Entrepreneurial Finance

1

• Entrepreneurial Finance
• An Entrepreneurs Guide to Managing the
  Financial Challenges of the Entrepreneurial
  Venture
• (aka FIN 6936 Special Topics In Finance
  Entrepreneurship)
• Spring 2008
• Instructor Federico Sanchez
• fsanchez_at_mba1995.hbs.edu

2
Agenda 02/25/08

• Welcome
• Class Logistics
• Course Content
• Introduction to Key Concepts
• The Case Method
• Assignments Sessions 2 and 3

3
Agenda 1/08/07

• Welcome
• Class Logistics
• Course Content
• Introduction to Key Concepts
• The Case Method
• Assignments Sessions 2 and 3

4
Introductions

• Course Entrepreneurial Finance (FIN 6936)
• An Entrepreneurs Guide to Managing the
  Financial Challenges of the Entrepreneurial
  Venture
• Instructor Federico Sanchez
• President L.I.C. Capital LLC
• Email fsanchez_at_mba1995.hbs.edu
• Students Background, professional goals, other

5
Communications

• Instructor office hours
• Mondays PM (by previous appointment only)
• Please direct communications to instructor via
  email
• fsanchez_at_mba1995.hbs.edu
• Syllabus and other course materials will be
  posted on the instructors page on the FIUs
  Global Entrepreneurship Center website
• http//www.entrepreneurship.fiu.edu/courses_sanche
  z_grad.htm

6
Class Assignments

• Please note that the course syllabus will serve
  only as a general guideline and that case
  assignments, readings and guest speakers will be
  adjusted as the course evolves
• Do not refer to the syllabus for class
  preparation! The instructor will communicate the
  assignment for the following week at the end of
  each class!

7
Textbooks

• Entrepreneurial Finance A Casebook
• by Paul A. Gompers, William Sahlman
• Wiley Text Books (December 14, 2001)
• ISBN 0471080667
• Financing Entrepreneurial Ventures, Business
  Fundamentals Series
• Harvard Business School Press Compilation 9202
• Harvard Business School Publishing
• ISBN 0-87584-920-2

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Course Grading

• Class participation 50
• Long assignment (TBD) 35
• Short assignments (TBD) 15

9
Teaching Approach

• Real-Life perspective direct study of actual
  companies and entrepreneurs and application of
  practical tools used currently in the business
  world
• Case-method based analyze and develop action
  plans and solutions by taking the perspective of
  the protagonist in a business situation
• Hands-on approach directly perform original
  analysis and recommendations specific to a given
  situation
• International focus develop awareness for the
  challenges and situations found in the global
  environment by studying companies in
  international settings.
• General managers perspective finance is an
  inseparable element of the multi-faceted job of
  the entrepreneur

10
Agenda 1/08/07

• Welcome
• Class Logistics
• Course Content
• Introduction to Key Concepts
• The Case Method
• Assignments Sessions 2 and 3

11
The Questions

• Is this a good entrepreneurial opportunity?
  Should I invest in this venture? Why?
• What tools can I use to evaluate entrepreneurial
  ventures and make decisions?
• Whats the value of this entrepreneurial
  venture? How can we maximize this value? How can
  we minimize the risks?
• How much cash will this new venture really need?
  How can I obtain financial capital for my growing
  company?
• What key financial management skills do I need
  to have to be a successful entrepreneur?

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Course Objectives

• Develop proficiency in the practical use of
  financial and non-financial analysis and tools
  specifically applied to an entrepreneurial
  setting.
• Provide entrepreneurial general managers with the
  knowledge and skills required to successfully
  manage the financial challenges of a growing
  company.
• Provide an understanding of the critical role
  that financial issues play in entrepreneurial
  situations, and the importance for
  entrepreneurial managers to develop a solid
  expertise in this area.
• Provide exposure to the challenges and rewards of
  entrepreneurship, specifically from the
  perspective the acquiring, managing and
  maximizing financial resources.

