Business Structure

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 1/24

Page 118

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 2/24

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 3/24

Financing and Accounting

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 4/24

Page 119

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

learning objectives After studying this chapter, you will be able to: LO7- 1

Identify key financial issues involved with starting a business.

LO7- 2

Discuss the basics of funding a business.

LO7- 3

Explain the importance of proper accounting when starting a business.

AEROPRESS

Alan Adler was always tinkering with new products. In the 1970s he was working as an engineer and a part-time instructor at Stanford University. At this time he would invent toy ideas in his garage and sell them to the big toy companies. Having taught himself how to sail and being fascinated with the aerodynamics of sailing, he wondered if there was a way to make a better flying disc. In 1984, he developed a far superior version of the flying disc that he called the Super Aerobie. The Super Aerobie made the 1986 Guinness Book of World Records for the farthest object thrown. It set the new record in 2003 at 1,333 feet. Ultimately he grew the business to an eight- person company in Palo Alto, California, called Aerobie. The firm focused on a variety of toys all built around taking advantage of aerodynamics. His firm ultimately became a leader in the disc golf movement.

However, Alan’s frustration with coffee brought about a huge change in the life of this company. Alan was not a great fan of coffee because it would upset his stomach. He liked the taste, just not the acid. His fascination with making a better cup of coffee changed the whole company. After tinkering with more than 30 different prototypes, in 2004 he invented the AeroPress. The AeroPress uses air pressure and a plunger in much the same way that a French press coffee maker does, but forces the water through a filter at very high velocities to create a perfect cup of espresso in less than 30 seconds.

Fans of the AeroPress have created competitions around the world for the perfect cup of espresso using the product. Retailing at $26, the AeroPress now accounts for more than half the company’s sales. Alan has over 40 patents to his name and, at age 75, the latest invention has taken his entrepreneurial venture in a whole new direction.

Questions 1. What other product areas would seem to fit with AeroPress’s capabilities set? 2. How did Alan Adler’s interest in brewing a better cup of coffee fit with the business?

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 5/24

Sources: http://aerobie.com/about.htm; http://aerobie.com/about/history.htm; C. Jung, “Invention Brews Good Coffee—Faster,” South Bend Tribune (2006), http://articles.southbendtribune.com/2006-05-08/news/26971788_1_coffee-maker-espresso-filter; N. Summers, “Iterate, Iterate, Caffeinate,” Bloomberg Businessweek, April 28, 2014, pp. 72–73.

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 6/24

Page 120

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

Financing the start of a new business and establishing the accounting systems are central operational concerns in the start-up of a new business. In Chapter 6 we examined the basic financial analysis (on a pro forma basis) that should be used to evaluate the decision to start a business. The next issue to develop is the specific financing and accounting issues that impact the operational start-up of the business. Specifically, three questions are examined in this chapter:

1. How will the entrepreneur or entrepreneurial team fund the new business, and what funding level is really needed for the new venture?

2. What accounting records should be maintained, and how will they be maintained? 3. How should the business manage the paper and data flow of the new company? All of these issues are directly related to the establishment of the financial structure and record keeping of the new company.

Too often new businesspeople put these issues at the bottom of their priority list (both during and after start-up) and do not devote much time to them. However, it is far easier to establish items such as a sound system to account for the transactions of the business at the beginning of the venture. Some forethought on the process will save lots of frustration after the business is up and running.

Key Financial Issues Involved with Starting a Business LO7-1 Identify key financial issues involved with starting a business.

There are a wide range of issues that new businesses need to be aware of that are related to financing of the start-up. The issues we address in this chapter are not ordered by their importance; instead these issues are intertwined with each other. The first is the funding and funding level of the firm. The next is the establishment of an accounting system. Finally, the flow of information in the new business needs specific attention. If the new business does not address all of these issues very early on in the process, then the owners will constantly be putting out fires related to these items rather than focusing on building the firm.

The experience of the founders of Friends’ Home Health demonstrates the interconnection of a rich set of issues that any entrepreneurial firm faces. The owners were very concerned with their need for an effective means of accounting. This need really stood out when they realized they did not know the true cost of any individual service in their operation (an important issue in this business). In developing a bid for the hospital’s work, the owners had not included the cost of hiring temporary workers to handle short-term increases in the number of patients, had not planned how to ensure the skills of those employees, nor how to account for the purchase of additional medical supply items that weren’t in the plan for a standard patient. The opportunity to showcase their business as well as how to gain a larger, more consistent business as partners was not something they had originally addressed in their business plan. In effect, this opportunity would divert Friends’ focus from its business plan during its first days of operation, a time at which the partners might not have a clear idea of what they were actually getting involved with. Whether this possible partnering with the hospital was really a good opportunity or not, was truly a question they couldn’t answer. Entrepreneurial firms often face such opportunities—ones that may or may not be beneficial to the entrepreneur. However, the entrepreneur needs to evaluate clearly the pros and cons of any such major shift to their business plan.

