Entrepreneurial Finance, Seventh Edition
By J. Chris Leach and Ronald W. Melicher
Contents:
Preface xi
About the Authors xvii
PART 1
The Entrepreneurial
Environment 1
CHAPTER 1
Introduction to Finance for Entrepreneurs 3
1.1 The Entrepreneurial Process 5
1.2 Entrepreneurship Fundamentals 6
Who is an Entrepreneur? 6
Basic Definitions 7
Entrepreneurial Traits or Characteristics 7
Opportunities Exist but Not Without Risks 8
1.3 Sources of Entrepreneurial Opportunities 9
Societal Changes 9
Technological Changes 12
Emerging Economies and Global Changes 13
Crises and “Bubbles” 14
Disruptive Innovation 15
1.4 Principles of Entrepreneurial Finance 15
Real, Human, and Financial Capital Must be Rented
from Owners (Principle #1) 16
Risk and Expected Reward Go Hand in Hand
(Principle #2) 16
While Accounting is the Language of Business, Cash
is the Currency (Principle #3) 17
New Venture Financing Involves Search,
Negotiation, and Privacy (Principle #4) 17
A Venture’s Financial Objective is to Increase Value
(Principle #5) 18
It is Dangerous to Assume that People Act Against
their Own Self-Interests (Principle #6) 19
Venture Character and Reputation Can be Assets or
Liabilities (Principle #7) 20
1.5 Role of Entrepreneurial Finance 21
1.6 The Successful Venture Life Cycle 23
Development Stage 24
Startup Stage 24
Survival Stage 24
Rapid-Growth Stage 24
Early-Maturity Stage 25
Life Cycle Stages and the Entrepreneurial Process 25
1.7 Financing Through the Venture Life Cycle 26
Seed Financing 27
Startup Financing 27
First-Round Financing 28
Second-Round Financing 28
Mezzanine Financing 29
Liquidity-Stage Financing 29
Seasoned Financing 30
1.8 Life Cycle Approach for Teaching Entrepreneurial
Finance 30
Summary 34
CHAPTER 2
Developing the Business Idea 41
2.1 Process for Identifying Business Opportunities 43
2.2 To be Successful, You Must Have a Sound Business
Model 44
Component 1: The Business Model Must
Generate Revenues 45
Component 2: The Business Model Must
Make Profits 45
Component 3: The Business Model Must Produce
Free Cash Flows 46
2.3 Learn from the Best Practices of Successful
Entrepreneurial Ventures 47
Best Marketing Practices 47
Best Financial Practices 48
Best Management Practices 49
Best Production or Operations Practices are also
Important 49
2.4 Time-to-Market and Other Timing Implications 49
2.5 Initial “Litmus Test” for Evaluating the Business
Feasibility of an Idea 51
2.6 Screening Venture Opportunities 53
An Interview With the Founder (Entrepreneur) and
Management Team: Qualitative Screening 54
Scoring a Prospective New Venture:
Quantitative Screening 58
Industry/Market Considerations 61
Pricing/Profitability Considerations 62
Financial/Harvest Considerations 65
Management Team Considerations 67
Opportunity Screening Caveats 67
2.7 Key Elements of a Business Plan 69
Cover Page, Confidentiality Statement, and Table of Contents 69
Executive Summary 71
Business Description 71
Marketing Plan and Strategy 71
Operations and Support 71
Management Team 72
Financial Plans and Projections 72
Risks and Opportunities 73
Business Plan Appendix 75
Summary 75
Appendix A Applying the VOS Indicator™: An Example 81
PART 2
Organizing and Operat ing the
Venture 85
CHAPTER 3
Organizing and Financing a New Venture 87
3.1 Progressing Through the Venture Life Cycle 89
3.2 Forms of Business Organization 89
Proprietorships 92
General and Limited Partnerships 93
