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Harvard Business Review Entrepreneur’s Handbook Everything You Need to Launch and Grow Your New Business Harvard Business Review PressBoston, Massachusetts H7303-Entrepreneur.indb iii H7303-Entrepreneur.indb iii 11/2/17 1:14 PM 11/2/17 1:14 PM HBR Press Quantity Sales Discounts Harvard Business Review Press titles are available at signiﬁ cant quantity dis- counts when purchased in bulk for client gifts, sales promotions, and premiums.

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Copyright 2018 Harvard Business School Publishing Corporation All rights reserved The material in this book has been adapted and revised from works listed in the Sources section and from Harvard Business Essentials Entrepreneur’s Toolkit:

Tools and Techniques to Launch and Grow Your New Business (Harvard Business School Press, 2005), subject adviser Alfred E. Osborne.

No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording, or otherwise), without the prior permission of the publisher. Requests for permission should be directed to permissions@ hbsp.harvard.edu, or mailed to Permissions, Harvard Business School Publishing, 60 Harvard Way, Boston, Massachusetts 02163.

The web addresses referenced in this book were live and correct at the time of the book’s publication but may be subject to change.

Library of Congress cataloging information is forthcoming. eBook ISBN: 9781633693715 H7303-Entrepreneur.indb iv H7303-Entrepreneur.indb iv 11/2/17 1:14 PM 11/2/17 1:14 PM Contents Introduction 1 PART ONE Preparing for the Journey 1. Is Starting a Business Right for You? 11 PART T WO Deﬁ ning Your Enterprise 2. Shaping an Opportunity 23 3. Building Your Business Model and Strategy 41 4. Organizing Your Company 63 5. Writing Your Business Plan 77 PART THREE Financing Your Business 6. Startup-Stage Financing 103 7. Growth-Stage Financing 115 8. Angel Investment and Venture Capital 131 9. Going Public 149 H7303-Entrepreneur.indb v H7303-Entrepreneur.indb v 11/2/17 1:14 PM 11/2/17 1:14 PM PART FOUR Scaling Up 10. Sustaining Entrepreneurial Growth 171 11. Leadership for a Growing Business 181 12. Keeping the Entrepreneurial Spirit Alive 195 PART FIVE Looking to the Future 13. Harvest Time 213 Appendix A:

Understanding Financial Statements 225 Appendix B:

Breakeven Analysis 241 Appendix C:

Valuation: What Is Your Business Really Worth? 245 Appendix D:

Selling Restricted and Control Securities: SEC Rule 144 257 Glossary 263 Further Reading 273 Sources 277 Index 285 vi Contents H7303-Entrepreneur.indb vi H7303-Entrepreneur.indb vi 11/2/17 1:14 PM 11/2/17 1:14 PM Introduction William Bygrave, a scholar and practitioner of entrepreneurship, describes an entrepreneur as someone who not only perceives an opportunity but also “creates an organization to pursue it.”That last part of Bygrave’s deﬁ nition is essential. Ideas are one thing, but opportunities as we generally understand them are best addressed through business organizations formed by entrepreneurs. Thomas Edison, for example, recognized the business opportunity in urban electric illu- mination, which he pursued through tireless laboratory e xperiments that eventually produced a workable incandescent light bulb. But invention was only part of Edison’s genius. He also formed a company that brought to- gether the human and ﬁ nancial resources needed to implement his vision of commercial and residential lighting. That company was the forerunner of the General Electric Company, one of today’s largest and most powerful enterprises. The same formula has been repeated through history: recognizing op- portunity and addressing it through an organization. Some opportunities are evident and just need to be harnessed; others are created by the en- trepreneur. For example, in 2007, when roommates Brian Chesky and Joe Gebbia could no longer afford the rent on their San Francisco loft, they decided to rent out space to guests. They set up a website with some photos of their apartment, quickly gaining three guests for their ﬁ rst weekend, at $80 each. Soon they began hearing from others who had found their site and wanted a similar offering for informal lodging in cities around the world. H7303-Entrepreneur.indb 1 H7303-Entrepreneur.indb 1 11/2/17 1:14 PM 11/2/17 1:14 PM 2 HBR’s Entrepreneur’s Handbook The next spring, Chesky and Gebbia enlisted former roommate Nathan Blecharczyk to help them establish Airbed & Breakfast. To raise early fund- ing, they bought cartons of breakfast cereal, repackaged it in the theme of the 2008 election, and resold it to conventioneers, raising about $30,000.

