten years may prove worthwhile.
implied pre-money valuation amount inherent in that offer. The value of the shares prior to
the investment is simply the pre-money valuation divided by the number of outstanding Every One to Two Years or As Needed

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There are plenty of companies that engage in high volume investing, seek financing and restrictions. Although investor mandates are usually meant to mitigate risk and protect
capital on a regular basis, or participate in other types of activities that necessitate the invested capital, these restrictions can make it harder for company founders to act in a
occasional valuation. In these instances, the analysis could be conducted as needed or every strategic manner that would eventually behoove the company.
one to two years. Obtaining an occasional valuation is probably sufficient for most It is a lot easier to engage in risky maneuvers when someone else's money is at stake, but a
companies. Because the economic landscape shifts so frequently, most valuations are likely lot harder to justify and deal with the potential fallout. A higher valuation may seem like
only accurate or valid for a year or less. more dollars to work with, but it generally results in far less flexibility.
On a Regular Basis Potential Down Rounds and Dilution
Performing a business valuation on a frequent basis is most common for large companies In some cases, high valuations actually end up damaging a company when unforeseen
engaging in high stakes activities and transactions. However, these companies are likely circumstances arise and subsequent fundraising rounds are needed. In the event that things do
seeking the valuations of other firms more than they are assessing their own valuation. not proceed as planned, companies may be forced to engage in a down round, undermining
Additionally, for startups experiencing significant success in a short period of time, their the company's value and essentially negating the high valuation given in the first place. And,
estimated valuations will change more dramatically, but these cases tend to be the exception down rounds ultimately mean dilution for the original investors, who may balk and bail as
rather than the rule. soon as possible, further damaging the company. Companies have to proceed with realistic
Considerations Before Conducting a Business Valuation valuations or risk having all of their hard work be for naught.
Many startups become consumed with the valuation process, in hopes of obtaining higher Irresponsible Spending
levels of funding. Although valuation is undoubtedly a key figure in the fundraising process, An infusion of cash creates a lot of opportunities for budding entrepreneurs, but there is
there is also some potential downside that results from a high valuation. something to be said for creating something big out of something rather small. The ability to
Here are some of the common outcomes for companies that receive a high business valuation: grow and problem solve on a frugal budget typically bodes very well for a company’s future.
And, if taking that path, any subsequent need for funding to further accelerate that growth
Higher Expectations trajectory will actually help to justify a decent valuation, without having to worry about the
If a company manages to secure an impressive valuation at the outset, they are usually external hindrances and obstacles that a high initial valuation may have presented.
expected to soar to success in record time. In general, a high valuation will entail some hefty Even entrepreneurs who understand that valuation is just one of many important facets to a
investments, and anytime substantial sums of money are on the line, some pretty high deal probably have to fight the urge to seek the highest number possible. In some cases,
expectations go along with that. Unfortunately, such high expectations may be the bigger simply is not always better, especially in the early stages, and ascending to that peak
impediment to a startup's ability to succeed. With so much pressure to deliver, companies must occur via a more natural progression.
often try to do too much too soon. Clearly, there is a belief that the monetary resources will
support such efforts, but a lack of structure, skills, and know-how often prove problematic.
Rather than impose stressful expectations from the beginning, conservative goals and Venture Capital Valuation using Present Value and Future Value
measures should be put into place. Then, if a company does extremely well, they are
exceeding expectations instead of falling short or barely meeting them, which is far more Basic Venture Capital Valuation Method
likely to occur with a high valuation in the early stage.
Less Flexibility We begin our treatment of VCSCs with the simplest of the shortcuts, a procedure sometimes

In addition to the imposition of high expectations that may be difficult to meet, large called the venture capital method. The basic venture capital (VC) method estimates the

investments associated with a high valuation often correspond with other conditions and venture’s value by projecting only a terminal flow to investors at the exit event (say, in four

