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In this document topics covered which are MBA COURSE NOTES ON ENTREPRENEURSHIP, THE ENTERPRISE SOCIETY , THE ENTREPRENEUR
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This monograph describes entrepreneurship and an approach to entrepreneurial finance, as well as the interface between the entrepreneurial and corporate worlds. Its includes a section on financial forecasting in the context of an overall business plan for start-up or modestly- sized but expanding enterprise. Indeed, of key importance to anyone interested in founding or running a new enterprise is the need to plan for cash needs and capital structure.
The traditional large corporation features in this report mainly as a comparison and contrast with founder-managed enterprises.
The monograph also considers risk and reward, that is, how an entrepreneur may eventually claim or at least measure his return after years of building a company into a success.
Before entering the details of business planning, valuation, etc., the context of Western business can be usefully reviewed. Much of what is taken for granted in the West is not the common condition for business in the world as a whole, as the author has learned not least from his dealings with the former USSR.
Business can be conducted anywhere, even in conditions of hyper-inflation or absence of currency. Yet a wealth-creating market economy clearly has some special requirements which might be called "pre-requisites" in the context of countries emulating the West in economic development. Four such prerequisites of particular relevance today can be identified:
stability of currency
acceptance of risk and reward
mutual trust and business law
reliable banking and trade credit.
a) Stability of Currency
Every country has inflation. The only time that prices in general have fallen has been in a slupm or depression, and deflation is reckoned to be a harbinger of a major fall in output. Moderate inflation seems unavoidable in a prosperous free-market economy, or has been since the beginning of the 20th century.
"Moderate" may be taken as a few per cent. The norm varies in time and from country to country, but 2-5% per annum is fairly common in the West; 10% may be considered getting out of hand.
Acceptance of moderate inflation does not endorse monetary instability or imply that money does not have durable value. Interest earned on bank savings exceeds the inflation rate, or it does most of the time and, if it does not, an economy is judged to have gone seriously awry. Thus economists speak of a "real rate of interest".
Real rate of interest is approximately equal to nominal rate of interest minus rate of inflation*.
A positive real interest rate encourages people to save. A negative one has just the opposite effect: why attempt to save money for a future purchase if the purchasing power of savings is
One of society's most important legal bases is the assumption of "bona fides", good faith. A person's bona fides is assumed until he or she proves otherwise. This is one of the greatest strengths of the free enterprise system, even though it leaves open the crack through which all sorts of fraudsters and cheats can operate against the interests of the honest majority.
d) Reliable Banking and Trade Credit
In the West, cash is used as a means of payment only for retail, i.e. personal expenditure, and even then cheques and "plastic money" (credit cards and direct charge cards) have largely taken over for expensive items. Trade between companies is conducted on a credit basis, or at least it is once supplier/customer relations have been established. Goods and services are provided and invoices issued, with the expectation that the invoice be settled in one or two months. It is a sign of recession that invoice settlement is pushed out to three months with large companies hard-heartedly exploiting their smaller suppliers.
For credit trading to work, there has to be a basic trust in the written contract (and often even in a telephone order) and a means of legal back-up in the event of non-settlement of invoices. Banks have to be able to pay quickly and reliably when told to do so by the account holder. Bank transfer (in Europe) or cheque (the common method in the USA) is the means of settling invoices. A clear and independent record of transactions is obtained in the form of bank statements -- of vital importance in proper bookkeeping -- and the opportunity of fraud much decreased. Cash payments are tinged with suspicion; they are the preferred means of settlement for the criminal world and tax evaders.
Risk and reward are intimately linked. If you want absolute security, you can put your money into a solid bank and obtain interest, preferably at a rate above that of inflation. If you want to earn greater returns than can be obtained on a bank deposit, you have to accept risk. Although probability favours high reward, there is also a possibility of loss, partial or complete. For example, the stock or bonds you own may lose some of their capital value, the house you have bought may decline in market price or that the savings institution offering better returns than your bank may go bankrupt. Even the country offering high interest rates on government bonds may default.
Some interesting parallels can be found with gambling. Roulette is a game of pure chance; the probability that a given number or colour comes up is unaffected by events that have gone before. If you bet on a single number, the odds against you are 37:1 (assuming a single zero) and the house pays you a return somewhere near this. If you bet on "red", you have a 18: chance of winning but will win back less than double your stake; the lower the risk, the less the reward.
In card games, even with perfect shuffling, there is some skill at assessing probabilities. As the game advances, cards that have already been seen cannot come up again. In cards, an element of skill in assessing probabilities slightly reduces the element of pure chance.