Corporations 97
Limited Liability Companies 99
3.3 Choosing the Form of Organization: Tax and Other Considerations 100
3.4 Intellectual Property 104
Protecting Valuable Intangible Assets 104
What Kinds of Intellectual Property Can be
Protected? 104
Copyrights 111
Other Methods for Protecting Intellectual Property
Rights 111
Employment Contracts 112
3.5 Seed, Startup, and First-Round
Financing Sources 113
Financial Bootstrapping 114
Business Angel Funding 117
First-Round Financing Opportunities 119
Summary 120
CHAPTER 4
Preparing and Using Financial Statements 127
4.1 Obtaining and Recording the Resources Necessary
to Start and Build a New Venture 129
4.2 Business Assets, Liabilities, and Owners’
Equity 130
Balance Sheet Assets 132
Liabilities and Owners’ Equity 133
4.3 Sales, Expenses, and Profits 134
4.4 Internal Operating Schedules 136
4.5 Statement of Cash Flows 140
4.6 Operating Breakeven Analyses 142
Survival Breakeven 142
Identifying Breakeven Drivers in Revenue
Projections 147
Summary 149
Appendix A NOPAT Breakeven: Revenues Needed
to Cover Total Operating Costs 156
CHAPTER 5
Evaluating Operating and Financial
Performance 159
5.1 Users of Operating and Financial Performance
Measures by Life Cycle Stage 161
5.2 Using Financial Ratios 162
5.3 Cash Burn Rates and Liquidity Ratios 165
Measuring Venture Cash Burn and Build Amounts
and Rates 165
Beyond Burn: Traditional Measures of Liquidity 167
Interpreting Cash-Related and Liquidity-Related
Trends 168
5.4 Leverage Ratios 170
Measuring Financial Leverage 170
Interpreting Changes in Financial Leverage 172
5.5 Profitability and Efficiency Ratios 173
Income Statement Measures of Profitability 173
Efficiency and Return Measures 175
Interpreting Changes in Profitability
and Efficiency 177
5.6 Industry Comparable Ratio Analysis 178
5.7 A Hitchhiker’s Guide to Financial Analysis 179
Summary 182
PART 3
Planning for the Future 191
CHAPTER 6
Managing Cash Flow 193
6.1 Financial Planning throughout the Venture’s Life
Cycle 194
6.2 Surviving in the Short Run 196
6.3 Short-Term Cash-Planning Tools 198
6.4 Projected Monthly Financial Statements 202
6.5 Cash Planning from a Projected Monthly Balance
Sheet 205
6.6 Conversion Period Ratios 206
Measuring Conversion Times 206
Interpreting Changes in Conversion Times 210
Summary 212
CHAPTER 7
Types and Costs of Financial Capital 221
7.1 Implicit and Explicit Financial Capital Costs 223
7.2 Financial Markets 223
7.3 Determining the Cost of Debt Capital 225
Determinants of Market Interest Rates 227
Risk-Free Interest Rate 227
Default Risk Premium 228
Liquidity and Maturity Risk Premiums 231
A Word on Venture Debt Capital 234
7.4 What is Investment Risk? 234
Measuring Risk as Dispersion Around an
Average 234
Historical Return Versus Risk Relationships 238
7.5 Estimating the Cost of Equity Capital 240
Cost of Equity Capital for Public Corporations 241
Cost of Equity Capital for Private Ventures 243
Sources and Costs of Venture Equity Capital 245
7.6 Weighted Average Cost of Capital 247
A Life Cycle–Based Wacc Example 248
Summary 250
Appendix A Using WACC to Complete the
Calibration of EVA 258
CHAPTER 8
Securities Law Considerations When Obtaining
Venture Financing 261
8.1 Review of Sources of External Venture
Financing 263
8.2 Overview of Federal and State Securities Laws 265
Securities Act of 1933 266
Securities Exchange Act of 1934 266
