Entrepreneurial Finance PDF
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EntrEprEnEurial FinancE 7E J. chris lEach University of Colorado at Boulder ronald W. MElichEr University of Colorado at Boulder Australia • Brazil • Mexico • Singapore • United Kingdom • United States Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 30742_fm_ptg01E_dii-toxrviaiili .rienvdiedw h a1s deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it1.1/02/20 7:23 PM This is an electronic version of the print textbook. Due to electronic rights restrictions, some third party content may be suppressed. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. The publisher reserves the right to remove content from this title at any time if subsequent rights restrictions require it. For valuable information on pricing, previous editions, changes to current editions, and alternate formats, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword for materials in your areas of interest. Important Notice: Media content referenced within the product description or the product text may not be available in the eBook version. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Entrepreneurial Finance, © 2021, 2018 Cengage Learning, Inc. Seventh Edition WCN: 02-300 J. Chris Leach and Unless otherwise noted, all content is © Cengage. Ronald W. Melicher ALL RIGHTS RESERVED. 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Cengage Art Director: Chris Doughman 200 Pier 4 Boulevard Boston, MA 02210 Text Designer: Chris Doughman USA Cover Designer: Chris Doughman Cengage is a leading provider of customized learning solutions Cover Image: tandaV/ShutterStock.com with employees residing in nearly 40 different countries and sales in more than 125 countries around the world. Find your local representative at: www.cengage.com. Cengage products are represented in Canada by Nelson Education, Ltd. To learn more about Cengage platforms and services, register or access your online learning solution, or purchase materials for your course, visit www.cengage.com. Printed in the United States of America Print Number: 01 Print Year: 2020 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 30742_fm_ptg01_i-xviii.indd 2 11/02/20 7:23 PM Dedication To my wife Martha, our great joys Laura and John, and the life we share J. CHRIS LEACH In memory of my parents, William and Lorraine, and to my wife, Sharon, and our children, Michelle, Sean, and Thor RONALD W. MELICHER Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 30742_fm_ptg01_i-xviii.indd 3 11/02/20 7:23 PM Brief Contents PART 1 THE ENTREPRENEURIAL ENVIRONMENT 1 CHAPTER 1 Introduction to Finance for Entrepreneurs 3 CHAPTER 2 Developing the Business Idea 41 PART 2 ORGANIZING AND OPERATING THE VENTURE 85 CHAPTER 3 Organizing and Financing a New Venture 87 CHAPTER 4 Preparing and Using Financial Statements 127 CHAPTER 5 Evaluating Operating and Financial Performance 159 PART 3 PLANNING FOR THE FUTURE 191 CHAPTER 6 Managing Cash Flow 193 CHAPTER 7 Types and Costs of Financial Capital 221 CHAPTER 8 Securities Law Considerations When Obtaining Venture Financing 261 PART 4 CREATING AND RECOGNIZING VENTURE VALUE 329 CHAPTER 9 Projecting Financial Statements 331 CHAPTER 10 Valuing Early-Stage Ventures 361 CHAPTER 11 Venture Capital Valuation Methods 409 PART 5 STRUCTURING FINANCING FOR THE GROWING VENTURE 455 CHAPTER 12 Professional Venture Capital 457 CHAPTER 13 Other Financing Alternatives 483 CHAPTER 14 Security Structures and Determining Enterprise Values 507 PART 6 EXIT AND TURNAROUND STRATEGIES 543 CHAPTER 15 Harvesting the Business Venture Investment 545 CHAPTER 16 Financially Troubled Ventures: Turnaround Opportunities? 