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 7/24

Page 121

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

Friends’ Home Health was continuing on its path to make the new business a reality. The owners had established a banking relationship with the region’s largest bank, found a place of business, and were working on obtaining the required business licenses for the firm, and the certifications for their employees. The two founders had left their employer by this time and, to help start cash flow for the firm, the two opened for business with just two home health patients that the owners handled personally. In the process of spending money and receiving invoices, the two founders quickly realized they needed a means to track their transactions. For the first few weeks they simply kept a classic accounting T-chart with all the expenses on one side and all the income (of which there was very little) on the other.

During this time they also received their first bank statement and, more importantly, a call from someone at a nearby hospital who had learned of their new operation. The hospital had decided to add home health care as part of their offering but wanted to partner with a local company to actually provide the services. The hospital had a policy of supporting local businesses and wanted to know if Friends’ Home Health could handle the volume of patients the hospital expected to generate. They also wanted Friends’ to consider being an exclusive partner with the hospital, which would mean they would only accept patients who were referred to them from the hospital.

The founders traveled to the hospital and worked out a deal to be the exclusive operator of the home health care operation for the hospital. On average, the hospital discharged 14 people per day who required home health care. The average patient needed this care for less than two weeks, but there would be patients who would require long-term care. The hospital wanted to announce the new arrangement as soon as possible and asked the founders of Friends’ to be ready to start accepting patients within three weeks. The hospital agreed to handle all the medical payment processing for 10 percent of the total bill. In addition, they agreed to pay Friends’ one-fourth of the total estimated weekly bill up front, with the remainder payable when the hospital was paid by the insurance company or government.

Betty and Joan were thrilled with the prospect of this business and went straight back to develop a plan. The founders initially thought they could run ads to hire workers. However, as they thought more about this, they realized they did not have time to hire workers and still develop the business they planned. The entrepreneurs still wanted to offer a differentiated service so the employees would need training. They contacted several temporary (“temp”) agencies and began to realize that the potential employees from these agencies would still need to be trained, and further, they could not control for the quality of the potential employees. Betty and Joan found that their cost estimates were not accurate when they realized the hourly rate they were going to have to pay to get the workers from these agencies. Betty and Joan also were concerned that if they were a captive unit of the hospital they would not have the control they wanted of their business, nor would they necessarily capture the profits they wanted. In their position as a captive unit of the hospital, pricing and most key strategic decisions would most likely be determined by the hospital. Thus, the founders decided to not align with the hospital.

This episode made the entrepreneurs realize they did not have a full understanding of the potential costs they may face. The human resources issue above was simply one of many areas that they had to understand more fully. For example, the medical supplier they wanted to use for the goods for their patients had a policy regarding new businesses that required full payment up front for the first 90 days that they did business together. After that time period, the supplier would start extending a 2/10, net 30 policy to them (2/10 meant that Friends’ could get a 2 percent discount on its purchases if the business paid its bill within 10 days, and if the bill was not paid during that 10 days, then the full amount would be due in 30 days).

Betty and Joan determined that they needed to track every item that they would use at each patient location so that they could tell if their plan for a 100 percent markup would in fact cover their other costs. The owners came to see that their business was a lot more complex than they had initially thought, and they needed to have a much better system to track all of their finances. The realities of the business were confronting them.

Betty and Joan called an accountant they found in the phone directory. This accountant told them that

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 8/24

Page 122

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

maintaining accurate records was going to be critical, and the sooner they got a computer accounting package and used it, the better. The accountant recommended a straightforward package that was available at most office supply stores and was easily understood. They quickly acquired the software and went about learning it and setting up all of the business records. The result was that they were learning how to use the system and seeking to adapt it to their needs while, at the same time, preparing to run the business.

QUESTIONS 1. What is your assessment of the potential deal the founders were offered by the hospital? 2. How important will inventory control be to this business? What do you recommend? 3. What do you think the most critical cash flow issues will be with the business as it is currently crafted? What do you

recommend the founders do to manage cash flow?

Extra expenses, especially early on in a business’s life when no (or virtually no) income is coming in, can quickly use up the cash intended to found and grow the business. By the time Friends’ pays for all the additional expenses related to this opportunity, the business could well be out of cash. How much initial funding does a business need to survive the first year of operation? What type of financial cushion should be in place to help buffer the business when an unexpected cost such as the one facing Friends’ arises? Central to a financial cushion is the nature of the firm’s funding. When considering funding, the firm needs to evaluate not only the amount provided but also the sources of that funding. A key aspect of how the funding will be used is found in the information provided by the business, and that comes through the accounting system and the data flow management. Thus, all of these issues are interconnected and will be discussed in turn.

Basics of Funding a Business LO7-2 Discuss the basics of funding a business.

Funding for almost any new business starts with the founder(s) and his or her personal resources. However, at some stage (often prior to actual startup), the firm may need to find other sources of funding. These sources may be small and may or may not be tied to an equity (ownership) interest in return for the funding.

equity investment Funds received by a business in exchange for a percentage ownership of the business.

crowdfunding Funds received by a business by soliciting a large number of very small investors usually via the Internet.