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or five years). Modifications of this basic VCSC will allow us to consider additional rounds fifth-year income gives a venture exit value of $10,000,000. Discounting the $10,000,000
and incentive compensation. We will conclude our discussion of VCSCs by extending the exit value by 50 percent per year for five years gives a present value of $1,316,872 or
basic method to reintroduce intermediate cash flows and incorporate scenario extensions. As 10,000,000/(1.5)5 . Figure 10.1 depicts the $10,000,000 future value “exit pie” as well as the
an example, we will present a “three-scenario” venture valuation with intermediate flows. $1,316,872 present value of the exit pie. We can “work” the VC valuations using either form
The basic VCSC approach is simple: of the exit pie. For initial purposes, we will begin with the present value exit pie, which is
consistent with applying the discounted cash flow valuation methods in Chapter 9, whereby
(1) Cash investment today, we discount future cash flows back to the present. To apply the VC shortcut method, one
must first calculate the percent ownership to be sold and then calculate the shares necessary
(2) Cash return at some future exit time, to achieve that ownership. Equations 10.1 and 10.2 implement the VC method. Using I for
the investment, E5 for the venture’s earnings or net income in Year 5, price/earnings ratio
(3) discount this entire return flow back at the venture investors’ target return, (P/E) for the comparable price per dollar of earnings or net income, m for existing shares, n
for new shares to be issued, and r for the expected or demanded rate of return, we have:
(4) divide today’s cash investment by the venture’s post-money present value, and you get

Acquired % of Final Ownership:

(5) the percent ownership to be sold in order to expect to provide the venture investors’ target
return.

An example of this simple procedure will help clarify its structure. Lynda Chen founded a
new venture last year with $10,000 in equity capital for which she received 2,000,000 shares
of common stock. The venture is now moving into its startup stage and needs an additional
$1,000,000 to carry out the business plan. If Lynda had $1,000,000 to invest, she could retain
100 percent ownership of the venture. However, because Lynda does not have additional
equity funds to invest, she is negotiating with a venture investor who is willing to invest
$1,000,000 for an ownership position in the firm in the form of newly issued shares of
common stock. The investor and the founder agree that the horizon (time to exit) for the
investment should be five years. The investor expects a 50 percent compound annual rate of
return for the entire five years. We need to value the venture based on a five-year exit and
determine how many shares to issue to the investor for the $1,000,000. Looking ahead five
years, we can say that the successful venture is expected to produce $1,000,000 per year in
income at that time. We also know that a similar venture recently sold shares to the public for The Venture Valuation Pie

$20,000,000 (denoted as P below), and that its last twelve months of income was $2,000,000
(denoted as E below). We infer from this that the going price per dollar of income in this
technology sector is $10 ($20,000,000/ $2,000,000) and estimate the venture’s exit value five
years from now.2 Multiplying 10 dollars per dollar of income by the $1,000,000 of projected

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 Equation 10.3’s numerator would be $7,593,750, which is equal to $1,000,000 inflated by
(1.50)5 . The denominator is the same $10,000,000 exit value (i.e., $1,000,000 net income
In equation 10.1, we have an investment (numerator) of $1,000,000. The denominator gives times the P/E of 10) as before. Dividing the future value of the investment by the future exit
the venture’s $10,000,000 future value (i.e., $1,000,000 in net income times the P/E multiple value also suggests granting a 75.9375 percent ownership position to the new investor.
of 10) discounted back to the present using (1.50)5 . The result is $1,000,000/$1,316,872, Although the result is the same whether the calculations take place in present or future values,
which equals 0.759375 or 75.9375 percent, the equity ownership percentage that must be it is important always to compare present values to present values (or future values to future
given to the $1,000,000 investor to get the deal done. Equation 10.2 calculates the number of values).
shares to be issued to the new investor so that he can achieve his stated expected compound
annual rate of return of 50 percent. The new shares to be issued can be found by dividing
1,518,750 by 0.240625, which equals 6,311,688. The total number of shares that will be
outstanding after the investment will be 8,311,688 (i.e., 2,000,000 original shares plus
6,311,688 new shares). Dividing 6,311,688 by 8,311,688 gives the 75.9375 percent
ownership acquired by the new investor. Likewise, the founder will own 2,000,000/8,311,688
or 24.065 percent of the venture after the new $1,000,000 investment. Although it is common
practice to calibrate investment decisions using present values, ventures often require more
than one round of financing and also may have an incentive ownership round. Because these
additional financing rounds are likely to occur sometime in the future (up to the venture exit), DIVIDING THE FUTURE VALUE VENTURE VALUATION PIE: FOUNDER FULL
OWNERSHIP AND FIRST-ROUND FINANCING
venture capital shortcut methods sometimes work directly with future exit values instead of
their present values. We can easily change the reference time frame from present values
($1,000,000 investment and $1,316,872 present venture value) to Year 5 values ($7,593,750
future value of the $1,000,000 investment and $10,000,000 future venture value). We will get
the same answer:

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 Using Present Values

Pre-Money Present Valuation ¼ 2,000,000 shares $0:15843622 per share ¼ $316,87224

Post-Money Present Valuation ¼ 8,311,688 shares $0:15843622 per share ¼ $1,316,87224

Put differently, the pre-money present valuation of $316,872 plus the proceeds of $1,000,000
results in a post-money present valuation of $1,316,872. It is important to recognize that both
the pre-money and the post-money present valuations depend on executing the business plan
and its necessary $1,000,000 investment.

Using Future Values

Panel A of Figure 10.2 shows that founder Lynda Chen could retain 100 percent ownership if
she could make the $1,000,000 investment herself. At exit, she then would own all of the
Pre-Money Future Valuation ¼ 2,000,000 shares $0:15843622 per share ð1:50Þ 5 ¼ $2,406,25024
$10,000,000 future value. However, because this is not feasible, Panel B illustrates what
would happen to Lynda’s ownership position assuming a new $1,000,000 investment (needed Post-Money Future Valuation ¼ 8,311,688 shares $0:15843622 per share ð1:50Þ 5 ¼ $10,000,00024
to carry out the business plan) in which the investor expects a 50 percent compound annual
rate of return. After the $1,000,000 capital infusion, the founder would have only a 0.240625 The pre-money future valuation of $2,406,250 plus the future value of the $1,000,000
(1 − 0.759375) ownership position, or 24.0625 percent of the venture. In other words, the investment of $7,593,750 results in a post-money future valuation of $10,000,000. Both the
ownership percentage for the founder drops from 100 percent ownership as follows: present and the future value versions of the VCSC ignore all potential or actual intermediate
cash flows to, or from, existing or future investors. As we mentioned in Chapter 9, the
Founder % Between Financing and Exit ¼ 2,000,000=8,311,688 ¼ 24:0625% associated surplus cash penalty is partially diminished by providing financing in sequences of
rounds called staged financing. Before we modify our example to include two rounds of
Investor % Between Financing and Exit ¼ 6,311,688=8,311,688 ¼ 75:9375%
financing, we first digress to consider the quick method we have used for calculating an exit
With our equations, it is easy to calculate deal parameters commonly used in discussing value ($10,000,000 here) and how it relates to the terminal values found by discounting
venture investments. First, we calculate the issue share price: perpetual cash flows.

Venture investors sometimes refer to pre-money and post-money valuations. The pre-money
valuation is the value of the existing venture and its business plan without the proceeds from
the contemplated new equity issue. The post-money valuation is the pre-money valuation
plus the proceeds from the contemplated new equity issue.

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Life Cycle Approach: Venture Operating and Financial Decisions