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KEY SLIDE
Defining Entrepreneurial Finance

• Entrepreneurship
• The relentless pursuit of opportunity without
  regard to the resources currently controlled
• Finance
• The study of the allocation of cash and risk
  with the goal of creating value for the
  enterprise
• Entrepreneurial Finance
• How to manage cash and risk to create value in
  the relentless pursuit of opportunity

Source Howard Stevenson, William Salhman, HBS
14
Course Structure
Assessing the Investment Opportunity
Determining the Financial Resources Required
Understanding and Managing Financial Value
Obtaining the Required Financial Resources
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Module 1 Assessing the Investment Opportunity

• Key issues
• What are the key elements that determine the
  financial attractiveness of an entrepreneurial
  opportunity?
• How can these be managed to increase probability
  of success?
• Analytical approach to support investment
  decisions.
• Tools
• The Fit Model Four critical success factors
  for entrepreneurial ventures People
  Opportunity Deal - Context
• Dynamic questions
• What can go right? - What can go wrong?
• What actions can be taken to increase the
  probability that things will go right and
  minimize the chances that things go wrong?

Fit model source William Salhman, HBS
16
Module 2 Determining the Financial Resources
Required

• Key issues
• Understanding the key drivers of cash flow and
  the cash flow requirements of the entrepreneurial
  venture
• How can these elements be managed to maximize
  cash flow?
• Develop proficiency in quantifying cash flow and
  other quantitative elements in an entrepreneurial
  setting.
• Tools
• Cash flow forecasting (i.e. drivers, financial
  modeling, scenarios, accounting vs. cash flow)
• Entrepreneurial finance basic math (i.e.
  contribution margin, cash flow break even,
  variable vs. fixed costs)

17
Module 3 Understanding and Managing Financial
Value

• Key issues
• Key drivers of financial value in an
  entrepreneurial setting
• Analysis of financial valuation approaches and
  their limitations
• Practical approach to technical issues in
  valuation (terminal value, discount rates,
  options)
• Tools
• Core valuation methodologies (multiples,
  discounted cash flow, liquidation)
• Basic valuation math and valuation building
  blocks (e.g. cost of capital, terminal value,
  dilution, tax-shield)
• Real options in an entrepreneurial setting

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Module 4 Obtaining the Required Financial
Resources

• Key issues
• Analysis of available sources of capital for
  entrepreneurial ventures (debt, equity, venture
  capital, angels)
• Develop an understanding for the basic elements
  of financial contracting in entrepreneurial
  setting
• Understand the key elements involved in
  negotiating financing from available funding
  sources
• Tools
• Technical and legal elements of financial
  contracts (preferences, veto rights, minority
  rights, seniority)
• Sensitivity analysis and financial modeling

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Agenda 1/08/07

• Welcome
• Class Logistics
• Course Content
• Introduction to Key Concepts
• The Case Method
• Assignments Sessions 2 and 3

20
Understanding Value

• Value Cash and Risk

• More cash is better than less cash
• Less risk is better than more risk
• Cash today is better than cash tomorrow
• Less-risky cash is better than more-risky cash

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Understanding Cash

• First rule of entrepreneurial finance Cash is
  the most critical resource
• More cash is better than less cash
• Less risk is better than more risk
• Cash today is better than cash tomorrow
• Less-risky cash is better than more-risky cash
• Focus is on free cash flow versus accounting
  income
• Taxes affect cash in investing, financing and
  accounting situations
• Growth must be supported by investments in assets
  (which consume cash flow)
• Focus on the dynamic picture of cash flow
• Cash cycles, seasonality, competition
• Todays investments are tomorrows growth
  opportunities
• Cash management is critical for the new
  enterprise. Dont run out of cash!