In contrast, other investors will make equity investments, where someone provides funding in return for some ownership in the new business. Each of these types of funding will be reviewed in turn. First, we review those funding sources that do not require equity in the firm, followed by a review of equity investments, and wrap up with alternative sourcing tools, such as crowdsourcing and crowdfunding, that have become so popular.1 Separately we will discuss a means for determining the actual amount of funding a new business should seek, to ensure it has sufficient resources at the outset of the business.

Non-Equity Funding There are several sources for non-equity capital to start a business. Debt is a major source of such non-equity financing and can come from banks, credit cards, asset leasing companies, individuals, and/or suppliers. Grants

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 9/24

Page 123

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

are another type of non-equity funding to which some businesses may have access. A grant may come from the government or a nonprofit agency; it is simply money designed to help the new business begin operations with no expectation of repayment.

Debt. A firm can obtain debt in many forms, each with positives and negatives for a new business. Debt is any form of capital infusion that must be paid back with interest. Debt allows the new business to manage its cash flow through the various peaks and valleys in the operation of a business, or more importantly, to handle the disparity between when goods must be purchased and when money will be received from a customer to pay for those goods. The most common forms of debt for new businesses can be classified as follows:

debt

A generic term to describe any type of non-equity funding tied to the business.

1. Loans from a. Bank or finance company b. Individuals c. Founders

2. Credit cards 3. Supplier credit

Loans. A loan, regardless of its origin, involves a contractual agreement whereby the business receives some amount of money that must be repaid over a specified period of time at a specified interest rate. Loans are most often repaid monthly from cash flow and, especially early in the life of a business, are secured by assets or a personal guarantee. In the case of business failure, debt must be paid back prior to any equity investors receiving a distribution.

loan

Contractual agreement whereby the firm receives some amount of money that must be repaid over a specified period of time at a specified interest rate.

Banks have traditionally been a major source of funds for established firms but are quite restrictive in their lending to start- up firms, as the risk is perceived to be too high. However, there are some specific ways that banks lend to new businesses. For example, banks will make loans for the purchase of some types of equipment. In this type of lending, the bank will estimate the residual value of the equipment if the bank had to repossess the equipment and then lend the business a percentage of the difference between that number and the sale price. This discount is typically quite significant. This type of lending is referred to as asset-based lending. As will be discussed in Chapter 12, a relationship with a bank is critical to the new business’s ability to obtain bank financing. 2

asset-based lending

A loan provided for the purchase of a necessary asset for the business.

Banks will also lend money for the establishment and maintenance of inventory by arranging a revolving line of credit. A lender will periodically perform an on-site examination of the inventory to ensure that the inventory is being accounted for properly. A particular problem with lines of credit for inventory is that a firm may have old inventory that has not been sold for a period of time. Such inventory needs to be discounted, as its value in the market has shrunk. Too often firms still reflect that old inventory on their books at full market value.

A classic source of entrepreneurial finance is friends and family. Although the conditions for borrowing from friends and family may be a bit more relaxed, the new business owner should view the loan as he would one from a bank. One issue to consider in such loans is that if the business fails, the inability to repay such loans can permanently rupture the family relationship or friendship.

The founder(s) of the business may also choose to personally lend money to the new business. Even though it may strike some as odd to lend money to your own business, debt is a secured investment. Therefore, if you lend your

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 10/24

Page 124

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

firm $1,000, then you, along with the other debt holders, have the right to the firm’s assets if the firm fails to pay off that debt. An equity investor generally receives only those proceeds that are left after paying off all other debts.

Credit Cards. Credit cards are another form of non-equity investment. A credit card is simply another type of credit. However, a credit card is not tied to any particular asset, nor does it have a set repayment schedule (other than a minimum payment).

credit card Card entitling one to revolving credit that is not tied to any particular asset, does not have a set repayment schedule, typically has a set upper limit, and is usually tied to a much higher interest rate than that of a bank loan.

We have worked with a number of new businesses that decided early on to finance their operations with credit card debt. One new business-person running an advertising agency would, when faced with a new bill for the company, go to the center desk drawer to look through more than 60 active credit cards to decide which one should be used to pay the bill. Not only is this a very poor management system that is extremely expensive, but it is also one where the debt is almost always tied personally to the founder(s), thus exposing them to personal bankruptcy. That said, credit cards can be a wonderful short-term method of managing your cash flow, especially during peak times in the early stages of the business. If paid off each month, business- issued credit cards provide the company with an excellent financial tracking system that can be divided up by individuals within the company, and payment can be delayed by up to 25 days, allowing for a unique positive cash flow situation. However, the new business must be able to manage such debt carefully if it is going to be employed. The interest rates can easily exceed 30 percent and will quickly bankrupt a firm if allowed to build.

What are the risks and rewards of using credit cards when financing a business?