581 PART 7 CAPSTONE CASES 615 CASE 1 Eco-Products, Inc. 617 CASE 2 Spatial Technology, Inc. 647 Glossary 673 Index 681 iv Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 30742_fm_ptg01_i-xviii.indd 4 11/02/20 7:23 PM Contents Preface xi First-Round Financing 28 About the Authors xvii Second-Round Financing 28 Mezzanine Financing 29 PART 1 Liquidity-Stage Financing 29 Seasoned Financing 30 THE ENTREPRENEURIAL 1.8 Life Cycle Approach for Teaching Entrepreneurial ENVIRONMENT 1 Finance 30 Summary 34 CHAPTER 1 Introduction to Finance for Entrepreneurs 3 CHAPTER 2 1.1 The Entrepreneurial Process 5 Developing the Business Idea 41 1.2 Entrepreneurship Fundamentals 6 2.1 Process for Identifying Business Opportunities 43 Who is an Entrepreneur? 6 2.2 To be Successful, You Must Have a Sound Business Basic Definitions 7 Model 44 Entrepreneurial Traits or Characteristics 7 Component 1: The Business Model Must Opportunities Exist but Not Without Risks 8 Generate Revenues 45 1.3 Sources of Entrepreneurial Opportunities 9 Component 2: The Business Model Must Societal Changes 9 Make Profits 45 Demographic Changes 12 Component 3: The Business Model Must Produce Technological Changes 12 Free Cash Flows 46 Emerging Economies and Global Changes 13 2.3 Learn from the Best Practices of Successful Crises and “Bubbles” 14 Entrepreneurial Ventures 47 Disruptive Innovation 15 Best Marketing Practices 47 1.4 Principles of Entrepreneurial Finance 15 Best Financial Practices 48 Real, Human, and Financial Capital Must be Rented Best Management Practices 49 from Owners (Principle #1) 16 Best Production or Operations Practices are also Risk and Expected Reward Go Hand in Hand Important 49 (Principle #2) 16 2.4 Time-to-Market and Other Timing Implications 49 While Accounting is the Language of Business, Cash 2.5 Initial “Litmus Test” for Evaluating the Business is the Currency (Principle #3) 17 Feasibility of an Idea 51 New Venture Financing Involves Search, 2.6 Screening Venture Opportunities 53 Negotiation, and Privacy (Principle #4) 17 An Interview With the Founder (Entrepreneur) and A Venture’s Financial Objective is to Increase Value Management Team: Qualitative Screening 54 (Principle #5) 18 Scoring a Prospective New Venture: It is Dangerous to Assume that People Act Against Quantitative Screening 58 their Own Self-Interests (Principle #6) 19 Industry/Market Considerations 61 Venture Character and Reputation Can be Assets or Pricing/Profitability Considerations 62 Liabilities (Principle #7) 20 Financial/Harvest Considerations 65 1.5 Role of Entrepreneurial Finance 21 Management Team Considerations 67 1.6 The Successful Venture Life Cycle 23 Opportunity Screening Caveats 67 Development Stage 24 2.7 Key Elements of a Business Plan 69 Startup Stage 24 Cover Page, Confidentiality Statement, Survival Stage 24 and Table of Contents 69 Rapid-Growth Stage 24 Executive Summary 71 Early-Maturity Stage 25 Business Description 71 Life Cycle Stages and the Entrepreneurial Process 25 Marketing Plan and Strategy 71 1.7 Financing Through the Venture Life Cycle 26 Operations and Support 71 Seed Financing 27 Management Team 72 Startup Financing 27 Financial Plans and Projections 72 v Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 30742_fm_ptg01_i-xviii.indd 5 11/02/20 7:23 PM vi Contents Risks and Opportunities 73 Appendix A NOPAT Breakeven: Revenues Needed Business Plan Appendix 75 to Cover Total Operating Costs 156 Summary 75 Appendix A Applying the VOS Indicator™: An CHAPTER 5 Example 81 Evaluating Operating and Financial Performance 159 5.1 Users of Operating and Financial Performance PART 2 Measures by Life Cycle Stage 161 oRgAnizing And oPERATing THE 5.2 Using Financial Ratios 162 VEnTuRE 85 5.3 Cash Burn Rates and Liquidity Ratios 165 Measuring Venture Cash Burn and Build Amounts CHAPTER 3 and Rates 165 Organizing and Financing a New Venture 87 Beyond Burn: Traditional Measures of Liquidity 167 3.1 Progressing Through the Venture Life Cycle 89 Interpreting Cash-Related and Liquidity-Related 3.2 Forms of Business Organization 89 Trends 168 Proprietorships 92 5.4 Leverage Ratios 170 General and Limited Partnerships 93 Measuring Financial Leverage 170 Corporations 97 Interpreting Changes in Financial Leverage 172 Limited Liability Companies 99 5.5 Profitability and Efficiency Ratios 173 3.3 Choosing the Form of Organization: Tax and Other Income Statement Measures of Profitability 173 Considerations 100 Efficiency and Return Measures 175 3.4 Intellectual Property 104 Interpreting Changes in Profitability Protecting Valuable Intangible Assets 104 and Efficiency 177 What Kinds of Intellectual Property Can be 5.6 Industry Comparable Ratio Analysis 178 Protected? 