22
KEY SLIDE
Profit and Loss Statement
Year 1
Year 2
Year 3
Year 4

• Revenues
• Cost of Goods Sold (COGS)
• Gross Profit
• Selling, General Admin Costs (SGA)
• Operating Profit (EBIT)
• Interest
• Net Profit Before Taxes
• Taxes
• Net Profit After Taxes

EBIT Earnings Before Interest and Taxes
23
KEY SLIDE
Free Cash Flow

• EBIT (Earnings Before Interest and Taxes)
• - Taxes (EBIT x Tax Rate)
• Depreciation (and other non-cash
  charges)
• -/ Increase/Decrease Current Assets (1)
• /- Increase/Decrease Current Liabilities
  (1)
• - Capital expenditures
• Free Cash Flow

(1) Changes in Net Working Capital
24
KEY SLIDE
Net Working Capital (NWC)
() Only applies to Cash or other Liquid
Investments balances required for normal
operation and not to excess of funds beyond
normal operating levels.
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KEY SLIDE
Free Cash Flow (Illustrative Sample)
Year 1
Year 2
Year 3
Year 4

• Revenues
• Cost of Goods Sold (COGS)
• Gross Profit
• Selling, General Admin Costs (SGA)
• Operating Profit (EBIT)
• Taxes (EBIT x Tax Rate)
• Depreciation (and similar)
• Change in Net Working Capital (NWC)
• Capital Expenditures (CAPEX)
• Free Cash Flow (FCF)

EBIT Earnings Before Interest and Taxes
26
Understanding Risk

• Understanding risk is a complex task, but
  significant value can be created by managing risk
• Financial risk is the total amount of uncertainty
  about future cash flows
• Uncertainty of future events creates risk, but
  these can usually be analyzed to understand risk
• The price of risk in capital markets depends on
  risk that can not be eliminated by asset
  diversification
• Discount rates are used in finance to account for
  risk factors
• Estimating the precise discount rate or
  technically correct cost of capital might
  provide a false sense of security
• But this does not alleviate managers
  responsibility for estimating the opportunity
  cost of investing

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KEY SLIDE
Simplified Illustration of Elements of Present
Value Calculations

• Project EBIT for each periods 1 through n
• Project Revenues, COGS, SGA based on assumptions
• Calculate Free Cash Flow (FCF) for periods 1
  through n
• Subtract taxes for EBIT (EBIT tax rate)
• Add Depreciation and other non-cash expenses
• Subtract/Add Net Increase/Decrease in Working
  Capital (NWC)
• Subtract increases in Capital Expenditures (Capex
  or Fixed Assets)
• Calculate appropriate Discount Rate (s) (r)
• Estimate Unlevered Beta (B U )
• Estimate Market Risk Premium over risk-free rate
• Calculate Terminal Value (TV) based on perpetuity
  formula or multiple
• Calculate Tax Shields (TS) for periods 1 through
  n
• Calculate present value of FCFs, TV and TS for
  periods 1 through n
• Compare to Initial Investment

Note This is a simplified example of some
elements involved in a discounted cash flow
valuation it is only for illustrative purposes
and does not intend to be a technical guideline
for the application of valuation methodologies.
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Net Present Value Formulas

• PV of FCFs

FCF yr1 1 r
FCF yr2 (1 r)2
FCF yrT (1 r)T
TV T (1 r)T




FCF yrT (1 g) r g
TV T
PV present value TV terminal value r
discount rate g growth rate of cash flows
29
Discount Rates

• Discount rate Risk Free Rate
• Business Risk Premium
• Financial Risk Premium
• Risk Free Rate Return required on investments
  that have no business or financial risk
• Business Risk Premium For diversified investors
  is only systematic risk (risk relevant to the
  total diversified portfolio), for undiversified
  investors, total risk is what matters
• Financial Risk Premium determined by the
  financial structure of the investment