Investment Company Act of 1940 267
Investment Advisers Act of 1940 267
Jumpstart Our Business Startups Act of 2012 268
State Securities Regulations: “Blue-Sky” Laws 269
8.3 Process for Determining Whether Securities Must be
Registered 270
Offer and Sale Terms 270
What is a Security? 271
8.4 Registration of Securities Under the Securities Act of
1933 272
8.5 Security Exemptions from Registration Under the
1933 Act 276
8.6 Transaction Exemptions from Registration Under
the 1933 Act 278
Private Offering Exemption 278
Accredited Investor Exemption 280
8.7 SEC’s Regulation D: Safe-Harbor Exemptions 281
Rule 504: Exemption for Limited Offerings and Sales
of Securities not Exceeding $5 Million 282
Rule 506: Exemption for Limited Offers and Sales
Without Regard to Dollar Amount of Offering 283
8.8 Regulation a Security Exemption 289
8.9 JOBS Act Innovations 290
Summary 290
Appendix A Schedule A (Securities Act of 1933, as
Amended) 294
Appendix B Selected SEC Regulation D
Materials 299
Appendix C Other Forms of Registration
Exemptions
and Breaks 326
PART 4
Creat ing and Recognizing
Venture Value 329
CHAPTER 9
Projecting Financial Statements 331
9.1 Long-Term Financial Planning Throughout the
Venture’s Life Cycle 332
9.2 Beyond Survival: Systematic Forecasting 334
Forecasting Sales for Seasoned Firms 334
Forecasting Sales for Early-Stage Ventures 336
9.3 Estimating Sustainable Sales Growth Rates 340
9.4 Estimating Additional Financing Needed to Support
Growth 344
The Basic Additional Funds Needed Equation 345
Impact of Different Growth Rates on Afn 347
Estimating the Afn for Multiple Years 348
9.5 Percent-of-Sales Projected Financial
Statements 349
Forecasting Sales 349
Projecting the Income Statement 350
Projecting the Balance Sheet 351
Forecasting the Statement of Cash Flows 353
Financing Cost Implications Associated with the
Need for Additional Funds 354
Summary 355
CHAPTER 10
Valuing Early-Stage Ventures 361
10.1 What is a Venture Worth? 363
Does the Past Matter? 363
Looking to the Future 364
Vested Interests in Value: Investor and
Entrepreneur 364
10.2 Basic Mechanics of Valuation: Mixing Vision and
Reality 366
Present Value Concept 366
If You’re not Using Estimates, You’re not Doing a
Valuation 367
Divide and Conquer with Discounted Cash
Flow 369
10.3 Required versus Surplus Cash 372
10.4 Developing the Projected Financial Statements for a
DCF Valuation 374
10.5 Just-In-Time Equity Valuation: Pseudo
Dividends 378
10.6 Accounting versus Equity Valuation Cash Flow 385
Origins of Accounting Cash Flows 385
From Accounting to Equity Valuation Cash
Flows 386
Summary 390
CHAPTER 11
Venture Capital Valuation Methods 409
11.1 Brief Review of Basic Cash Flow-Based Equity
Valuations 411
11.2 Basic Venture Capital Valuation Method 413
Using Present Values 416
Using Future Values 416
11.3 Earnings Multipliers and Discounted Dividends 417
11.4 Adjusting VCSCs for Multiple Rounds 419
First Round 420
Second Round 420
11.5 Adjusting VCSCs for Incentive Ownership 421
First Round 422
Second Round 422
Incentive Ownership Round 422
11.6 Adjusting VCSCs for Payments to Senior Security
Holders 423
11.7 Introducing Scenarios to VCSCs 424
Utopian Approach 425
Mean Approach 426
Summary 431
PART 5
Structuring Financing for the
Growing Venture 455
CHAPTER 12
Professional Venture Capital 457
12.1 Historical Characterization of Professional Venture
Capital 459