Nevertheless, their site’s growth stalled. While living off the extra cereal, though, they were accepted into Y Combinator’s accelerator program. In the summer of 2009, they began testing their own services to better un- derstand their users’ needs. Realizing how poorly the properties were rep- resented online, the entrepreneurs began a photography program in which hosts could have professional shots of their properties taken. Learning and course-correcting as they went, Chesky and Gebbia saw their customer base rocket from one thousand in 2009 to over a mil- lion in 2011. Airbnb’s ﬁ nancials are not formally disclosed, but in 2015, market reports placed its value at $25.5 billion with projected revenue of $900 million for the year, based on the company’s reported three-million- plus listed properties worldwide. Not all startup stories are so bright, of course. A complete deﬁ nition of the entrepreneur must also recognize another factor: risk. In the ﬁ nancial world, risk contains the possibility of both gain and loss. The entrepreneur puts skin in the game—usually in the form of time and personal savings.

If the venture goes badly, his or her time and hard-earned savings are lost.

And indeed, 75 percent of startup ventures fail to return investors’ capital, according to research by Harvard Business School’s Shikhar Ghosh. But if things go well, the entrepreneur can reap a sizable proﬁ t. So if you have a business idea or a n idea about how to ﬁ ll a market need—or even if you just think you’re interested in starting a business—how do you make sure that your venture is successful? The same basic process applies whether your idea is the next high- growth wunderkind, a robust B2B player in a critical industry niche, or a local retail shop close to home. You recognize a potential commercial opportunity and pursue it through an organization, your own managerial or technical talents, and some combination of human and ﬁ nancial capital.

Of course it’s never quite this simple; in fact, the entrepreneurial journey H7303-Entrepreneur.indb 2 H7303-Entrepreneur.indb 2 11/2/17 1:14 PM 11/2/17 1:14 PM Introduction 3 often takes many twists and turns. This book will walk you through this process in more detail.

The role of entrepreneurs Entrepreneurs play an important role in society. As described by econo- mist Joseph Schumpeter in the 1930s, entrepreneurs act as a force for cre- ative destruction, sweeping away established technologies, products, and ways of doing things and replacing them with others that the marketplace as a whole sees as representing greater value. In this sense, entrepreneurs are agents of change and, hopefully, progress. Thus, it was entrepreneurs who displaced home kerosene lamps with brighter and cleaner-burning gas in the middle to late 1800s. Those gas lamps, in turn, were displaced by Edison’s incandescent electric light system, which provided better per- formance and greater safety. Fluorescent lighting came along years later, displacing many incandescent applications.

We see this pattern repeated in virtually every industry. Entrepreneurs invent or commercialize new technologies that displace the old. Photo- copying, the personal computer, the World Wide Web, the spreadsheet, and new and improved drug therapies and medical devices are all prod- ucts of enterprising entrepreneurs. Entrepreneurs also introduce products, services, and platforms that deliver something entirely new: the electronic calculator, next-day package delivery, crowd fund-raising, aircraft simu- lation software, oral contraceptives, angioplasty to open narrow heart ar- teries, and online marketplaces for everything from apartment rentals and ride-sharing to homemade crafts and ﬁ nancial payments. Entrepreneurs have given us even mundanely useful things that our parents or grand- parents would not have imagined: computers we take every where (like our iPhones), contact lenses, milk in aseptic packaging that requires no refrig- eration, online auctions that bring together buyers and sellers from every part of the world, and on and on. These products and services improve customers’ lives. Many are also beneﬁ cial to society and to the planet, be they improved drug therapies, microloan systems that alleviate poverty H7303-Entrepreneur.indb 3 H7303-Entrepreneur.indb 3 11/2/17 1:14 PM 11/2/17 1:14 PM 4 HBR’s Entrepreneur’s Handbook around the globe, or drones that target pesticides to the crops that need them most, eliminating waste and pollution.In conceiving of these new products and services and forming and running enterprises to bring them to customers and users, entrepreneurs often sweep away stagnant industries and replace them with growing ones that generate new jobs, often at higher wages. Thus they have a central role in building wealth and dynamism in the societies in which their enter- prises operate.

What’s ahead This book takes a linear approach to entrepreneurship, from initial ques- tions that you should ask yourself before you begin (“Am I the type of person who should start a business?”) to the last issue that you’ll need to consider as a successful business owner (“How can I cash out of the business I’ve built?”). Though your own experience is likely to differ from this simpliﬁ ed framework—the entrepreneurial process is nothing if not iterative—this book should give you a good over v iew of the issues you’ll probably face and how to approach them. Part 1 prepares you for your journey. In chapter 1, we describe the self-diagnosis that every prospective entrepreneur should undertake. Are you the right type of person to start up and operate a business? This chap- ter will help you answer that important question. Part 2 helps you deﬁ ne your enterprise. The ﬁ rst steps in the entrepre- neurial process are to identify and evaluate potential business opportuni- ties. Chapter 2 offers ﬁ ve characteristics you should look for in a business opportunity, particularly focusing on the problem your business is trying to solve. It also introduces the lean-startup methodology as a way to eval- uate market interest and to experiment with other hypotheses about the opportunity you’ve identiﬁ ed.