The skill of the gambler moves further in the direction of odds appreciation in racing (horses for example). In this, he has to weigh up the probability of a horse winning as a function of "form", i.e. recent performance, coupled with apparent condition, the jockey and what punters call "the going".
It is a small step to move from horse betting to investing on the stock exchange, although losses on the latter are unlikely to be so consistently severe as at the racetrack! The stock exchange investor is testing his skills against others' in assessing which shares are likely to go up in value and which down. If he wise he does this calling upon both “fundamentals” (data on the company’s past performance and expectations about the future) and “technical analysis” (which attempts to pick up future moves in prices from the past, using graphical techniques).
Greater rewards (“rates of return”) than can be achieved those achievable through trading stocks, by moving to “derivatives”, notably through options trading or the futures market. Investors can achieve great returns for limited capital outlays, but, for futures at least, at the risk of losing more than they have invested.
In all these examples of risk-taking, the investor, the gambler or the speculator are assessing probabilities, explicitly or not, of future events, but have no influence over them (or they are supposed to have no influence -- stock price manipulation, like horse "doping", is illegal). It is not so for a business risk. Investment in a business venture, whether by an individual, a group of friends, or by an established corporation, still entails an assessment of the probabilities of future events, many or most of them uncontrollable. But at the heart of a business risk is the influence of the risk-taker. His skills, or those of his manager, his enthusiasm and drive, his persistence and flexibility, all these weigh heavily on the chances of success or failure. The business risk is not static, in which, once the die is cast, events unfold. It is highly dynamic and interactive; the business manager is a powerful link in the chain that determines success or failure.
company, are called "equity". Equity applies to funds representing ownership. The profit of a company accrues to the equity-holder, so do the losses.
The whole principle behind an equity investment is to seek maximum reward while accepting greater risk. If a company does well, the profits (except for perhaps some bonus to workers and managers) belong to the equity-holders. If it does badly, then the workers, managers and creditors all get their due, and if there is nothing left for equity-holders, that is their misfortune. The equity-holders are at the back of the queue. For profits they only receive what is left over, but if much is left over, much is theirs. In the event of liquidation, they are again quite last; everyone else is paid before the equity-holders can lay claim to what is left. Obviously an equity investor will take this risk only if his potential reward is high.
Equity is not usually the only type of capital or funds in a company. Most companies expand their capital base by the use of debt, funds borrowed over several years and rewarded with interest. There may also be "preference shares", a type of superior equity in the sense that it receives dividends and liquidation capital before common (or ordinary) stockholders, but after creditors. Once debt has been contracted, its terms must be scrupulously honoured -- the interest paid regularly and, eventually, principal returned. A lender does not expect such a high return as the equity investor, but he is seeking security. He accepts a lower reward, but it must be a more certain reward with little "downside risk".
Debt is inherently less risky than equity because interest and principal always take priority over return to equity-holders. In fact, failure to pay interest or principal when due is grounds for bankruptcy and claiming the company assets. Nevertheless, debt based just on the company's performance as a whole remains risky just because companies do quite often fail. Many company loans are therefore made against specific assets, which are said to provide "collateral" or "security". In the event of loan default, the lender can claim the named assets before any other creditor (without, by so doing, actually bringing about bankruptcy). This is exactly parallel to the "mortgage" system used by most individuals when they buy houses.
Once a company has been formed, its equity-holders stand, in legal terms, outside it. Its capital is provided through a mixture of debt and equity. This capital is used to acquire assets, which become the profit-generating wherewithal of the company (although the use of the assets must never be considered in isolation of the labour and management of the company). Debt is rewarded by interest. Thus debt "costs" (costs the company, that is) the interest paid. Put more fully: the cost of debt capital is the interest rate of the debt (adjusted for tax effects).
The idea of debt having a cost to a company is a fairly easy concept; after all, interest must be paid and interest is real money. Can the concept of cost be applied also to equity? In one sense, the answer is no; there is no obligation for a company to make profits or give dividends to the shareholders. Yet if they do not see the profits, they will soon complain, for their company is not providing them with the financial reward they expect of it. This "expectation" of reward by the equity-holders is, for the company, a measure of the "cost of equity". It is measured, just like interest, in percentage terms and, at its simplest, is the ratio of the profit achieved, or to be achieved, by the company to the equity capital employed. In other words, cost of equity capital is the target return on equity, where equity value is measured at its book value.
These two concepts of the cost of debt and the cost of equity are fundamental quantitative measures of reward. Risk remains more elusive to measure, but at least its worst outcome, total failure, can be limited to the capital invested.