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Exit and Turnaround Strategy  Systematic Liquidation
Planning and Exit Strategy: Systematic Liquidation, Going Public, Investment Banking, and The process of liquidating the firm by distributing the cash or assets of venture to its
Strategies for Financially Troubled Ventures. owners is called systematic liquidation. Such liquidation occurs at the mature stage of
venture or when the free cash flow is in excess of amount required for maintaining
Planning and Exit Strategy sustainable growth.
It is important that the entrepreneur be keenly aware of investors’ and founders’ desires for A systematic liquidation occurs when a venture is liquidated by systematically
eventual liquidity. When an initial business plan is prepared, serious consideration should be distributing the venture’s assets to the owners. By the time a venture reaches the maturity
given to how and when the entrepreneur plans to provide a harvest for venture investors. In stage of its life cycle, it may be generating substantial amounts of free cash flow. That is,
many contexts, it is best to plan an exit strategy from the beginning. Waiting until there is internally generated funds may greatly exceed the amount needed to maintain the
significant pressure for an exit is likely to be much more traumatic than planning and venture’s sustainable growth. An entrepreneur may consciously slow or cease growth by
anticipating when a harvest would be appropriate. An awareness of, and concern for, exit not reinvesting in working capital and plant and equipment. As this use of cash ceases,
possibilities and timing is an important signal to potential investors. Some venture capitalists the cash account bulges. The venture can distribute the cash through dividends (or the
may insist on having an exit strategy in place before they will commit financial capital to equivalent in partnerships and limited liability companies) and repurchases of outstanding
early-stage ventures. There is value to having a consensus among investors and founders equity. As a nongrowing venture frequently dies, eventually the remaining assets can be
regarding the type of exit that eventually will be sought. sold and the business can cease operations.
Evidence suggests that over one-half of entrepreneurs either develop formal exit strategies or Why might an entrepreneur choose to plan an exit through a systematic liquidation? The
have thought about harvest strategies at the outset of the venture.2 J. William Petty, John venture’s industry may be in decline, offering immediate (but not long-term) profit
Martin, and John Kensinger interviewed twelve entrepreneurs who each harvested at least opportunities. As we know, industries come and go over time; the market for buggy
one business, ten venture investors who had harvesting experience, and two investment whips evaporated with the introduction of the automobile. The demand for typewriters
advisers who specialized in helping ventures go through the harvesting process. The virtually ceased with the introduction of the personal computer. While some firms move
interviewees emphasized how important it was to begin preparing for the harvest from the into the production and sales of replacement products, other firms make the most of the
very beginning. Comments included: decline and then cease to exist
 You plan for an acquisition and hope for an IPO.  Outright sale to
 Exit strategy begins before the money goes in. 1. Family members
 The worst of all worlds is to suddenly realize that for health or other reasons you have 2. Managers
to sell the company right now and you haven’t planned for it. 3. Employees
Petty, Martin, and Kensinger suggested that having a harvest plan in place makes it easier to 4. Outside buyers
take advantage of windows of opportunity to exit. Willing and able buyers may come and go  Going Public
quickly, and the markets for initial public offerings often move quickly between being “hot” We will return to these alternative harvesting methods after we review the process of
or “cold.” 3 Venture investors and founders should recognize, and give advance consideration valuing ventures at the exit date. Of course, the chosen path for exit may depend on
to, available exits for venture investors. Common alternative exits include: prevailing market conditions at the time.
There is no doubt that many venture investors and entrepreneurs consider an initial public
offering of venture stock as the symbol of venture success. In the typical initial public