Supplier Credit. Supplier credit is another form of non-equity funding that is available. 3 Suppliers will generally provide credit on both physical assets (refrigerators, molding equipment, etc.) and the actual supplies purchased. A firm such as IBM Credit LLC is an example of a firm that you may be familiar with that exists primarily to fund the acquisition or lease of IBM products and services although they also finance purchases from other organizations. The credit terms offered by such firms can be quite generous, but they are a liability for the company and need to be managed as such. Accepting supplier credit can tie you to that supplier, limiting your ability to shop around for a cheaper source. The terms can be quite generous and the rates are usually more competitive than those available from traditional bank sources.

supplier credit Another form of non-equity funding that is available. Suppliers often will provide credit on both physical assets (refrigerators, molding equipment, etc.) and the actual supplies provided.

Grants. The new business should also explore grants from both governmental and private foundation sources. There are special funds that are neither equity nor debt funds that are designed to aid businesses in specific areas. These grants typically target disadvantaged groups, economic areas, or particular industries. There are also grants for target groups such as veterans and women-owned businesses. The presence of such grants vary widely based on the given funding year and where you live. Grants should be explored through groups such as your local Small Business Assistance Center.

grants Special funds that do not require repayment and are designed to aid businesses in specific areas.

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 11/24

Equity Funding The new business should employ all non-equity funding mechanisms available to it. In the long run (assuming a successful business operation), the cost of such capital is generally less than that of equity investment. However, a growing business might need to seek equity funding beyond founders’ capital.

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 12/24

Page 125

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

In the founding process, the business generally receives funds from the founder(s) as well as other investors. An evaluation is needed to determine the percentage of ownership each founder will have in the business and the percentage that will be reserved for investors. We will cover valuation of the business in Chapter 13, and we recommend that prior to allowing any nonfounder to invest in your new business, you have a fair and valid estimation of the value of your company. That said, we would like to address several key issues related to equity financing of the new business with outside sources.

Obtaining equity investment from investors has a number of potential operational impacts. Investors can be active or passive, majority or minority, companies that might ultimately wish to buy the whole new venture, and/or suppliers looking to add new volume for their products. Each of these potential sources has characteristics that can have a major impact on your business. Additionally, accepting an equity stake from an outside investor adds a dimension of accountability to the founding of a new business and opens the new venture up to new concerns. Therefore, seeking outside funding is a significant decision.

To illustrate the impact of outside investors, we worked with an entrepreneur who started a new high-end restaurant. The initial investment needed to make the venture work was substantial and well more than the founder could invest. She sought outside investors for the business from her country club, social friends, and business acquaintances. She ended up with 47 total investors with separate investments that varied from $8,000 to $110,000. The restaurant was built and opened to great fanfare. Thursday, Friday, and Saturday nights were packed, with an average wait for a table of two hours. The founder worked nonstop on those evenings, but had continuous problems with her fellow “investors.”

A number of these investors believed that they deserved preferential treatment at the restaurant because they were “owners.” Many of them demanded special favors, such as being placed first on the wait list for a table; walking through the kitchen with guests (not a helpful thing to do on busy nights); talking to the chefs about their ideas; or even having their meals “comped” (received for free). Some investors similarly felt free to discuss employee performance with the individual employees. These investors would also call at will to talk to the founder about the restaurant’s direction, as well as expecting to be able to meet with the founder at their convenience.

The founder finally had a meeting with all of the investors to lay out the problems involved with their behavior and the disruption to the success of the business. Several of the investors were indignant and demanded their investment be returned. This was not something that the business could afford at this early stage, and legally it did not have to comply with their request. The result was fractious relations with some investors, and an enormous amount of time being taken away from the business to handle “bruised egos.” A little care in the initial setup of these relations could have prevented a series of problems later in the operation. Eventually each of the upset investors was bought out and all of the other investors agreed to end their disruptive behavior.

Equity investment traditionally involves selling a percentage of the business to an outside party. This should be done in consultation with an attorney who is well versed in this area of the law. The founder(s) must be very clear that in the case of dissolution, each investor is entitled to the percentage of the break-up value (after all debts and obligations are paid) equal to their investment percentage of ownership. However, even more critical to the success of the business is to carefully and clearly outline what rights and expectations each investor has as the business grows. Equity investment does not necessarily carry with it an equivalent percentage of control in the firm. An entrepreneur needs to clearly specify how ownership will be

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 13/24

Page 126

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

handled. Similarly, the entrepreneur needs to clearly specify how the profits of the business will be handled. Will the new venture divide up all profits at the end of each year? What will be retained in the business for future growth? How can each investor “sell” his or her shares? Does the company have first right of refusal in any share sale? Working with an attorney to develop a clear document that details all of the concerns about an equity investment should be completed prior to approaching a potential investor.

As previously mentioned, the sources of equity investment include other firms, venture capitalists, and business angels.