Entrepreneurship involves the creation of new enterprise based on the personal effort of the founders and managers and, at least partially, their personal funds.
Finance for entrepreneurs is quite different from that for large corporations because of its personal and risky nature. It may well be the objective of entrepreneurs to create companies that eventually become large corporations, but, on the way, they cannot expect to use the financial instruments of large corporations. The stock and bond markets are not open to them and conventional bank loans hard to come by and inadequate.
Historically, really successful entrepreneurs have never allowed institutional barriers to stand in their way. But there were probably less of them than today and, in past times, the very rich could act as sources of capital to emergent businessmen.
Recent history has seen a massive expansion of entrepreneurship, a sort of “democratisation”, where economic freedom, political preference and widespread education, often in high technology, have created large numbers of people wanting or being pushed to "do their own thing". Paradoxically, growing unemployment in West has encouraged entrepreneurship; the old assumption that a job with a large corporation gave automatic security no longer holds true.
New enterprises can be created by governments, either from scratch or through privatisation, and by large corporations through new subsidiaries or joint ventures. However, these mechanisms are not the dominant ones in the dynamics of an expanding and flexible economy. An important component of change and growth is the creation of thousand upon thousand of new enterprises, and, incidentally, of the death of the thousands that do not survive.
Indeed, of the many new enterprises, the majority fail, not necessarily through bankruptcy, but through voluntary liquidation when hopes are not realised. Yet, enough succeed and enough succeed handsomely to create the new jobs, new activities and further added value that a modern economy requires.
One response of free-enterprise society to the needs of their entrepreneurs has been the creation and expansion of "venture capital" funding specifically for entrepreneurs as they take their company from one stage to another in its life. Venture capital is used to invest in greater risks than banking, but seeks a greater reward. It relies on many mechanisms to reduce the risk and scope of failure and enhance the chance and scope of success.
The aim of many entrepreneurs is to achieve personal financial success through the company they found. A possible route to this is to increase share value by several times, using one of two basic mechanisms: going public or being bought out partially or completely by a large corporation. Nevertheless, companies are not founded with this objective, and many privately held companies are not for sale in either way. Many, very possibly the majority of companies are created to give long-term professional satisfaction to their founders, coupled to a reasonable standard of living, an enjoyable status in society and freedom from an outside boss. To these motives may sometimes be added a desire to create some sort of family enterprise dynasty.
Source: Roy G.C. DAMARY
that they will need additional capital. They turn, perhaps reluctantly, to outside sources. They are not sure whether they are going to seek debt or equity financing, but they do have a feeling that they ought to keep control of the company. In this regard, they should find no disagreement with their outside backers; they are just more likely to express the relationship in terms of the founders maintaining their responsibilities to manage the company while submitting to external control systems.
They will be asked to present a business plan: a forecast of market, sales, product development, financial and other resources needed for manufacture and marketing and, of course, cash flow. They will be asked to discount the cash flow and to come up with an "internal rate of return" (see chapter 3). Many of these concepts will be completely new to the entrepreneurs, but they will take steps to master them because they recognise that, without the formal plan, there can be no external capital. So they draft a plan and it is shuffled back and forth between them and their potential investors until the latter are satisfied. The whole exercise may be, so far as the entrepreneurs are concerned, is somewhat tongue-in-cheek, for they knowsfull well that future success is so dependent on particular events and customer relations that the very term "forecast" is dubious.
Perhaps that is why the expression "pro forma" is used instead of "forecast" for these forward- looking financial statements.
With the financing established, the new (outside) investors introduce changes in the management style of the company. They particularly want financial reporting and will very likely select and place a financial director as "their man" in the enterprise. Regular planning and reporting sessions and systems are set up. Formality is introduced where flair and individuality used to predominate.
Very often tensions arise over these contrasts of style and system, but they are not the only sources of difficulty. There will be differences of objectives such as the time scale of profitability, the level of returns and whether profit is taken as cash or not, and the route to converting increased asset value to cash. There is even a likelihood of a "hidden agenda". Neither side will have revealed precisely what they hope to obtain out of the relationship. For example, many entrepreneurs have found themselves responsible for diversification and acquisition far beyond the original scope of their business idea, e.g. they may have to assist a "sister company" about which they know little and care less.
The interface between an entrepreneur and outside capital involves a culture clash. Yet the two sides need each other and economic progress depends on their successful collaboration. Entrepreneurs and corporations must therefore understand each other better and learn more about the others’ language and thought processes.