If your initial evaluation of the opportunity pans out, you’ll further reﬁ ne your business model and strategy. These two critical concepts are the focus of chapter 3. It describes how the business model explains the way key components of the enterprise work together to make money—and H7303-Entrepreneur.indb 4 H7303-Entrepreneur.indb 4 11/2/17 1:14 PM 11/2/17 1:14 PM Introduction 5 how to beg in to test your business model w ith rea l customers. It a lso shows how strategy must be designed to differentiate the entity and confer it with a competitive advantage. Finally, the chapter offers a ﬁ ve-step process for formulating strategy and aligning business activities with it. Assuming that your evaluations and experiments have given you con- tinued conﬁ dence in your business idea, you’ll need to structure your busi- ness from a legal perspective. In chapter 4, you’ll learn about the various legal forms of business organization used in the United States. You’ll see their pros and cons and decide which organizational structure is best for your venture: a limited-liability corporation, a sole proprietorship, a part- nership, a corporation, or something else. Chapter 5 gets you started on writing a plan for your business, incorpo- rating many of the elements discussed previously. A business plan explains the opportunity, identiﬁ es the market to be served, and provides details about how your organization expects to pursue the opportunity. The plan also describes the unique qualiﬁ cations that the management team brings to the effort, lists the resources required for success, and predicts the re- sults over a reasonable time horizon. This chapter tells you why a business plan is necessary, gives you a format for organizing one, and offers tips for developing each section in the format. It also describes other documents similar to a business plan, such as a pitch deck. Part 3 focuses on how to get the funding you need to ﬁ nance the vari- ous stages of your enterprise. The global recession of 2008 took a big toll on entrepreneurship, a sector that has not yet recovered. In the United States, new business starts went from 525,000 in 2007 to just over 400,000 in 2014. There are many reasons for this drop-off, but small businesses tend to fare the worst in a recession because they depend heavily on bank debt, which becomes harder to obtain during economic downturns. Since the re- cession, some new forms of ﬁ nancing, such as crowdfunding, angel invest- ing, and online banking, have appeared. This part of the book describes those new forms along with more traditional methods of raising capital. Chapter 6 concentrates on the ﬁ nancing requirements that businesses typically encounter in the ﬁ rst phase of their life cycles. It also provides an overview of life cycles for different types of businesses. H7303-Entrepreneur.indb 5 H7303-Entrepreneur.indb 5 11/2/17 1:14 PM 11/2/17 1:14 PM 6 HBR’s Entrepreneur’s Handbook In chapter 7, the discussion of ﬁ nancing continues. It addresses the next stages of a business’s life cycle: that of growth and maturity. Chapter 8 focuses on rapidly growing ﬁ rms and their need for external capital speciﬁ cally. Entrepreneurs can bootstrap early development from personal sources, friends, and relatives, but these enterprises usually need external infusions of capital to move to a higher level. This chapter intro- duces two external sources of capital—angel investors and venture capi- talists or venture-capital ﬁ rms (VCs)—and explains how best to approach them and win their support. At some point , ma ny g row ing ﬁ rms with exceptional revenue potential seek and obtain ﬁ nancing through an initial public offering (IPO) of their shares to individual and institutional investors such as pension funds and mutual funds. That rare event results in a signiﬁ cant exchange of paper ownership shares for the hard cash the ﬁ rm needs for stability and expan- sion. Chapter 9 describes what it takes to be an IPO candidate, the pros and cons of going public, the role of investment bankers, and eight steps for doing a deal. Because very few businesses will obtain external capi- tal from an IPO, we also present an alternative arrangement: the private placement. In part 4, we discuss the effects of growth on your organization. Par- adoxically, success is sometimes the entrepreneurial company’s greatest enemy; hierarchy, bureaucracy, and complacency frequently follow. Chap- ter 10 walks you through the organizational and strategic aspects of deal- ing with growth, while chapter 11 emphasizes that you as a leader may need to reexamine your way of working and even your own role as your business becomes larger. As organizations grow, they tend to become more complacent about how to best serve their customers. Chapter 12 addresses how you can sus- tain entrepreneurial innovation and energy in your growing company even as it naturally becomes more process-driven and operations-focused. You can keep new ideas ﬂ ourishing through efforts to manage your organiza- tion’s culture, strategic considerations around innovation, and your own leadership involvement. H7303-Entrepreneur.indb 6 H7303-Entrepreneur.indb 6 11/2/17 1:14 PM 11/2/17 1:14 PM Introduction 7 Finally, in part 5, we look to the future. In chapter 13, you learn about harvesting your investment in a private business. Founders—and the busi- ness angels and venture capitalists who support them—look forward to the day when they can turn their paper ownership into real money. This chapter describes the motivations that lead to harvesting, the primary mechanisms for doing so, and the methods you can use to answer the all-important question, “What is this business worth?” H7303-Entrepreneur.indb 7 H7303-Entrepreneur.indb 7 11/2/17 1:14 PM 11/2/17 1:14 PM H7303-Entrepreneur.indb 8 H7303-Entrepreneur.indb 8 11/2/17 1:14 PM 11/2/17 1:14 PM PART ONE Preparing for the Journey H7303-Entrepreneur.indb 9 H7303-Entrepreneur.indb 9 11/2/17 1:14 PM 11/2/17 1:14 PM H7303-Entrepreneur.indb 10 H7303-Entrepreneur.indb 10 11/2/17 1:14 PM 11/2/17 1:14 PM 1.