104 5.7 A Hitchhiker’s Guide to Financial Analysis 179 Copyrights 111 Summary 182 Other Methods for Protecting Intellectual Property Rights 111 PART 3 Employment Contracts 112 PlAnning foR THE fuTuRE 191 3.5 Seed, Startup, and First-Round Financing Sources 113 CHAPTER 6 Financial Bootstrapping 114 Managing Cash Flow 193 Business Angel Funding 117 6.1 Financial Planning throughout the Venture’s Life First-Round Financing Opportunities 119 Cycle 194 Summary 120 6.2 Surviving in the Short Run 196 6.3 Short-Term Cash-Planning Tools 198 CHAPTER 4 6.4 Projected Monthly Financial Statements 202 Preparing and Using Financial Statements 127 6.5 Cash Planning from a Projected Monthly Balance 4.1 Obtaining and Recording the Resources Necessary Sheet 205 to Start and Build a New Venture 129 6.6 Conversion Period Ratios 206 4.2 Business Assets, Liabilities, and Owners’ Measuring Conversion Times 206 Equity 130 Interpreting Changes in Conversion Times 210 Balance Sheet Assets 132 Summary 212 Liabilities and Owners’ Equity 133 4.3 Sales, Expenses, and Profits 134 CHAPTER 7 4.4 Internal Operating Schedules 136 Types and Costs of Financial Capital 221 4.5 Statement of Cash Flows 140 7.1 Implicit and Explicit Financial Capital Costs 223 4.6 Operating Breakeven Analyses 142 7.2 Financial Markets 223 Survival Breakeven 142 7.3 Determining the Cost of Debt Capital 225 Identifying Breakeven Drivers in Revenue Determinants of Market Interest Rates 227 Projections 147 Risk-Free Interest Rate 227 Summary 149 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 30742_fm_ptg01_i-xviii.indd 6 14/02/20 5:20 PM Contents vii Default Risk Premium 228 Appendix B Selected SEC Regulation D Liquidity and Maturity Risk Premiums 231 Materials 299 A Word on Venture Debt Capital 234 7.4 What is Investment Risk? 234 Appendix C Other Forms of Registration Measuring Risk as Dispersion Around an Exemptions and Breaks 326 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 PART 4 Cost of Equity Capital for Private Ventures 243 CReATing And ReCognizing Sources and Costs of Venture Equity Capital 245 VenTuRe VAlue 329 7.6 Weighted Average Cost of Capital 247 A Life Cycle–Based WACC Example 248 CHAPTeR 9 Summary 250 Projecting Financial Statements 331 Appendix A Using WACC to Complete the 9.1 Long-Term Financial Planning Throughout the Calibration of EVA 258 Venture’s Life Cycle 332 9.2 Beyond Survival: Systematic Forecasting 334 Forecasting Sales for Seasoned Firms 334 CHAPTeR 8 Forecasting Sales for Early-Stage Ventures 336 Securities Law Considerations When Obtaining 9.3 Estimating Sustainable Sales Growth Rates 340 Venture Financing 261 9.4 Estimating Additional Financing Needed to Support 8.1 Review of Sources of External Venture Growth 344 Financing 263 The Basic Additional Funds Needed Equation 345 8.2 Overview of Federal and State Securities Laws 265 Impact of Different Growth Rates on AFN 347 Securities Act of 1933 266 Estimating the AFN for Multiple Years 348 Securities Exchange Act of 1934 266 9.5 Percent-of-Sales Projected Financial Investment Company Act of 1940 267 Statements 349 Investment Advisers Act of 1940 267 Forecasting Sales 349 Jumpstart Our Business Startups Act of 2012 268 Projecting the Income Statement 350 State Securities Regulations: “Blue-Sky” Laws 269 Projecting the Balance Sheet 351 8.3 Process for Determining Whether Securities Must be Forecasting the Statement of Cash Flows 353 Registered 270 Financing Cost Implications Associated with the Offer and Sale Terms 270 Need for Additional Funds 354 What is a Security? 271 Summary 355 8.4 Registration of Securities Under the Securities Act of 1933 272 CHAPTeR 10 8.5 Security Exemptions from Registration Under the Valuing Early-Stage Ventures 361 1933 Act 276 10.1 What is a Venture Worth? 