There are many dimensions of the cultural clash. Yet, despite all the differences, a mutually rewarding collaboration can be achieved. Exhibit II compares the motivations and attitudes of outside investors (left hand side) with those of entrepreneurs (right hand side).
A corporation develops a culture. Strong leaders of corporations have an effect on the culture and, if they are there long enough, may be largely responsible for moulding it. Nonetheless, corporate culture does not depend on a single person. Rather, it resides in the corporation almost as if it were a living organism in its own right.
Left to themselves without strong leadership, corporations suffer from "functionarianism". This word "functionarianism" is coined by the author to describe the attitude of "functionaries". Such people are found all over the world, but especially in countries with excessive state control. They work strictly within regulations, they have little initiative, their input in time and effort is kept to the minimum expected and they have no sense of customer orientation. The leadership of corporations works hard at establishing a culture to oppose functionarianism and instil a spirit of commitment, efficiency and initiative. Nevertheless, the power of size is partly offset by its own inefficiencies, allowing small and medium-sized enterprises to find their place in the marketplace and even to compete with giant corporations.
In founder-managed companies, the firm and its founder(s) are so intertwined that the enterprise "culture" is his/theirs. Whether that is a good thing or not depends on his/their skills. Of particular importance, assuming the enterprise has successfully passed the start-up phase and has clear growth potential, is matching management ability to the needs of the company as it expands.
If a formal definition is to be given to "entrepreneurs", two key features must be stressed:
entrepreneurs invests their own capital and time into a business they creates or takes over, individually or as partners,
they are innovative (in technical, product and operational, organisational or marketing terms) and seek growth and profit.
The following are key characteristics of successful entrepreneurs. The list does not define them but important in terms of likelihood of success::
entrepreneurs are dedicated to success
they hold a dream even though the dream may be vague
they identify with an idea (see comment about innovation above)
they are motivated by more than just the pursuit of wealth
they have a special skill in one of the dimensions of innovation.
The motivation of an entrepreneur is much harder to generalise about. "Ego satisfaction" lies behind most motivations. That may be true but it is too general a statement of human endeavour to lead much further. Examples of more useful dimensions of non-financial motivation include:
a desire to make a mark on and achieve recognition in society
satisfaction in the act of creation
a vocation to contribute to society
a wish to "do one’s own thing".
If an entrepreneur's motivation is, however, basically an interest purely in technical innovation, it can be dangerous since such an attitude is often associated with an inadequate interest in profit!
The following types of archetypal entrepreneur are found:
the "outsider", someone of a modest, even disreputable background, who wants to make good; likely to be lacking in formal education. These types are given a lot of attention in the literature and press, and are often seen as folk-heroes
the "academic", someone, probably of modest background, who had done well in academic terms and feels he ought to "do something with his education" (other than work for a corporation)
an in-place or redundant manager who wants to leave corporate life (management buy-outs fit here)
offspring of a wealthy family (sense of "stewardship")
offspring of an entrepreneurial family ("business is in the blood").
Superimposed on all these entrepreneur types is the presence or absence of the characteristic of wanting to share or be in partnership. There are entrepreneurs who wish to be solely in charge and there are others who prefer to share with partners. The former are very self- confident, possibly excessively so, and show entrepreneurial characteristics most strongly. People who prefer to work in partnerships may lack the confidence of "loners", but do have sufficient realism to recognise that they are unlikely to have all the requisite skills in their own person. Moreover, many people prefer to work with a small team of friends rather than in isolation.
Almost because the literature so adulates the lone entrepreneur, the entrepreneurial partnership tends to be overlooked. Yet it offers advantages in that the partners bring complementary skills right from the beginning are able to share and recognize their own limitations. This should make it easier for the company to expand its organisation internally, and accept outside capital sources such as venture capitalists. The very fact that it is a partnership also implies that some sense of organization is present from the very foundation.
The above list of possible types of entrepreneur includes people who come either from a wealthy family background or an entrepreneurial one (or maybe both!). This serves as a reminder that business is often passed from generation to generation, both in terms of individual companies and in terms of the wherewithal and desire to create new companies. Many founders and inheritors of business will find themselves in entrepreneurial situations, even if they do not know the "hunger" of the start-up entrepreneur.
3.1. Capital Structure
Although a company may have assets and liabilities of many different kinds, companies can be looked at according to a very simple, but powerful model:
ASSET BASE = CAPITAL BASE
Where ASSET BASE = Working capital + Fixed assets
"EBIT" is also often called the "operating profit". It reflects the earnings capability of the company as a group of assets with personnel and management. It excludes the impact of the structure of the capital base of the company supporting those assets, as well as the effect of taxation. In a way it is the “stripped-down business”.