Is Starting a Business Right for You?

What makes entrepreneurs tick? More speciﬁ cally, what are the personal traits and backgrounds of people who become successful entrepreneurs?

This chapter considers those questions and helps you decide whether you have the right stuff to be a business entrepreneur. Many books and websites include self-scoring tests that you can use to assess your ﬁ tness for entrepreneurial life. (The US Small Business Administration [SBA] provides one such test on its site at https://www .sba .gov/starting-business/how-start-business/entrepreneurship-you.) These assessments can be a good place to start as you think through what entrepreneurial work would mean for you and whether it’s a good ﬁ t for your personality and goals. This self-evaluation is especially useful if you’re starting with an idea for a business. Having ideas is important, but it’s only one step in a process that also requires other skills and per- sonality traits. H7303-Entrepreneur.indb 11 H7303-Entrepreneur.indb 11 11/2/17 1:14 PM 11/2/17 1:14 PM 12 Preparing for the Journey This and other tests typically integrate some combination or subset of the traits shown in table 1-1. Let’s look at these traits in more detail. Ideas and drive Christopher Gergen and Gregg Vanourek, founding partners of New Mountain Ventures, an entrepreneurial leadership development company, describe the basic process of entrepreneurship as follows: “Understand a problem, grasp its full context, connect previously unconnected dots, and have the vision, courage, resourcefulness, and persistence to see the solu- tion through to fruition.” Without those ﬁ rst elements—a full understanding of a problem, new connections, and a vision or direction for a solution—there is no entrepre- neurial venture. Whether the problem you’ve identiﬁ ed is global or local, broad or niche, your ability to spot it and conceive new solutions is a core element of entrepreneurship. And passion about the problem you are solv- ing might not be as important as you think—see the box “A passion for the work.” People skills Having identiﬁ ed a problem or even a potential solution is one thing. But to launch a successful venture, you must also make other people see the merits of your idea and invest in it—whether they are employees, custom- ers, or funders. Your ability to lead, persuade, take feedback, and build a network will determine whether you’ll actually be able to bring your idea to fruition. In the HBR Guide to Buying a Small Business , Harvard Business School professors Richard S. Ruback and Royce Yudkoff describe the people skills that entrepreneurs need ﬁ rst: “You need to feel comfort- able reaching out to people you don’t know—sellers, . . . investors, your employees—and when you do reach out, you need to project an air of con- ﬁ dent optimism.” H7303-Entrepreneur.indb 12 H7303-Entrepreneur.indb 12 11/2/17 1:14 PM 11/2/17 1:14 PM TABLE 1-1 Common entrepreneurial traits Ideas and drive People skillsWork styleFinancial savvyEntrepreneurial background Creativity Vision Ability to identif y opportunities Passion Leadership Persuasion Inﬂ uence Network building Ability to excite people by vision Goal oriented Comfortable with uncertainty Self-challenging Solitary: don’t like working for others; prefer being own boss Rarely satisﬁ ed or com- placent; can’t sit still Driven to plan and be prepared Experimental mindset; OK with starting small and recognizing and moving past failures Perseverance in the face of adversity Tendency to continuously look for a better or diﬀ er- ent way to do things Ability to close a deal Ability to listen, trust, take advice Comfortable with ﬁ n a n c e Comfortable with ﬁ nancial governance Family members have started businesses Friends have started businesses You have worked at a small business or startup Sources:

Bill J. Bonnstetter, “New Research: The Skills That Make an Entrepreneur,” HBR.org, December 7, 2012; Daniel Isenberg, “Should You Be an Entrepreneur ? Take This Test,” HBR.org, February 12, 2010; Harvard Business Review, “For Founders, Preparation Trumps Passion,” Harvard Business Review, July–August 2015; HBS Working Knowledge, “Skills and Behaviors That Make Entrepreneurs Successful,” June 6, 20 16; Veroniek Collewaert and Frederik Anseel, “How Entrepreneurs C an Keep Their Passion from Fading,” HBR.org, June 16, 2016. H7303-Entrepreneur.indb 13 H7303-Entrepreneur.indb 13 11/2/17 1:14 PM 11/2/17 1:14 PM 14 Preparing for the Journey When it comes to funders particularly, serial entrepreneurs Evan Baehr and Evan Loomis write that “potential investors will ask themselves three simple questions during a meeting: 1) Do I like you?, 2) Do I trust you?, and 3) Do I want to do business with you?” To earn an investor’s trust, you must ﬁ rst be appealing and interesting enough for them to get to know you well enough to trust you. To succeed in the high-pressure, fast- paced world of venture funding, you must know how to connect with peo- ple—and k now when your tactics for connecting w ith them aren’t work ing, and switch to a tactic that will. But successful entrepreneurship isn’t just about convincing others about the brilliance of your idea, just as networking isn’t only about get- ting funding, and just as selling to customers isn’t only about selling. These activities will also yield feedback about your business idea or how your company is operating. That information is worthless if you don’t know how A passion for the work Passion, long considered an important part of entrepreneurial work, keeps entrepreneurs going when the going gets tough. It’s the spark that inspires an investor to sign on; it’s the vision for the change you’re going to usher into the world through your new product or service. In- deed, “Follow your passion” is increasingly becoming a catchphrase as the generation that was raised with it comes of age in the professional world. But experts caution against thinking of passion as a primary require- ment for your success as an entrepreneur. Here’s why:

• Research shows that passion simply doesn’t correlate with success years out from the founding of a new business.

• Research also shows that passion in entrepreneurs tends to fade over time, even during the ﬁ rst few months of the enterprise’s founding. H7303-Entrepreneur.indb 14 H7303-Entrepreneur.indb 14 11/2/17 1:14 PM 11/2/17 1:14 PM Is Starting a Business Right for You? 15 to listen or accept feedback. In their research of entrepreneurs around the globe, marketing professors Vincent Onyemah, Martha Rivera Pesquera, and Abdul Ali found that one of the most common mistakes in selling a new offering was entrepreneurs’ failure to listen to their customers’ com- plaints about the product: “Some realized that their passion and ego made them respond negatively to criticism and discount ideas for changes that they later saw would have increased the marketability of their offerings.” Successful entrepreneurs know when to stick to their guns—and when to take the advice of others and shift course.

They also know how to recognize when they’ve reached the end of the road. When a project isn’t working, they accept that they have to shift to something else—failing fast is better than failing long and slow. On the subject, Isenberg quotes Joseph Conrad: “Any fool can carry on, but only the wise man knows how to shorten sail.” H7303-Entrepreneur.indb 15 H7303-Entrepreneur.indb 15 11/2/17 1:14 PM 11/2/17 1:14 PM 16 Preparing for the Journey Work style Being your own boss may sound appealing—no one to tell you what to do!—but it also means that to succeed, you need to challenge and motivate yourself. There won’t be anyone else to do it for you. Successful entrepre- neurs are intrinsically motivated by the problems they see around them and the solutions that they envision; they can’t sit still while there’s work to be done (and there’s always more work to be done).They are also often goal oriented: they ﬁ x their eyes on a prize and im- patiently and relentlessly try different ways to get there, shifting strategies quickly when necessary (see the box “Stretching the rules”). Stretching the rules In a comprehensive study of entrepreneurial characteristics conducted between 1987 and 2002, Walter Kuemmerle, an associate professor at Harvard Business School, identiﬁ ed comfort with stretching the rules as a common characteristic of successful entrepreneurs. Certainly, entrepre- neurs need to be creative, seeing opportunities where others don’t and challenging assumptions about every part of the business. For example, LinkedIn founder Reid Hoﬀ man maintains that “freedom from normal rules is what gives you competitive advantage,” describing, for example, how Uber’s use of employee referrals for hiring decisions—rather than formal screenings—helped the company scale up more quickly. But when this outside-the-box thinking turns into disregard for legal regulations or an excuse for personal misbehavior, the consequences are more troubling. For example, Uber and Airbnb are frequently faced with scrutiny about their skirting of regulations for taxis and hotels. Har- vard Business School professor Benjamin Edelman reﬂ ects on this issue:

“Uber counters that [the] rules primarily beneﬁ t taxi drivers and keep prices needlessly high. That may be. But the law’s unambiguous require- H7303-Entrepreneur.indb 16 H7303-Entrepreneur.indb 16 11/2/17 1:14 PM 11/2/17 1:14 PM Is Starting a Business Right for You? 17 ments were duly enacted by the responsible authority. In Uber’s world, a general contractor might decide building codes are too strict, then skimp on foundation or bracing. Who’s to say which rules are to be fol- lowed and which to be broken?” Meanwhile public scandals around employee mistreatment and sexual misconduct have suggested other ways that a disregard for the rules can go too far. Beyond the personal damage caused, research has shown that corporate punishment for CEO misbehavior (not necessarily outright illegal acts) can be inconsistent, but the eﬀ ects on the com- pany’s reputation if such misbehavior is made public can be signiﬁ cant and long- lasting, and negative eﬀ ects reverberate within the company as well. Entrepreneurs, then, have a harder charge than simply “breaking the rules”: they must ﬁ nd a way to deliver iconoclastic creativity without disregarding civil society.

Sources: Walter Kuemmerle, “A Test for the Fainthearted,” Harvard Business Review , May 2012, 122–127; Reid Hoﬀ man and Tim Sullivan, “Blitzscaling,” Harvard Business Review , April 2016; Benjamin Edelman, “Digital Business Models Should Have to Follow the Law, Too,” HBR.org, January 6, 2015; David Larcker and Brian Tayan, “We Studied 38 Incidents of CEO Bad Behavior and Measured Their Consequences,” HBR.org, June 9, 2016.

Indeed, most new ventures, no matter how well planned, are experi- mental, and as an entrepreneur, you will beneﬁ t from an experimental mind-set. A willingness to start small gives company founders an opportu- nity to test and ﬁ ne-tune a product or another offering before locking into a business model that will allow them to scale. They have the patience to see how customers respond to a product, its price, and the way it is served.

In this way, they can course-correct before expending large amounts of capital. The classic counterexample of this patient, experimental approach comes from Webvan, a dot-com-era company whose leaders were unwill- ing to take such an approach. The company’s founders—including Louis H7303-Entrepreneur.indb 17 H7303-Entrepreneur.indb 17 11/2/17 1:14 PM 11/2/17 1:14 PM 18 Preparing for the Journey Borders, founder of the Borders bookstore chain—envisioned a nationwide home-delivery system for groceries. Webvan began by building a monster 330,000-square-foot automated warehouse in Oakland, California. It quickly raised more than $850 million in equity capital and began work on twenty-six similar facilities in metropolitan areas across the United States.

But the company never came close to breaking even. Within two years, it had burned through its cash and was forced into bankruptcy. By most estimates, Webvan had tried to do too much too fast. Instead, successful entrepreneurs are willing to shift strategies quickly.But a good experimentation process can’t eliminate all risk in an en- trepreneurial venture. Unlike the more established corporate managers, you as an entrepreneur need to be comfortable with risk and must not be intimidated by a shortage of information. Compared with your corporate counterparts, you are much more likely to ﬁ nd yourself in a situation in which making a sale, landing a contract, or reaching an agreement with a lender means the difference between survival and bankruptcy. En- trepreneurs are so close to the edge of failure that every deal has major consequences. Whereas a corporate manager might say, “I’d like more in- for m at ion b e for e I c a n m a ke t h i s de c i sion ,” a n ent r epr eneu r mu s t m a ke t he best of uncertainty and move forward. Standing still and waiting for more information isn’t an option. Th i s k i nd of pre s su re bu i ld s pa r t ic u la rly a rou nd de a l m a k i ng. Suc c e s s - ful entrepreneurs, according to Kuemmerle, understand how to seal a deal.

“However tough the market or small the transaction, they know exactly what they must give up—and what they can get away with—while ﬁ naliz- ing deals under pressure.” Financial savvy In ongoing research at Harvard Business School, Lynda M. Applegate, Timothy Butler, and Janet Kraus have found that HBS graduates who have gone on to start businesses tend to rate themselves as more conﬁ dent with ﬁ nancial concepts and ﬁ nancial governance than do other graduates. If you’re less conﬁ dent with the numbers, this book includes appendixes with H7303-Entrepreneur.indb 18 H7303-Entrepreneur.indb 18 11/2/17 1:14 PM 11/2/17 1:14 PM Is Starting a Business Right for You? 19 an overview of common ﬁ nancial statements and concepts like breakeven analysis. These sections can introduce you to (or refamiliarize you with) these concepts.

