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BUS 529Lecture 2Business Plans, Financial Forecasting &

Planning (Part I), Sources of Funds & Securities Law

Goals:• To discuss business plans, especially the

financial aspects• To initiate a 3-part lecture on financial

planning and forecasting• To present and overview of funding sources

through the life cycle of the firm.

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Business Models, Strategies and Plans

Business Model: A (credible) story about how a business can make money for its owners, together with (credible) numbers that support the story. Includes a revenue model and a cost model.

Business Strategy: A firm’s theory about how to compete successfully.

Business Plan: (Ideally it is) a written version of the firm’s business model and business strategy.

Observation: A firm’s business model should influences the presentation of the financial forecasts in the firm’s business plan.

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Business Models -- Revenues

Categories of revenue sources:

-- single stream from one product or service

-- multiple streams from different products or services

-- interdependent streams / loss leaders (ex.: razors & razor blades; grocery stores)

Revenue Models

-- volume or unit-based (ex.: most goods)

-- licensing or royalty-based (e.g., HBSP)

-- transaction fee (ex: brokerage firms)

-- subscription / membership (e.g.: country clubs)

-- advertising-based (e.g., newspapers, Yahoo.com)

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Business Models -- Costs

Categories of costs:

--fixed production cost

--semi-variable production cost

--variable production cost

--infrequent (non-recurring?) production costs

Cost Structures / Cost Drivers

-- payroll-centered -- direct (ex.: professional services)

-- payroll-centered -- support (ex: insurance cos.)

-- inventory driven (ex.: car dealerships)

-- space/rent driven (e.g.: restaurants)

-- marketing/advertising driven (e.g., AOL)

-- fixed asset-driven (e.g., car makers; silicon chips?)

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Business Strategy

Porter’s Generic Competitive Strategies

-- overall cost leadership

-- differentiation

-- focus

Porter’s 5 Forces Driving Industry Competition

-- rivalry among existing firms

-- potential entrants

-- substitute products

-- bargaining power of suppliers

-- bargaining power of customers

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Business PlansThe ideal plan is a written version of the business model

and the business strategy.

Components of a Business Plan Introductory PageTable of ContentsExecutive SummaryIndustry Analysis / Product Description / Marketing Plan(Design and Development Plans)Manufacturing / Operations PlanOrganizational Plan Overall ScheduleCritical Risks, Problems and AssumptionsFinancial Plan

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Components of the Financial Plan

Statement of the amount of financing sought, and why funding is needed.

Historical financial data back three years (if applicable): – income statements– balance sheets– statements of cash flow

Financial Projections– monthly, years 1-3; annual, years 4,5

An indication of the gain from investing.

Probable exit strategy, and time-frame for exit.

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How to Write a Great Business Planby William Sahlman

• Relative importance of the business plan, and why• Factors to Emphasize in a Business Plan:

– The people– The opportunity– The context– The risks & rewards

• What numbers do matter:– The breakeven point– When cash flow turns positive

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Slope of the curve indicates the burn rate

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Attributes of a Good Financial Plan

• The plan focuses on the evolution of cash.– For what purposes is the founder group seeking funding?

(Acquisition of fixed assets? Current assets? R&D?) – How much cash does the founder group need, and what is

the timing of the need? – When does the firm start to generate positive free cash

flow?

• The plan reflects founders’ awareness that managerial accounting is more important than financial accounting.

– Conveying the business model clearly is more important than presenting projections in formats conforming to generally accepted accounting principles.

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Financial Forecasting and Business Plans

• Managerial accounting is more important than financial accounting

– Supporting schedules present key assumptions; these are needed for credibility.

– Forecasts are guesses, so the assumptions are important.– Choosing the right level of aggregation can be tricky.– The “unstructured approach” shows that financial

accounting need not be followed to be informative.

• Understanding how key financial statements helps in presenting informative projections.

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Overview of Sources of Funds & Securities Laws

A Leitmotiv :Raising money is hard work. Money is nearly unavailable at the

early stages of a firm’s life. At some point you will probably have to “bootstrap”: get by with small amounts of funds, usually personal ones, and use strategies and behaviors that generate cash flow.

Why is raising money such hard work?

-- asymmetric information

-- agency problems

-- “information opacity”; “informationally opaque”

These problems are very hard to overcome. That’s why “bootstrapping” is usually necessary.

• starting a venture with modest personal funds• using personal funds plus revenue internally generated by the

new firm to finance capital expenditures and growth.