Businesses as Equity Investors. Many established businesses are willing to make equity investments in other start-up firms. Large firms such as Microsoft, Intel, and Cisco have traditionally been among the most active equity investors in new start-up firms in the technology sector; corporate venture capital from these firms is actually one of the leading sources of venture capital in the United States. (Venture capital is discussed in greater detail below.) There are two scenarios that we have dealt with regularly in the funding from such firms. The first involves a company that will invest in a new venture with the idea of ultimately purchasing the operation. The second type is a large supplier that is willing to invest in a new operation as an additional outlet for its products.

The company that invests with the idea of an ultimate purchase does so because it is one of the least expensive means for trying out new ideas/ products/methods and for maintaining access to the latest thinking in the field. For the established company to try to develop every idea in-house, it would have to redirect significant resources away from the core focus of its business. Instead, the large business invests in a series of businesses that are trying new things within its industry, and in effect, it has taken out a series of strategic options without having to detract from its core business. 4 Those options that turn out to be successes are then purchased and brought into the core organization. This can be a wonderful harvest strategy for the entrepreneur to capture the value in a newly founded business; however, the founder(s) may not wish to sell the business at the exact point in time that the larger company wishes to close the sale. Depending on the nature of the investment, the founder(s) may not have the option to decide when the business is sold.

Intel is an active equity investor in start-up firms. What are the pros and cons of equity investment from a firm like Intel in a new small business?

Having a supplier invest in your new business is somewhat simpler, in that the supplier is generally not trying to run your business, nor looking to take the business over if it does particularly well. Instead, the issue with this type of equity investment is one of restriction. The deal usually involves an exclusivity agreement to use only that supplier’s products. This can be a significant (and in some cases a business-killing) proposition. The founder(s) must be careful not to trap themselves into an agreement that prevents flexibility that may be needed in the future.

venture capital fund A fund that is organized to make significant equity investments in high-growth new ventures.

Venture Capital (VC). A form of equity investment that seems to garner considerable press because of the sheer size of their investments is venture capital. A venture capital fund is a fund that is usually organized as a limited partnership. 5 Limited partners in the fund, which may include very wealthy individuals, insurance companies, other businesses, and retirement funds, invest in such funds seeking high returns. The general partner in the fund is the venture capitalist, who then investigates and invests in each new

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 14/24

Page 127

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

business. Venture capitalists might invest in less than one out of the thousand business plans they see in a year. They are seeking extremely high-growth businesses that have an opportunity to “cash out” with an IPO or sale to a larger company within a set period of time. VCs are looking to make a significant investment, generally something greater than $2 million. As such, they are not a source of funding for very many new businesses, and we spend very little time in this text on venture capital.*

Business Angels. Business angels are a form of equity investors that are more widely available to new businesses. Business angels are high-net-worth individuals that invest widely in businesses. 6 These individuals may include entrepreneurs who have built one or more businesses and have cashed out (i.e., sold their businesses and have the excess cash in hand), executives with large organizations that have high incomes, professionals such as doctors and lawyers, and individuals with significant inheritances. These individuals can be very helpful sources of expertise and contacts in the area. However, the new businessperson should seek individuals who have relevant knowledge (not just money) to add to the firm. When seeking investment from such individuals, we suggest that you evaluate the nature of their advice, how intrusive they will be, the nature of their business experience, and what other contacts and relationships the angels may have that can help the new firm.

business angels

High-net-worth individuals who invest in businesses not as a business, but as an individual.

Crowdfunding. Crowdfunding is a relatively new means for raising capital that may result in either an equity approach or an in-kind exchange for the firm. Companies seeking to raise capital without using the traditional approaches have found that the Internet is an excellent means to try to reach out to potential investors. 7 Internet sites such as Kickstarter.com, EquityNet.com, Indiegogo.com, and others have systematized the process. Entrepreneurs seeking capital make their pitch on the site and let potential investors know what they will receive for their funding. This might be equity (depending upon the size of the investment), but is more often a product/ service, or gift. 8

Other Financing Tools Several other financing tools are available to the new business as it starts. These mechanisms include asset leasing and factoring.

Asset Leasing. A form of funding for a new organization is an asset lease arrangement. Similar to leasing a car, many of the assets needed by the new business can be leased from the manufacturer, or from a third-party reseller. Instead of owning the assets, the company simply leases what it needs. In fact, there are companies (third-party resellers) that have a significant part of their inventory in equipment that they lease to other companies. The advantages are relatively straightforward. The new business is able to acquire the assets that it needs to begin operations with a minimal cash outlay. The company pays the lease from production that is a direct result of using the equipment that it has leased. Furthermore, it is not stuck with an aging asset. As newer, higher-quality machines become available, the entrepreneur is able to trade up.

asset lease

A form of lease tied to a particular asset used by a business to conserve cash and maintain the latest versions of whatever equipment is available.