Entrepreneurial background Entrepreneurship runs in families to a surprising degree. Children of business owners are more likely than others to start or purchase their own enterprises. Similarly, anecdotal data indicates that children of busi- ness owners are more likely than others to enroll in the entrepreneurship courses offered by undergraduate and MBA programs. This connection should not be surprising. The challenges, joys, dif- ﬁ cult choices, and rewards of business ownership are frequent topics of discussion around the dinner tables of business-owning families. The chil- dren often learn the what and how of enterprise ownership from these dis- cussions and from many weekends and summers working in the family store or factory. Indeed, Paul Newman, whom most people think of sim- ply as an accomplished actor, grew up in a business-owning family and has recounted in interviews the many childhood weekends he spent in his father’s store. Those experiences surely had something to do with his founding of Newman’s Own, a packaged-foods company whose proﬁ ts are donated to charity. Jim Koch, founder and chairman of Boston Beer Company, repre- sents the sixth generation of brewing in his family. Similarly, Dan Brick- lin, co-inventor of the ﬁ rst spreadsheet software VisiCalc, came from a family that owned and ran its own business. Bricklin’s background surely inﬂ uenced the future course of his life: “My father headed up the family printing business, Bricklin Press, which had been founded by his father in the 1930s. Afternoons spent at the printing plant and dinners devoted to the day’s business problems prepared me . . . for the trials I would face in my own business ventures . . . Growing up, I never ex- pected that some big company would eventually take care of me; instead, I was always looking for opportunities to turn some nifty ideas into a business.” H7303-Entrepreneur.indb 19 H7303-Entrepreneur.indb 19 11/2/17 1:14 PM 11/2/17 1:14 PM 20 Preparing for the Journey No matter what your background is, an entrepreneurial venture may be right for you. Successful enterprise is a combination of personal qualities and quality planning. You don’t have to be a genius with a killer idea: most successful startups begin with incremental innovations. You don’t have to be totally fearless, either: entrepreneurs who prosper have a healthy aver- sion to risk. Nor is technical business know-how essential: you can learn as you go along, or you can enlist an experienced businessperson as a co- owner. An individual who has all the right qualities for entrepreneurial work but a poor plan will not succeed. Nor will a person with a great plan but weak motivation and a fear of uncertainty. What you must have is a solid plan, the ability to execute it, and a high degree of motivation—motivation that makes business success an impor- tant personal goal. Do you have these qualities? Summing up ■Ideas are an important element of success for entrepreneurs, but they’re not suﬃ cient—you also must consider your personal background, inclina- tions, motivation, and skills.

■Tests are available to measure a person’s suitability for an entrepreneurial life, but these tests should be used only as a rough gauge.

■Entrepreneurship runs in families. Children of business owners are more likely than others to start or purchase their own enterprises. H7303-Entrepreneur.indb 20 H7303-Entrepreneur.indb 20 11/2/17 1:14 PM 11/2/17 1:14 PM PART T WO Deﬁ ning Your Enterprise H7303-Entrepreneur.indb 21 H7303-Entrepreneur.indb 21 11/2/17 1:14 PM 11/2/17 1:14 PM H7303-Entrepreneur.indb 22 H7303-Entrepreneur.indb 22 11/2/17 1:14 PM 11/2/17 1:14 PM 2.

Shaping an Opportunity Cesar managed the service department of a large car dealership. With ﬁ ve years on the job as manager and many more as a mechanic, Cesar under- stood the economics of the auto service business, and he saw what might be an opportunity. “We’re starting to sell more electric cars,” he told his sister at a family gathering. “The national organization estimates that electrics w ill account for 10 percent of our unit sales ﬁ ve years from now. And two other auto- makers are moving into electrics. I think that these plug-in vehicles will deﬁ ne the automobile market in the coming years.” “How’s that going to affect your service department?” his sister asked.

“Quite a bit,” Cesar responded. “We’ve already brought in new diag- nostic machines and trained people on the electric vehicles’ electronic sys- tems—which are substantially different from those of traditional cars and even hybrids. And we’ll be very busy in the years ahead, since we’ll get all the repair and maintenance business on these cars for the foreseeable H7303-Entrepreneur.indb 23 H7303-Entrepreneur.indb 23 11/2/17 1:14 PM 11/2/17 1:14 PM 24 Deﬁ ning Your Enterprise future, even after warranties have expired. Traditional mechanics don’t know how to work on electrics, and many will never learn.” Later that day, Cesar reﬂ ected on this conversation. “There may be an opportunity here,” he told himself. After new electric vehicle warranties expired, he reasoned, owners would have no options for repair and main- tenance except high-priced dealer service departments like his. Neighbor- ho o d me cha n ic s wou ld n’t b e e qu ipp e d or t r a i ne d t o de a l w it h t he se c a r s for many years. Many owners would welcome a lower-priced alternative—one that specialized in the repair and maintenance of electric engine vehicles.

Cesar began envisioning a service center called the Electric Car Care Cen- ter. And if that proved successful, he could foresee a chain of cloned out- lets—perhaps a national franchise. Cesar had recognized a business opportunity, a great way to begin. But before he begins to pursue it, he needs to further evaluate what he knows about the opportunity—and what he doesn’t.

