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Seven Principles of Entrepreneurial Finance

1. Real, human, and financial capital must be ‘rented’ from owners

They expect a return that is comparable to what they could get somewhere else

2. Risk and expected reward go hand in hand

Incredibly high risk – they’ll expect a return that compensates

3. While accounting is the language of business, cash is the currency

4. New venture financing involves search, negotiation, and privacy

You can’t just sell stocks

Constantly searching for funding

5. A venture’s financial objective is to increase value

Prove that there’s value so that money will come and you can exit and get the value

(free cash flow)

6. It’s dangerous to assume that people act against their own self-interest

7. Venture character and reputation can be assets or liabilities

Financing through the Venture Life Cycle

- Revenue generation begins at time 0

- Eventually revenue levels off

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- Seed financing – originally came from the owner, family, friends

- Start-up stage: use angel investors and venture capitalists

- Angel – an individual who is a self-made millionaire that has money to invest (like the Dragons)

- Venture capitalist – more formal and organized in a firm; have a lot of people involved and a lot

of ventures to spread the risk

- Survival stage – still need venture capitalist, may get government assistance, may have to put

your house up as collateral for bank loans

- Time cash flows to your advantage (get trade credit from suppliers – ex. 90 days to pay) while

get cash from customers quickly

- Rapid-growth stage – cash-flow positive, need even more funding

- Mezzanine financing – debt with an equity kicker (need to get financing without collateral); offer

a portion of the company

- Liquidity financing – investment bank, public needs to see the value so they’ll buy the stock, it’s

easier to get $5 million from 1 million people (rather than just from one person)

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Measuring Financial Performance

Why maintain a record of operations? Provide feedback for internal decision-making Provide information for creditors and investors to make decisions Reflect the venture’s initial and developing assets and ownership Record sales and costs and whether making a profit Gain understanding of how cash is generated and depleted Interpret financial situation and project when reach breakeven

Where recorded? Balance Sheet (Statement of Financial Position)

Records ASSETS including cash Records financing obtained by owners (OWNERS’ EQUITY) and lenders

(LIABILITIES) Provides a ‘snapshot’ of the venture’s financial position on a specific date Built on premise that:

ASSETS = LIABILITIES + OWNERS’ EQUITY ex: buy car for $15,000 with $5,000 of own money and $10,000 loan

15,000 = 10,000 + 5,000 sell the car for $12,000 shortly after

12,000 = 10,000 + 2,000 Income Statement Statement of Cash Flows

Balance Sheet PSA Company as of June 30, 2012

- $30,000 from seed financing - $10,000 in inventory (payable- you still owe the supplier for this inventory) - Divide up current assets (something that has a shorter life – at most a year; liquid assets) and

long-term assets

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- Also divide current and long-term liabilities - Owner’s equity is lumped together when it’s a sole proprietorship – claim on profitability unless

the owner takes some out - If venture is incorporated, Owners’ (Shareholders’) Equity looks more complicated:

- Common stock Paid-in Capital

- Preferred stock

- Retained earnings

- Formalized system of sharing the profit; if you haven’t shared it, you’ve retained it

Income Statement PSA Company for the period ended Dec 31, 2012

- For the first 6 months - Net sales: 1200 units at $100 each, 500 on credit - It doesn’t matter if you’ve collected the money yet or not, it still counts as revenue - Equipment depreciates over time - Interest: 10000 at 10% for ½ a year

Balance Sheet PSA Company as of Dec 31, 2012

Earned Capital = Profit - Dividends

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- Receivables are assets we don’t have yet - Take away depreciation - The owner has a claim on their income and equity - New liability of 25,000

o $96,000 in assets had to be funded somehow; receivables were outstanding, couldn’t keep the business going without getting a short-term loan from the bank

- Biggest loss: people haven’t paid us yet - Looks like we’re profitable (accounting profit isn’t not the same as what’s in our bank) - What you see as revenue on an income statement, hasn’t necessarily been paid to you

Cash vs. Profit Can a company that is profitable go bankrupt? Sales Revenue – Accounts Receivable Expenses – Accounts Payable Owner’s equity is the claim the owner has on their initial investment – it is not cash Depreciation/Amortization – not cash Remember Principle 3 of entrepreneurial finance:

While accounting is the language of business, cash is the currency.

- A company that’s profitable can still go bankrupt (not able to pay bills)

Statement of Cash Flows PSA Company for the period ended Dec 31, 2012

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- Shows how we went from $3000 in net income down to $1000 in cash - Receivables go up; cash goes down (we made the sale, but haven’t received the cash yet) - Inventory goes up; cash goes down (we used cash to increase inventory) - Payables go up; cash goes up (Money we haven’t spent yet) - Increase in accrued wages; cash goes up (Haven’t paid them yet) - Liabilities go up; you have to pay back a loan that you got (means that you got money; which is a

positive in-flow)

Statement of Cash Flows

Impact on Cash Operating Activities:

○ Start with Net Income ○ Add back Depreciation/Amortization (it’s an accounting thing, not cash) ○ + Decrease / - Increase in Receivables ○ + Decrease / - Increase in Inventory ○ + Increase / - Decrease in Payables ○ + Increase / - Decrease in Accrued Liabilities

Investing Activities: ○ + Decrease / - Increase in Gross Fixed Assets

Financing Activities: ○ + Increase / - Decrease in Loans ○ + Increase / - Decrease in Stock ○ - Cash Dividends paid