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offering (IPO), a firm registers new (and sometimes “used”) shares with the Securities overnight pricing risk. Of course, it is not always the case that investment banks make a
and Exchange Commission (SEC) and state securities regulators, and proceeds to sell profit when reselling the securities to the public. If the investment bankers misjudge the
those shares to the public. The sale of new shares is a primary offering, and the sale of demand for the new securities, they can end up unable to sell the securities at an average
used shares is a secondary offering. While there usually are restrictions on how many price above what they must pay the corporation. Such instances are rare. In a case in
secondary shares can be sold, an initial public offering can involve primary and secondary 1974, the investment banks lost $8 million on a bond issue by New Jersey Sporting
shares. During the IPO process, the firm presents itself to the public and prepares for its Arena. There were major losses on a British Petroleum offering in 1987 when the overall
new life under the “microscope” that the public applies to publicly traded companies. market crashed during the offering. Given that the public offering price is set just before
Typically, firms retain the services of an investment bank to facilitate the IPO process. the actual offering, and given that many underwriting contracts now include clauses
We begin with a discussion of investment banking. protecting the underwriters from major marketwide declines, the mispricing risks do not
appear to be as large as they may have been in the past or as large as the underwriting
 Investment Banking community might suggest. While securities laws prohibit formal agreements with the
When a firm employs an intermediary to assist in the creation, sale, and distribution of its public to buy the soonto-be-offered securities, investment bankers contact many potential
financial assets, the intermediary’s activities are referred to as investment banking. buyers and construct reasonable demand curves for the new securities. While all such
Institutions involved in the investment banking process are known as investment banks. conversations must be informal and nonbinding, investors who back away from their
Employees of investment banks are loosely referred to as investment bankers. In the stated nonbinding intent to buy may find future opportunities to buy other issues
investment banking process, investment banks act neither like investors nor like banks. somewhat altered. We are not suggesting anything improper here; we are merely noting
That is, investment banks are not the targeted investors for a firm’s securities, and that the verbal indications are not merely “cheap talk.”
investment banking is not about offering banking services such as checking accounts. The end of Tesla Motors’ securities registration filing is an example of how the company
Investment bankers specialize in the critical process of finding buyers for a firm’s and its investment bankers promote their joint efforts in taking a company public. Such
securities. They initiate markets for a venture’s newly issued public securities. Owing to promotions appear with the obligatory red herring disclaimer:
their extensive network of possible buyers for the securities (through their affiliated This advertisement is neither an offer to sell nor a solicitation of an offer to buy any of
brokerage and client services activities), investment bankers are considered experts in these securities. The offering is made only by the Prospectus.
predicting the value of the newly issued securities. It seems reasonable, therefore, to An offer would be illegal before the actual offering date. In some cases, the ads appear
assume they have some comparative advantage in taking mispricing risk. Investment after the securities have been allocated. Once you’ve seen the ad, it may not be possible to
banks assume mispricing risk by buying newly issued shares from the corporation at a get a member of the investment banking syndicate to indicate informally that you will be
price that is typically set just (the night) before the shares are available for public able to buy some of the securities when they are legally offered.
purchase (from the investment banks). If the investment bankers have done their Investment bankers have an extensive set of security holders who may act as purchasers
homework, the public offering of the securities at a slightly higher price will be of newly distributed securities. There are two major issues with this. The first is the
successful. The underwriting process is designed to lock in the corporation’s proceeds quality of the distribution. Public companies usually do not wish to have an entire
before the securities are legally offered to individual or institutional investors. The offering land in the hands of a small group of investors. If the company is selling off a
difference between what the investment banks get from public investors and what they significant portion of ownership, a concentrated distribution could effectively overthrow
pay to the issuing firm is called the investment banker’s underwriting spread and is the control of the existing shareholders (and result in the displacement of management).
typically 7 percent to 10 percent. This spread is the largest component of compensation Investment bankers argue that part of their function is providing a widely dispersed
for the investment banks’ provision of marketing services and for bearing their portion of security-holding base, which is particularly valuable when the security being sold is the