30
Discount Rate (DCF)
rf B (rm - rf)
r
r discount rate rf risk free rate B
beta measure or systematic risk rm market
return on equity
31
Beta (B )
B L E/V
B U
B U Unlevered Beta B L Levered Beta E
Market Value of Equity V Total Value of
Enterprise (Market Value of Equity plus Market
Value of Debt)
32
Approaches to Terminal Value
1. Assume a perpetuity
FCF Free Cash Flow TV terminal value r
discount rate g forecasted growth rate of cash
flows
FCF yearT (1 g) r g
TV T
2. (or) Calculate a relevant multiple
P/E Price Earnings ratio
Earnings yearT Comparable P/E
TVT
3. (or) Other relevant calculation e.g.
Liquidation Value
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Tax Shields
Tax Rate X Interest Payment YearT
TS YearT
TS Tax Shield
34
Net Present Value Formulas

• PV of FCFs

FCF yr1 1 r
FCF yr2 (1 r)2
FCF yrT (1 r)T
TV T (1 r)T




FCF yrT (1 g) r g
TV T
FCF Free Cash Flow PV present value TV
terminal value r discount rate g growth rate
of cash flows
35
Managing Risk

• It is the managers responsibility to manage risk
• Significant value can be created this way
• Risk should be transferred to those most able and
  willing to bear it
• The role of financial contracting can be
  understood as a way to manage risks
• Risk is dynamic in nature
• Uncertainty tends to be resolved with the passage
  of time
• Key risks should be disaggregated and understood
• Risk increases the value of real options
• Options have significant value that often goes
  ignored
• Maintaining options and flexibility is key to
  entrepreneurial settings
• Options today may create more options tomorrow

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The Fit Model (Salhman, HBS)

• People

Opportunity
Deal
Context
Source William Salhman, HBS
37
FIT Model

• The Fit elements
• People
• Opportunity
• Context
• Deal
• The dynamic view of the Fit model
• What can go wrong?
• What can go right?
• What decisions can management make today and in
  the future to ensure that what can go right
  does go right, and what can go wrong is
  avoided, or its negative impact managed
  appropriately?
• The Fit elements and its interactions change
  constantly over time and may also be managed at
  different points in time.
• The Fit elements are interdependent, so it is
  important to focus on the interactions.

Source William Salhman, HBS
38
KEY SLIDE
Situation Analysis Blueprint
Key Issues
Key Analysis/Tools
Managements Decisions and Actions
Note This is a general and non-exhaustive
illustrative list of some of the issues and
analysis relevant to a business case in an
entrepreneurial situation. Source William
Salhman, HBS
39
Entrepreneurial Finance is also Entrepreneurial
Management

• Managers must be able to view problems from the
  financial perspective as well as from other
  perspectives.
• Figuring out how a particular decision will
  create value is a key responsibility of
  management and does not require elaborate
  systems. Financial analysis can be carried out in
  the mind an well as on paper.
• But finance does not answer questions it does
  not make decisions. Finance can help identify the
  right questions to ask and narrow down the
  options
• YOU are the manager and your job is to make
  decisions

Source Note on Financial Perspective What
should Entrepreneurs Know? William Sahlman, HBS
40
Agenda 1/08/07

• Welcome
• Class Logistics
• Course Content
• Introduction to Key Concepts
• The Case Method
• Assignments Sessions 2 and 3

41
The Case Method of Teaching

• A powerful learning methodology based on a direct
  study of actual business situations
• Requires that the student assume the perspective
  of the protagonist to develop actual solutions to
  business situations
• Depends on the active, effective participation of
  the students
• The primary responsibility for the learning
  experience resides with the group of students
• Students need to accept and maintain ownership
  for the discussion
• The instructor serves as a resource to facilitate
  and focus the groups discussion
• Its a dynamic and evolving process that improves
  with practice.
• Requires thorough preparation and proactive
  participation
• Each group of students is unique and develops its
  own dynamics

42
Your Responsibility The Four Ps

• Preparation
• It is indispensable for a productive discussion
  and critical to the learning experience.
• Requires 2-3 hours per each 1 hour of class.
• Team preparation can increase efficiencies and
  effectiveness.
• Focus on preparing both quantitative and
  qualitative analysis
• Presence
• Since most of the learning comes from the case
  discussion, learning will not happen if the
  student is not present.
• Promptness
• Case discussions need to start on-time and
  shouldnt be interrupted.
• Participation
• Sharing your insights and analysis is the key to
  advancing the collective knowledge.
• Class participation is a skill that is developed
  and improved overtime.
• Thorough preparation increases the impact of
  participation