The big disadvantage to leasing is that over time the new business may spend more money for the equipment than if it had bought the unit outright. However, the net present value of the lease may actually work out to a net positive as the new businessperson does not have to put as much cash initially into the lease as in a purchase. Therefore, the decision maker

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 15/24

Page 128

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

should evaluate two areas: (1) How much cash does the new business have to invest in equipment up front? and (2) Given the pace of equipment obsolescence in that industry, would it be more advantageous to lease or own the equipment needed to operate the business?

Factoring. With the exception of new businesses that operate strictly on cash, as the business begins to make sales it will generate accounts receivable—that is, sales that have been made, but not yet paid for. If the firm needs to generate cash in the short run, these accounts can be sold at a discount via a technique known as factoring. Numerous businesses provide this service. They will discount the dollar amount of such accounts based on the quantity and quality of the receivables. The quality of the receivables is determined by such issues as: (1) who owes the new business money; (2) the debt age; (3) the size of the transaction; and (4) the debtor’s credit rating. For example, if a blue-chip firm such as ExxonMobil or a government entity owes you the money, there is a virtual 100 percent chance of being paid. In contrast, if your accounts receivables are from a small building contractor (an industry segment with a considerable history of turnover), then the accounts will be more heavily discounted. The benefit for the entrepreneur is that the new business gets the money from the accounts receivable immediately. Aside from obtaining the cash up front, the new business does not have to spend time and effort trying to collect the accounts receivable. The negative is that the new business will not receive the full amount of the debt that is due to it.

factoring Accounts receivable that are sold at a discount to another company to receive immediate cash.

Initial Funding The new businessperson needs to calculate how much money will be needed to start up the business. Although it would appear that more initial funding would be somewhat better than less, it must be tempered by what the founder has to give up to obtain the money. In Chapter 6 we examined the financial issues associated with breakeven and basic cash flow analysis. The complexity of capital funding increases substantially as the new business requires external investment to begin operations.

To calculate the maximum amount that you may wish to obtain in outside financing, recall from Chapter 6 that we recommend the entrepreneur calculate the entire cash flow projection without adding in any equity investment and look for the point where the ending cash balance is at its lowest point. A safe rule of thumb suggests taking that number and multiplying it by 150 percent. The resulting amount is what we recommend for the initial equity or equity-plus-debt investment. The new businessperson then connects this amount with the percentage of the firm that was previously determined would be made available to other investors. The two points frame the new businessperson’s investment parameters. Consider the following example:

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 16/24

Page 129

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

It is important to remember that negotiations between the founder(s) and your investor are just that, negotiations. It takes two willing parties to reach an agreement. You may see the investment in your firm as worth X, whereas an investor sees it as worth Y. It will take negotiation to determine the ultimate value. A review of Chapter 13’s discussion of valuation and negotiation should be helpful in conceptualizing these issues.

EXERCISE 1 1. How much funding will you need for your new business? 2. How do you plan to fund the new business? 3. What assumptions have you made regarding your funding?

Importance of Proper Accounting When Starting a Business LO7-3

Explain the importance of proper accounting when starting a business.

We do not presume in the next few pages to show you how to do all of the accounting that you will ever need to know to manage your business. There are many fine texts and courses available that focus tightly on this huge and complicated area of business. Furthermore, we covered the basics regarding the balance sheet and income statement in Chapter 6. That said, we would like to suggest that the needs of most new entrepreneurs are very straightforward and can best be met with one of the numerous computer software programs available.

The new businessperson will need to quickly decide whether she will use a cash- or accrual-basis accounting system. In its simplest form, cash-based accounting recognizes expenses as they are paid and recognizes revenue as it is generated. Accrual- based accounting is the more typical form of accounting used, with expenses and revenues recorded when they actually occur, regardless of when the cash is received. Accrual accounting must be used if you have inventory; if you have to report your financial statements; and if your business is a Subchapter C corporation, partnership, or trust. The end result is that only the smallest businesses use cash-basis accounting.

The new businessperson will need to carefully evaluate which accounting program would be the best for his business. Choosing a package that will be useful for your business is a process of understanding your new business first and then finding a package that will accommodate your needs with the least impact on the business. Most of the packages will provide any report that could be demanded by the owner(s), potential investors, auditors, or loan officers. Some of the key reports that the new businessperson should be prepared to generate include these: (1) chart of accounts, (2) petty cash register, (3) check register, (4) expense accounts, (5) inventory accounts, (6) accounts payable, and (7) payroll.

ETHICAL CHALLENGE You have seen in this chapter that there are different types of investors, and there can be different levels of investment. These investors come into the business facing potentially different types of risk and return.

QUESTIONS 1. Think about and discuss the ethical obligations you have to early-stage investors versus later-stage investors. Do you

promise more returns to someone who shows faith in you at an earlier stage? 2. What are the ethical obligations if some investors are family members and some are not? Do family members

deserve different investor treatment?

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 17/24

Page 130

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

Chart of Accounts The chart of accounts is the master system for tracking the activity of the business. It requires a bit of care up front in its establishment and will need updating as the business grows. This chart is not complex; however, the new businessperson needs to ensure that the system designed provides the information necessary to analyze the business and its performance. This topic will be discussed more in Chapter 8 as we examine business performance of the going concern and ensure that the firm is performing as desired.