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Idea StageConcept StageProduct Develop- ment StageTest marketing Stage

SeedFinancing

ARound

B Round

C Round

D Round

Mez-zaine

Start-up Financing

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Sources of Funds by Stage of Business Development

Sources of Funds Stage 0, I Stage 1, 2 Stage 3, 4 Stage 4, 5

Equity Sources

Entrepreneurs M M P U

Angels M M U U

Venture Capital U P M P

Private Offering U P M U

IPO U U U M

Debt Sources

Trade Credit U U/P M M

Commercial Banks U U/P M M

Finance Companies U P M M

SBA Loans P M M U

Other Sources

SBIRs M U U U

M = most likely; P = possible; U = Unlikely

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External Equity Sources of Funds

Entrepreneurs (& Families & Friends)

“Angels”

--- "The typical angel is a 47-year-old white male with a college education earning $100,000 per year and having a net worth (excluding a home) of $1 million. Most have substantial business and financial experience and prefer to invest in companies at the start-up or infant growth stage.”

--- probably invest mostly in the $250,000 - $1 m range,

-- less than what ventures capitalists invest

-- more than what entrepreneurs have

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External Equity Sources of Funds

-- Advantages of using Angels

-- will invest in early stage firms (unlike VCs)

-- will invest in high-tech firms

-- require lower returns: 35-50% per year

VC: 60-75% per year

-- take less equity and less control than VCs

-- Disadvantages of using Angels

-- may be unable to assess the business idea

-- may have no experience starting a business

-- may bring no useful skills or contacts

Angel Networks– angels investing individually hold highly undiversified

portfolios; networks circulate bplans and make pooled investments

– to be an “accredited investor” angels must comply with SEC Rule 501.

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External Equity Sources of Funds:Venture Capital

VC firms are limited partnerships

limited partners are investors

general partners are the fund managers

Key evaluation criteria:

strong management

growth industry

unique opportunity

appropriate annual rates of return:

seed stage: 60-75%

start-up stage: 50-60%

growth/expansion: 30-50%

harvest: 30% or less

VCs gather info before investing. (“due diligence”)

Advantages of VC: experience, expertise

Disadvantages of VC: want to run the show

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External Equity Sources of Funds Private and Public Stock Offerings

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Debt Sources of FundsTrade Credit, Commercial Banks & Finance Cos.

Trade Credit• Unsecured financing provided by suppliers• Major source of funds • Evidence of ability to repay before extending credit.Commercial Banks• Major source of funds• Mainly short-term lending (under 1 year)• Very conservative in lending practices • Banks want evidence of good stable cash flow.Finance Companies• "asset-based lending."• less conservative than banks: more stable funding• shun small loans• charge 2-10% more interest and fees than banks. • Factoring: buy AR at a discount (5%)

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Debt Sources of FundsSmall Business Admin. (SBA) Loans

• Main program is the 7(a) program available mainly thru banks; 80-90% of the loan is guaranteed by the SBA

• eligibility requirements:– business must be "small" – no speculation or real estate– data needed for application:

• existing ventures: 3 years of historical financials; 3 years of pro formas

• start-ups: a business plan w/ pro formas; 20-30%+ equity from founders

• Loan features:– installment loans (level principal & interest)– amounts and terms-to-maturity by the bank

• the median loan is about $175,000 • average term is about 12 years

– interest rate: prime + 2.25 - 2.75%

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Other Sources of Funds: SBIR Grant Program

Small Business Innovation Research

Small Business Innovation Development Act of 1982. Federal agencies with big R&D budgets award part of their funds to small businesses.

11 Fed agencies: DOD, NASA, DOE, HHS, NSF, USDA, DOT, Nuculear Regulatory Commission, EPA, DOI, DOEd. Each department develops a list of R&D areas in which it will fund research.

Types of awards:

Phase I: up to $50,000 for feasibility study

Phase II: up to $500,000 for prototype development

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Some successful bootstrapping behaviors:• Accept quick break-even, cash-generating projects.• Control growth because growth eats cash. • Focus on cash alone. Bootstrappers need strong cash flow from

the start to cover costs and save for expansion.• Cultivate banks before the business becomes creditworthy.

Bootstrap Finance Again

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Bootstrap Finance Again

Neal Hunter, founder, former CEO of Cree Research

Cree founded in 1987 by 6 NCSU graduates

Raised $350m in equity before going public in ’93.

Funds raised:

Months 1-2: $28,000 2nd mortgage, credit cards

Months 3-4: $20,000 friends and family

Months 5-8: $400,000 private investors

Months 9–12: $2.8m private investors

Sources of funds: home equity loans, credit cards, family and friends, government contracts (SBIR), private equity, operating income.

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Summary and Conclusions

• Business plans are like war plans; they describe a future that never happens. Preparing them is useful nevertheless. You can’t get funding without one.

• Financial projections can be useful if well-crafted. They must be supported by reasonable assumptions and focus on the things that matter: evolution of the firm’s ability to generate cash, eventual return on investment.

• Raising money is really hard because start-up and young firms are informationally opaque. (Bootstrapping.) As firms become less opaque, more funding sources become available.