43
KEY SLIDE
Hints on Class Participation

• Always put yourself in the protagonists position
  and develop and action plan.
• Be prepared to open the case. The instructor
  will cold-call during the class.
• Share your unique perspective and dont be afraid
  to disagree.
• Always be respectful of others opinions.
• Listen proactively and focus on the discussion,
  not your notes.
• Be answer first and concise.
• Support your assertions with data and analysis.
• Stay focused and follow the flow of the
  discussion.
• Quality is more important that quantity or
  length.
• Preparing well is the best way to improve your
  participation.
• Have a good time!

44
KEY SLIDE
Situation Analysis Blueprint
Key Issues
Key Analysis/Tools
Managements Decisions and Actions
Note This is a general and non-exhaustive
illustrative list of some of the issues and
analysis relevant to a business case in an
entrepreneurial situation. Source William
Salhman, HBS
45
Agenda 1/08/07

• Welcome
• Class Logistics
• Course Content
• Introduction to Key Concepts
• The Case Method
• Assignments Sessions 2 and 3

46
Session 2 (03/03/2008) Foundations

• Instructor David Hinds PhD. Real-life
  entrepreneur and FIU EMBA Instructor on
  entrepreneurship topics.
• Reading Entrepreneurial Finance A Casebook
  Chapter 5 Some Thoughts on Business Plans (pg
  80-111). Mandatory.
• Case No case to be discussed at this session,
  but you should be already working on preparing
  case for Session 3 (The Knot)!
• Study questions
• What are the key elements of the Fit model? How
  can you use the Fit model to analyze a
  situation (or to prepare for a class discussion)?
  
• What are the basic financial statements and its
  elements?
• What is net working capital? How do you
  calculate it?
• How do you calculate a cash flow statement?
• What is free cash flow? How to you calculate
  it?
• What is the relationship/differences between cash
  flow and accounting conventions? What is
  depreciation?
• How to prepare for your first case discussion and
  what analysis should you do?

Note This is a mandatory session in which some
of the most important technical/theoretical
foundations for this course will be discussed.
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Session 3 (03/10/2008) Preparation

• Reading Entrepreneurial Finance A Casebook
  Chapter 5 Some Thoughts on Business Plans (pg
  80-111)
• Case Entrepreneurial Finance A Casebook Chapter
  2 The Knot
• Study questions
• Who are the people? Is it a good team? What are
  they good at? What are they missing? What would
  lead you to believe that they will succeed?
• What is the nature of the opportunity? What is
  good about the market? What is the nature of the
  competition? What are the key success factors in
  the registry business?
• What is the business model? What are the
  operating characteristics of the business?
  Working capital needs? Fixed asset intensity?
  Scale economies?
• How has The Knot done? What financial and
  non-financial metrics would you use to gauge?
• What are the funding needs? When? What is that
  money for?
• Reconstruct the Statement of Cash Flow for
  1998-2001 (Exhibit 2-12D) using information from
  the Balance Sheet and Income Statement.
• What should David Liu and Carley Roney do?

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Session 1 Key Learnings

• Welcome to this course. Im happy youre here.
  Have a good time.
• Work hard you will be rewarded
• Participate everybody has a contribution to make
• Case Method
• Always approach like a CEO
• Have and action plan and be ready to present it
• Always support with qualitative/quantitative
  analysis
• The Fit model is an excellent blueprint
• Entrepreneurial Finance How to manage cash and
  risk to create value in the relentless pursuit of
  opportunity
• Key concepts for this session
• Fit model
• Financial statements profit and loss, balance
  sheet, cash flow statement
• Value Cash and Risk
• Free Cash Flow
• Net working capital