12.2 Professional Venture Investing Cycle: Overview 463
12.3 Determining (Next) Fund Objectives and
Policies 464
12.4 Organizing the New Fund 465
12.5 Soliciting Investments in the New Fund 468
12.6 Obtaining Commitments for a Series of Capital
Calls 469
12.7 Conducting Due Diligence and Actively
Investing 470
12.8 Arranging Harvest or Liquidation 477
12.9 Distributing Cash and Securities Proceeds 478
Summary 479
CHAPTER 13
Other Financing Alternatives 483
13.1 Business Incubators, Seed Accelerators, and
Intermediaries 485
Business Incubators and Seed Accelerators 485
Intermediaries, Facilitators, and Consultants 486
13.2 Business Crowdsourcing and Crowdfunding 487
13.3 Commercial and Venture Bank Lending 488
13.4 Understanding Why You May not Get Debt
Financing 491
13.5 Credit Cards 493
13.6 Foreign Investor Funding Sources 494
13.7 Small Business Administration Programs 494
Overview of What the Sba does for Small
Businesses 495
Selected Sba Loan and Operating Specifics 496
13.8 Other Government Financing Programs 497
13.9 Factoring, Receivables Lending, and Customer
Funding 498
13.10 Debt, Debt Substitutes, and Direct Offerings 500
Vendor Financing: Accounts Payable and Trade
Notes 500
Mortgage Lending 500
Traditional and Venture Leasing 500
Direct Public Offers 501
Summary 502
Appendix A Summary of Colorado Business
Financial
Assistance Options 505
CHAPTER 14
Security Structures and Determining Enterprise
Values 507
14.1 Common Stock or Common Equity 509
14.2 Preferred Stock or Preferred Equity 510
Selected Characteristics 510
Convertible Preferreds 511
Conversion Value Protection 513
Conversion Protection Clauses 514
Conversion Price Formula (CPF) 514
Market Price Formula (MPF) 514
14.3 Convertible Debt 516
14.4 Warrants and Options 517
14.5 Other Concerns About Security Design 523
14.6 Valuing Ventures with Complex Capital Structures:
The Enterprise Method 524
Summary 531
PART 6
Exit and Turnaround Strategies 543
CHAPTER 15
Harvesting the Business Venture Investment 545
15.1 Venture Operating and Financial Decisions
Revisited 547
15.2 Planning an Exit Strategy 548
15.3 Valuing the Equity or Valuing the Enterprise 550
Relative Valuation Methods 550
Dividing the Venture Valuation Pie 551
15.4 Systematic Liquidation 553
15.5 Outright Sale 554
Family Members 554
Managers 555
Employees 558
Outside Buyers 559
15.6 Going Public 561
Investment Banking 561
Some Additional Definitions 564
Other Costs in Issuing Securities 565
Post-Ipo Trading 566
Contemplating and Preparing for the Ipo
Process 569
Summary 574
CHAPTER 16
Financially Troubled Ventures: Turnaround
Opportunities? 581
16.1 Venture Operating and Financing Overview 583
16.2 The Troubled Venture and Financial Distress 584
Balance Sheet Insolvency 585
Cash Flow Insolvency 586
Temporary versus Permanent Cash Flow
Problems 587
16.3 Resolving Financial Distress Situations 588
Operations Restructuring 590
Asset Restructuring 593
Financial Restructuring 595
16.4 Private Workouts and Liquidations 596
Private Workouts 596
Private Liquidations 597
Venture Example: Jeremy’s Microbatch Ice Creams,
Inc. 598
16.5 Federal Bankruptcy Law 598
Bankruptcy Reorganizations 599
Reasons for Legal Reorganizations 600
Legal Reorganization Process 602
Bankruptcy Liquidations 605
Summary 609
PART 7
CAPSTONE CASES 615
CASE 1
Eco-Products, Inc. 617
CASE 2
Spatial Technology, Inc. 647
Glossary 673
Index 681