A chart of accounts is simply a listing of each type of activity (income or expense) and each type of asset within the company. The account number used is completely at your discretion, but income categories are usually first, expense categories next, and asset categories last. You may use two-digit or three-digit numbers as you wish and in accordance with the level of detail you anticipate in the future. There are usually far more expense categories than there are income categories. Table 7.1 shows the chart of accounts of an electronics manufacturer, which displays some of the expense categories for the firm.

EXERCISE 2 1. Develop a preliminary chart of accounts for your new business. 2. Have fellow classmates review the chart and add or delete as necessary.

The new businessperson will want to leave room for new account detail to be put into the chart of accounts. As the business develops, you will find that you want to obtain additional detail, as new income/ expense categories will appear. Notice that the chart tracks not only income and expense accounts but also asset accounts.

Table 7.1 Chart of Accounts—Electronics Manufacturer

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 18/24

Page 131

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

Petty Cash Register There are numerous expenses that are simply too small to write a check for, and there are times when a check is simply inappropriate (for example, if you had pizza delivered for everyone because the whole group was working late to meet a deadline). A petty cash fund operates much like a bank savings account. The founder purchases a small lockbox and writes a check to “Petty Cash” for whatever amount they would like to keep on hand (this is not the same as cash register money, which should be handled as a separate deposit/expense account). A register is maintained to track the amount of money in the box, much like a savings account register. For example, if you decide that $100 is the amount that you would like to have on hand, you would start the box off with $100. As withdrawals are made, each is recorded and all change is put back in the box. The founder should be able to glance at the register and know exactly how much money is in the petty cash fund at any point in time, as well as know how the money has been spent. As it depletes, a new check should be written to “Petty Cash” to fill the box back up to the $100 level.

Check Register As simple as it sounds, it is important to create a listing of all checks that have been written and all that have cleared through the bank. Today, with online banking and the ability to transfer data directly, this process has become quite easy. Regardless of how the entrepreneur might maintain her personal checking account, it is very important to record and balance the company account on at least a monthly basis.

Expense Accounts Depending on the volume of business that your venture processes, you will have either a daily or a weekly listing of expenses. These will allow the entrepreneur to perform a monthly tracking of expenses and ultimately form an annual record of all expenses. The process requires you to have both your check register and your petty cash register available to record all outflow of funds. Credit card payments should be handled by recording the interest as an interest expense, recording the payment made to the account, and then recording each line item with a notation of “Visa,” “MC,” “Am. Ex.,” and so on, next to the expense. The only other expenses that are truly handled in a different manner are those related to travel. The IRS has very specific requirements related to the record keeping necessary to deduct these expenses. You should be sure to familiarize yourself with the latest rules regarding these expenses.

A young woman looking at the First Direct Bank website. Online banking is not only efficient but convenient.

Inventory Account Any business that has even a small inventory should maintain an inventory record that lists a description of the item, the quantity, an item number, a unit cost, and a total cost. Inventory should be taken at scheduled times during the year and an exact match should be completed between starting inventory, units sold, and ending inventory. A second record should be kept to track inventory ordered and inventory received. It is a fact of business that shrinkage will occur. This reduction in inventory can come from poor record keeping on any of the fronts mentioned previously, but can also result from either employee or customer theft.

shrinkage

The difference between what is sold and what was brought into the business.

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 19/24

Page 132

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

Accounts Payable A separate accounts payable record should be maintained for each creditor. All invoices received should be recorded and a record of payment toward each invoice should be included (Date Paid, Amount Paid, and Check Number/Transfer Tracking Number).

Payroll A payroll record should be maintained for every employee, tracking time for hourly employees and attendance for exempt (salaried) employees. Additionally, an employee record should be maintained that tracks every payroll check (electronically or in paper form) issued to the employee. This record will list all of the items that make up the check:

Date Check number Number of hours worked (or 40, for exempt employees) Base pay Overtime hours worked Overtime pay rate Gross pay Taxes (federal, state, local, Social Security, and Medicare) Benefit deductions (if appropriate) Net pay

Table 7.2 Profit and Loss Statement

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 20/24

Page 133

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

Accounting software packages the entrepreneur may buy have the ability to produce all of these records plus many more. These become both the control records and the input records to produce your financial statements (Cash Flow, Balance Sheet, and Statement).

One additional statement is a must-have for most businesses and comes directly from the effective collection of all this information: the profit and loss statement (P&L statement). This statement represents your business performance over time. It is a brief, easily understood document that should be prepared monthly. An example is shown in Table 7.2.

profit and loss statement (P&L statement)

A financial statement that summarizes the revenues, costs, and expenses incurred during a specific period of time.