3.2. Contribution Analysis
One of the most powerful tools for the financial analysis of the operations of a company is contribution analysis, which is built around what may be termed the "Myth of the Straight Line". The myth states that, over the range of analysis, costs are either unchanging with volume, or change in direct proportion to volume: "fixed costs" and "variable costs" respectively. This simple division into two types of cost is the foundation of much managerial accounting: the analysis of cost-volume behaviour, budgeting and the comparison of actual performance with budgets ("variance analysis"). While the myth is not literally true, it reflects actual cost behaviour over the range of interest well enough to be enormously helpful. It is widely accepted and applied.
The principles of financial accounting requires that manufacturing overhead be incorporated along with direct labour and materials in making up "cost of goods sold", and various inventory valuations. However, the allocation of fixed manufacturing costs depends on the volume of production. This can be budgeted but, in the case of start-up companies, may increase so rapidly from year to year that the allocation basis has no consistency. Better then to avoid the issue in financial forecasting by using the managerial accounting concepts of variable and fixed costs, otherwise known as "direct costing".
The managers of a company must know its basic cost structure and the selling prices that can be achieved. They can budget for the volume they can produce and sell. Or, if the analysis proposed here is of past performance, historical cost structure, prices and volumes are what matter.
Although there will be various steps in contribution analysis, the end result 4 can be distilled into:
revenue - variable costs = contribution
contribution - fixed costs = operating profit (or EBIT).
From these equations it may be observed that the higher the contribution margin, the greater the impact on operating profit 5 .) Every additional dollar (or whatever currency is involved) of revenue increases operating profit by $1 times the contribution margin.
Every percentage increase in revenue increases operating profit by an even greater percentage. The ratio of the % increase in operating profit to the % increase in revenue is called the "degree of operating leverage". It is a simple ratio number, greater than one, and equal to:
% F 04 4contribution/(fixed costs – contribution) divided by % F 04 4revenues/(revenues
where F 04 4 refers to a small (or marginal) increase;
(^4) profit = revenue – costs = revenue –variable costs –fixed costs = contribution – fixed costs (^5) .contribution margin = unit contribution as a percentage of selling price = overall
contribution as a percentage of revenue
Working through this equation 6 leads to to two simple expressions for the degree of operating leverage:
DOL = contribution/(contribution – fixed costs) or DOL = contribution margin/operating profit as a percentage of revenue
This analysis allows the company to determine its historical basic earning power (BEP) or to forecast it at various levels of activity or volume. It remains to be seen what impact the capital structure has on the eventual reward to the shareholders (or equity-holders).
3.3. Financial Leverage
In normal economies, interest rates are less than reasonable rates of basic earning power. If this were not so, business activity would cease as it would be more rewarding to lend than to invest in business assets. The statement might not be true in start-up situations or companies performing less well than intended, but by and large, it is applicable. It follows that return on equity (RoE = the profit after interest and tax (PAT) divided by the equity base) will be greater the more debt the company has. The absolute amount of PAT declines but the RoE, a percentage, increases. This is the phenomenon called "leverage", or "gearing", or more fully "financial leverage".
Degree of financial leverage (DFL) = % F 04 4profits/profits divided by % F 04 4EBIT/EBIT
If there is no debt, and therefore no interest, it is trivial to observe that a given percentage increase in EBIT gives rise to the same percentage increase in PAT (always supposing tax is levied in direct proportion to profits). But if debt is carried and interest paid on that debt, then, working through the equation 7 gives:
DFL = EBIT/(EBIT – interest costs) Or DFL = BEP/(BEP – iD) Where “i” = interest rate And “D” = ratio of debt capital to total capital
The multiple of the two degrees of leverage leads to the percentage increase in PAT for a given percentage increase in revenue. Note that percentage increases are involved here -- not absolute amounts.
3.4. Financial Forecasting
The return on equity (RoE) is the most basic measure of a company's performance. It shows what the equity-holders receive, either as dividend or as increased value of their company. Of course, entrepreneurs, who have the combined role of investors and managers, receive other rewards, notably their compensation as managers. But a distinction needs to be made between their two roles. What they receive as managers is payment for work done; what they receive as equity-holders is return on investment.
(^6) it suffices to consider re-express DOL as the ratio of contribution margin x marginal revenue over EBIT to marginal revenue over revenue (^7) replace EBIT by BEP x asset base, and note that interest is equal to interest rate times debt ratio.