363 8.6 Transaction Exemptions from Registration Under Does the Past Matter? 363 the 1933 Act 278 Looking to the Future 364 Private Offering Exemption 278 Vested Interests in Value: Investor and Accredited Investor Exemption 280 Entrepreneur 364 8.7 SEC’s Regulation D: Safe-Harbor Exemptions 281 10.2 Basic Mechanics of Valuation: Mixing Vision and Rule 504: Exemption for Limited Offerings and Sales Reality 366 of Securities not Exceeding $5 Million 282 Present Value Concept 366 Rule 506: Exemption for Limited Offers and Sales If You’re not Using Estimates, You’re not Doing a Without Regard to Dollar Amount of Offering 283 Valuation 367 8.8 Regulation a Security Exemption 289 Divide and Conquer with Discounted Cash 8.9 JOBS Act Innovations 290 Flow 369 Summary 290 10.3 Required versus Surplus Cash 372 Appendix A Schedule A (Securities Act of 1933, as 10.4 Developing the Projected Financial Statements for a Amended) 294 DCF Valuation 374 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 30742_fm_ptg01_i-xviii.indd 7 14/02/20 5:21 PM viii Contents 10.5 Just-In-Time Equity Valuation: Pseudo 12.9 Distributing Cash and Securities Proceeds 478 Dividends 378 Summary 479 10.6 Accounting versus Equity Valuation Cash Flow 385 Origins of Accounting Cash Flows 385 CHAPTER 13 From Accounting to Equity Valuation Cash Other Financing Alternatives 483 Flows 386 13.1 Business Incubators, Seed Accelerators, and Summary 390 Intermediaries 485 Business Incubators and Seed Accelerators 485 CHAPTER 11 Intermediaries, Facilitators, and Consultants 486 Venture Capital Valuation Methods 409 13.2 Business Crowdsourcing and Crowdfunding 487 11.1 Brief Review of Basic Cash Flow-Based Equity 13.3 Commercial and Venture Bank Lending 488 Valuations 411 13.4 Understanding Why You May not Get Debt 11.2 Basic Venture Capital Valuation Method 413 Financing 491 Using Present Values 416 13.5 Credit Cards 493 Using Future Values 416 13.6 Foreign Investor Funding Sources 494 11.3 Earnings Multipliers and Discounted Dividends 417 13.7 Small Business Administration Programs 494 11.4 Adjusting VCSCs for Multiple Rounds 419 Overview of What the SBA does for Small First Round 420 Businesses 495 Second Round 420 Selected SBA Loan and Operating Specifics 496 11.5 Adjusting VCSCs for Incentive Ownership 421 13.8 Other Government Financing Programs 497 First Round 422 13.9 Factoring, Receivables Lending, and Customer Second Round 422 Funding 498 Incentive Ownership Round 422 13.10 Debt, Debt Substitutes, and Direct Offerings 500 11.6 Adjusting VCSCs for Payments to Senior Security Vendor Financing: Accounts Payable and Trade Holders 423 Notes 500 11.7 Introducing Scenarios to VCSCs 424 Mortgage Lending 500 Utopian Approach 425 Traditional and Venture Leasing 500 Mean Approach 426 Direct Public Offers 501 Summary 431 Summary 502 PART 5 Appendix A Summary of Colorado Business Financial Assistance Options 505 Structuring Financing for the Growing Venture 455 CHAPTER 14 CHAPTER 12 Security Structures and Determining Enterprise Professional Venture Capital 457 Values 507 12.1 Historical Characterization of Professional Venture 14.1 Common Stock or Common Equity 509 Capital 459 14.2 Preferred Stock or Preferred Equity 510 12.2 Professional Venture Investing Cycle: Overview 463 Selected Characteristics 510 12.3 Determining (Next) Fund Objectives and Convertible Preferreds 511 Policies 464 Conversion Value Protection 513 12.4 Organizing the New Fund 465 Conversion Protection Clauses 514 12.5 Soliciting Investments in the New Fund 468 Conversion Price Formula (CPF) 514 12.6 Obtaining Commitments for a Series of Capital Market Price Formula (MPF) 514 Calls 469 14.3 Convertible Debt 516 12.7 Conducting Due Diligence and Actively 14.4 Warrants and Options 517 Investing 470 14.5 Other Concerns About Security Design 523 12.8 Arranging Harvest or Liquidation 477 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 30742_fm_ptg01_i-xviii.indd 8 11/02/20 7:23 PM
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