Developing and maintaining effective records is essential in the operation of a business, and some forethought to the process and needs of the business will pay off in the knowledge and understanding developed by the founder(s). We will examine a number of analysis tools in Chapter 8, but for analysis to have any value, good records must be kept.

Managing Data Flow The entrepreneur needs to recognize that new businesses will differ in the time frames that they need to obtain data based on their industry and experience. The founder(s) should seek to visit with other similar firms and find out what reasonable time frames might be for the monitoring of data. The experience of other firms can be very helpful in the start-up phase of your business.

Well-established firms have aggressively moved to using just-in-time (JIT) inventory. This method of inventory control seeks to minimize excess capital investment in inventory. These firms seek to have inventory present only shortly before it is used. New firms do not have the same complex data measurement methods of large firms, but they should be driven by the same basic philosophy. The key to this ability is obtaining data in a timely manner that is tied to the strategic needs of the organization. We worked with a restaurant that wanted to serve fresh vegetables and meats; however, the owner wanted to perform his inventory check only once a week. “Freshness” as a strategic position would dictate that the data collection cycle should be shortened. If deliveries are constant, then a high-turnover firm should monitor its inventory needs on a daily or every- other-day basis. The accounting system of a firm is a powerful tool asset that should be used as a fine-grained tool to provide data about when and how inventory is needed.

Chris spent several weeks visiting an extensive line of relatives and friends of the family. Over that period of time, he was able to put together the entire $500,000 he estimated he needed to purchase the business and ensure its survival for the first year. He had managed to raise the money with just eight investors. Three of the investors put in $100,000 each, which was the same amount that Chris and his wife were investing financially in the business. The other four investors each put in $25,000. Chris took a 25 percent stake in the business; the three $100,000 investors each took a 20 percent stake, while the four $25,000 investors each got just 3 percent. The remaining 3 percent was held out to use in the future as incentives for valuable employees.

Having cleared that hurdle, Chris faced a significant issue in the design of statements and tracking of funds in the business. He had no formal accounting training, and during several conversations with other entrepreneurs he had been told repeatedly to purchase an accounting software package—which he did. Not knowing what he might need for the business, Chris decided to just set up some rudimentary categories and then add new ones as he needed.

The business was developing nicely. Even though the location came with a lot of equipment, Chris was excited about the opportunity to buy the remaining things that he thought he needed on the used market. One of the beer distributors told him about a big, national chain restaurant that had closed less than 90 miles away. Chris contacted the agent handling the dissolution and was able to buy some excellent furniture that he really wanted for the business.

As the equipment, furniture, and supplies began arriving, Chris was simply too busy trying to set everything up to spend time entering all of the information into his accounting package. He wasn’t worried because he had a good head for numbers and knew that he was right on track for what he had predicted for the business. He thought that he might ask his wife to enter the information from the invoices over the weekend. When he and his wife took a look at the invoices, the two of them quickly realized that Chris’s temporary system was not working. There were bills that did not appear to be accurate, but no

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 21/24

one had asked about them when the shipment of supplies came in. Similarly, there were a few bills that had already gone past due.

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 22/24

Page 134

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.

EXERCISE 3 1. How could Chris have done a better job setting up the accounting system? 2. What kind of data flow system should Chris use to track his business?

SUMMARY This chapter examined two important operational issues directly tied to the start-up of a new venture. Obtaining sufficient initial funding is a key method to allow for the variances inherent in any business. We examined several means of obtaining that financing. We then examined the development of the firm’s accounting system and method of data gathering and handling. Establishment of a quality method for data gathering at the outset will allow the founders to focus their efforts on the running of the business.

KEY TERMS asset-based lending asset lease business angels credit card crowdfunding debt equity investment factoring grants loans profit and loss (P&L) statement shrinkage supplier credit venture capital fund

REVIEW QUESTIONS 1. How can using loans help the new business grow? 2. Explain the best use of credit cards in a new business operation. 3. What are the negative impacts of supplier credit on the new business start-up? 4. How can a new business take advantage of grants? 5. Why should a new businessperson be wary of equity investments by other companies? 6. How will venture capital impact a growing business? 7. What are the pros of having angel investors in a new business? 8. How can asset leases be used to improve the income generation of a new business? 9. Why might a business choose to factor its accounts?

10. How might an entrepreneur find out how much a business is worth? 11. What factors impact how much equity a new business gives away for a set dollar investment? 12. How does a new businessperson use a P&L statement? 13. Why should a new business spend time setting up a chart of accounts?

BUSINESS PLAN DEVELOPMENT QUESTIONS

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 23/24

1. At this point in your business development, what mix of equity and debt are you planning on using? Why? 2. Develop a plan for fundraising. Make a list of who you will approach and why. 3. Create a potential chart of accounts for the new business.

5/13/2018 University of Phoenix: ENTREPRENEURSHIP: The Art, Science, and Process for Success

https://phoenix.vitalsource.com/#/books/1259720888/cfi/6/34!/4/4/240/70@0:74.9 24/24

Page 135

PRINTED BY: [email protected]. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.