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common stock of the firm. The second aspect of distribution is simply physical. Firms for them to borrow additional money to help them manage a period of reduced income or
need the distribution channel for new securities only when they are issuing new stocks. It revenue.
is not efficient for firms to maintain an in-house investment banking department to carry Summary
out securities issuing functions on the rare occasions when they are required. It is much  Financial distress: describes any situation where an individual’s or company’s
cheaper to contract for these services when needed. Investment banking firms, financial condition leaves them struggling to pay their bills, especially loan payments
specializing in such services and maintaining continuous contact with potential investors, due to creditors.
have a comparative advantage.  Causes: There are numerous potential causes of financial distress, and some of them
In addition to the underwriting and marketing services, investment banks provide advice are beyond the control of the individual or company that ends up suffering financial
and consulting. They also can help locate potential acquirers or possible acquisition problems.
targets. Because they are accustomed to taking mispricing risk, investment banks take  Common Remedies: for financial distress include cutting costs, improving revenues
reasonable care in reviewing the company’s investment plans and may be in a position to or cash flow, and restructuring existing debt.
provide valuable insights into the company. Investment banks also expend relatively large Financial Distress in Companies
amounts of human and financial capital discovering and introducing new financial It is easy for a company to encounter a period of financial distress, even a well-managed
products. company. It is because financial distress can occur for several reasons, some of which are
The investment banking function relies heavily on reputations gained through repeated completely beyond a company’s control. For example, a sudden, unexpected downturn in
interactions with buyers and issuers in the market for new securities. Retaining an the overall economy may result in a substantial drop in a company’s revenues.
investment bank involves leaning on that bank’s reputation, a carefully guarded asset. It is As a result of the quarantine and lockdown conditions imposed in the wake of the
not hard to find investment banks that have walked away from deals that they thought COVID-19 pandemic, many brick and mortar stores that previously enjoyed a high,
would damage their long-term reputations. Woe to the firm that spends hundreds of steady income for years suddenly saw their revenues plummet to zero.
thousands of dollars before finding out that the credible investment banks are no longer A company might have taken out a large loan with an adjustable interest rate. In that
interested in assisting the firm in placing new securities. situation, a sharp increase in interest rates can significantly raise the company’s cost to
Strategies for Financially Troubled Ventures / Financial Distress repay its loan, thereby causing financial problems for the organization.
Any situation where an individual’s or company’s financial condition leaves them Of course, many times, a company suffers financial distress as a result of failures by
struggling to pay their bills management. Top executives may overextend the company financially by borrowing
What is Financial Distress or Financially Troubled Ventures? money to fund growth. If the borrowed money does not lead to increased revenues or
Financial distress is a term commonly used in corporate finance that describes any profits quickly enough, then the company may begin to struggle to meet its debt
situation where an individual’s or company’s financial condition leaves them struggling payments.
to pay their bills, especially loan payments due to creditors. Severe, prolonged financial Bad decisions related to marketing or pricing can also lead to financial distress for a
distress may eventually lead to bankruptcy. company. An expensive advertising campaign that doesn’t work or ineffective changes to
When a condition of financial distress occurs, it must be addressed immediately in order a product or pricing structure that leads to a loss in sales are other potential causes of
for the condition not to worsen. Financial troubles often lead to more financial troubles if financial distress. Such missteps can be made by even the most successful companies.
they cannot be promptly remedied. Consider as an example Coca-Cola Company’s introduction in 1995 of a new beverage
For example, an individual or company in financial distress may see their credit product, “New Coke,” which was a disaster for the blue-chip company. Consumers
rating drop. It would cause lenders to charge them higher interest rates, making it difficult utterly rejected the new product, and it led to a severe drop in revenue, as some bottlers

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even refused to carry New Coke. However, it’s interesting to note that when Coca-Cola 4. Failure to adequately manage your finances
abandoned New Coke and reintroduced “Coca-Cola Classic,” its sales soared to new Even people with high incomes can end up in financial distress if they fail to manage their
heights. money well. Expenses can creep upward, such as credit card bills, and suddenly a person
Poor budgeting, inability to collect accounts receivables in a timely manner (which can finds themselves struggling financially. It’s important to always budget your money
cause severe cash flow problems), and poor accounting practices are other potential carefully.
causes of financial distress. If you should experience a time of financial distress, your best options are the same as
The most common remedies that companies apply to ease financial distress include those used by large corporations – look for ways to reduce your expenses and/or increase
cutting costs, improving cash flow or revenues, and debt restructuring aimed at reducing your income and consider negotiating with your creditors for at least a temporary period
the size of debt payments. of reduced debt payment requirements.
Causes Remedies for Financial Distress
Individual Financial Distress Common remedies for financial distress include cutting costs, improving revenues or
Because many people struggle financially paycheck-to-paycheck, with little or no cash flow, and restructuring existing debt.
savings, it is very easy for an individual to experience financial distress. As is the case
with companies, an individual’s financial distress may be a result of their own poor
management of their finances or may come about through no fault of their own. Below
are some of the most common causes of financial distress for individuals:
1. Lost or reduced income
Anyone can suffer a sudden drop in income at any time. You may be unexpectedly fired
or laid off from a job, or the company that you work for may go out of business, leaving
you suddenly unemployed.
A severe economic crisis or other circumstance may compel you to take a substantial pay
cut to remain employed. Whatever the cause, if you don’t have savings to dip into, you
may quickly find yourself struggling just to pay your most basic expenses, such as
housing, utilities, and food.
2. Unexpected expenses
Large unexpected expenses, such as high medical bills or an expensive car repair, are
another common cause of financial difficulties.
3. Divorce
Divorce is one of the most frequent and severe causes of financial distress. In fact,
divorce is such a financial strain often on both parties that, according to studies, the rate
of bankruptcy filings for single mothers in the United States is 300% higher than the
national average.

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