Survival/Cash Flow Breakeven

Some new ventures show profitability during the startup stage, but…

It is more common for a new venture to have losses – survival stage

Need to know level of sales necessary to cover costs – break even

Therefore need to compare revenues to cash operating and financing costs…

Some businesses could be cash flow positive from the beginning but that is very rare

At what point will you actually become cash flow positive? We need to know what the cash costs are that we need to cover

Two types of expenses/costs: 1. Variable

Costs of directly providing a product or delivering a service – therefore vary with sales

For example – cost of goods sold 2. Fixed

Expected to remain constant over a range of revenues for a specific time period (have to cover them at the amount they are, they don’t fluctuate with sales) – they are costs related to your revenue

EBDAT – Earnings without depreciation but include interest EBIT – Separate non-cash and financing costs from operating costs

Survival/cash flow breakeven is when EBDAT = 0

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We can see that it has achieved breakeven in year 2 but when and what level of sales is needed to breakeven?

Breakeven is when EBDAT = 0

EBDAT = Revenues (R) – Variable costs (VC) – Cash Fixed costs (CFC)

R = VC + CFC

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- Revenue is going up at $100/ unit; total revenue starts at the fixed costs line (it’s a combination of both costs)

- Total costs goes up at a slope of 65% or $65 per unit (because 65% on $100 is $65) - Before breakeven, our cost line is higher than our revenue line (losing money) - After breakeven, our revenue line is higher than our cost line (making money)

Breakeven Calculation

Looking for volume of sales where total revenue = total costs R = VC + CFC Price (volume) = VC (volume) + CFC Price-VC (volume) = CFC Breakeven volume = CFC / (Price – VC) Survival Breakeven = CFC / (1 – VCRR) When you sell a unit and get a price, consider what it’s costing you directly to do it and see

what’s left over from each sale; this has to go to cover fixed costs Contribution margin – what contributes from every sale to cover fixed costs If we can adjust VC in relation to FC – if I can adjust VC I’ll have more left over to cover fixed

costs Breakeven: when contribution remaining from sale covers fixed costs

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Breakeven Drivers

Most important influence/driver on venture breakeven is its variable cost revenue ratio (VCRR) and hence its contribution margin VCRR = (VC/R X100)

For example, let’s say that in year 2, due to volume discounts, PSA could lower production costs to $60 per unit (60% of $100 revenue per unit)

Survival revenue (SR) Survival Breakeven = CFC / (1 – VCRR)

At higher contribution margin of 40%, the level of survival revenue needed to breakeven

drops to $1 million or 10,000 units When variable costs are lower and contribution margin is higher, breakeven point drops

(you can start making money sooner)

A highly leveraged venture can turn a small increase in revenues into a major increase in EBDAT

For example, a firm can choose to pay higher up-front fixed costs to gain lower variable costs

Each additional unit of revenue will result in a higher EBDAT once FC are covered, because VC per unit is lower

○ Higher contribution margin

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Beginning Cash Balance

+ Receipts

Total Cash Available

- Disbursements

Cash Excess / (Deficiency)

Minimum Cash Balance Desired

Borrowing Req’d / Surplus or

Repayment

Ending Cash Balance

Tradeoff between increases fixed costs in order to reduce variable costs (each unit provides more revenue)

- Increasing fixed costs shifts line up (increases profits) - SR = 500,000/ (1 – 6)

= $1 250 000 - So, with greater leverage, the contribution margin is higher and therefore the return (EBDAT) is

higher above breakeven

- 40% contributes from every sale to cover fixed costs vs 35%

- But, breakeven is higher and therefore you have to sell more to reach it – the risk of not meeting

it is greater…

- Principle 2 of entrepreneurial finance:

- Risk and expected reward go hand in hand

Cash Budget

- Tool to forecast and manage cash flows

- Look at where we’re at compared to where

we want to be (do we need to borrow?)

Manage timing to make sure we have cash

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* Worksheet based on historical measures of amounts and timing of cash flows / what is typical

in industry

Example:

You have to do a budget until you’re cash flow positive

You need to prepare a cash budget for the months of June, July and August

Minimum cash balance requirement = $6,000

Beginning cash balance in June = min. cash balance

Assume that sales are forecasted at $10,000, $20,000, $30,000, $15,000, $25,000, and $20,000

from April to September respectively

Assume also that you expect to collect 30% in month of sale, 60% in month following sale, and

10% in the 2nd month after sale

Assume that purchases are 75% of the next month’s sales

Assume also that you pay for 20% of purchases in the month of purchase, and 80% in the month

following

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- Figure out if you need to borrow or if you have a surplus

- Blue numbers from worksheet

- Red numbers are totals

- Green numbers carry over from the previous month

- The ending balance you want is the beginning balance of the next month

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Keys:

- 3 possibilities (besides excess = balance req’d)

1. Deficiency

- borrow for deficiency + minimum

- Make sure you arrange financing

2. Excess > Minimum

- surplus available to repay borrowing

- if do… ending balance = minimum required (you paid it back using all of the surplus)

- if don’t… ending balance = total excess gets carried forward (you have to know your

assumptions)

3. Excess < Minimum

- borrow to = minimum req’d (plan for borrowing to bring it up to minimum requirement)

- end balance = minimum requirement