Identifying a problem to solve In 2004, leading expert on entrepreneurship Jeffry Timmons described a business opportunity primarily as a product or service that creates sig- niﬁ cant value for customers and offers signiﬁ cant proﬁ t potential to the entrepreneur. Increasingly, entrepreneurs and those who study entrepre- neurship are focusing on what creates that value to begin with, on deﬁ ning and reﬁ ning the problem that needs to be solved for customers and users.

You need to be sure that the problem exists and be able to describe it in some detail before you begin to invest heavily in building your solution.

In other words, Cesar will need to make certain that drivers of electric cars will need his specialized service. He’ll also need to know the number of these drivers and understand their behavior to ensure that his solution meets an actual need that customers have. This problem focus has come to the fore because the entrepreneurial journey is rarely a straight line between seeing a need, identifying a solu- tion for that need, and then simply executing on that solution. In the H7303-Entrepreneur.indb 24 H7303-Entrepreneur.indb 24 11/2/17 1:14 PM 11/2/17 1:14 PM Shaping an Opportunity 25 long-accepted standard process for entrepreneurship, would-be business owners would identify an opportunity in the marketplace and, using what- ever data at their disposal, create a business plan and ﬁ nancial forecast that would be pitched to investors. If they got the funding, then they would follow through on the long process outlined in the document to build a team, create the product, market it, and hope the plan panned out. But more often than not, it didn’t. No matter how well conceived the original product or offering, there are always major unknowns at the out- set of a business venture: What is the right business model? Will it scale?

What will competitors do? What will be the unexpected glitches in the supply chain? And there’s the biggest questions: Is there really a market for the product or service as conceived, and if so, how big is it? Many entre- preneurs are so excited about what their new gizmo or service can do that they forget to assess its value to customers. But in the end, the business can succeed only if enough people recognize this value and are willing to pay for it. For example, perhaps there is a market for service for electric cars in Cesar’s town, but it’s not the lower-price market he imagined. It turns out that the people who buy electric cars are wealthy and are more interested in convenience than cost savings. If Cesar can discover this marketing information before he begins building his company around the idea of a lower-cost shop, he’ll have a chance to reassess how he’ll differentiate his business from the existing dealers. Whether your business idea is a local service operation or the next big thing in the tech sector, begin by asking the following customer and mar- ket questions. As you go, evaluate your conﬁ dence in your answers, and begin thinking about how you will test them. Note that the questions don’t assume that the person using your offering is necessarily the customer pay- ing for it—many businesses create a product for a user but are paid by a downstream customer like an advertiser.

• What is the problem you are trying to solve for your customers or users? H7303-Entrepreneur.indb 25 H7303-Entrepreneur.indb 25 11/2/17 1:14 PM 11/2/17 1:14 PM 26 Deﬁ ning Your Enterprise • How many people have this problem? In other words, what is the size of the market?

• Are your potential customers or users aware of this problem, or is the need latent, that is, undiscovered?

• Is the market stable or growing? If it’s growing, at what annual rate?

• How will your solution beneﬁ t customers or users?

• What percentage of the total market could the product or service reasonably hope to capture over the next few years?

• Is another product or service from competitors available to ﬁ ll part of this demand?

• Who exactly are the potential customers? Can you name them? Can you describe them?

• How can you reach the potential customers and make a trans- action—directly, on your own website or bricks-and-mortar loca- tion; through distributors like the Apple or Google app stores; or through already-existing retail channels?

• How does the utility of the product or service compare with substi- tutes? For example, a tablet device is easier for a customer to carry around than a laptop. But it may not have all the functionality of the full computer.

With his experience and knowledge of service department costs to guide him, Cesar begins to answer these questions and measure the breadth of his newfound business opportunity. He has industry estimates of electric vehicle sales; he knows which diagnostic and other equipment is needed—and what it costs; and he is intimately familiar with the cost of running a fully staffed service facility. When he begins putting these num- bers together, his optimism grows. But running through this exercise also helped him realize where he needs more information. Table 2-1 shows how Cesar has sized up what he knows about the problem he’s trying to solve. H7303-Entrepreneur.indb 26 H7303-Entrepreneur.indb 26 11/2/17 1:14 PM 11/2/17 1:14 PM TABLE 2-1 Market evaluation for the Electric Car Care Center Aspect of the market Cesar’s evaluationCesar’s conﬁ dence and unknowns Problem you are trying to solve• Help customers take care of their electric vehicles. Conﬁ dent that this will be a need—but will customers see it, and what will make them choose my shop rather than their dealer?

Customer beneﬁ t from your solution • Lower price than equivalent service at the dealer.

• Greater expertise. We service only electric vehicles and have all the right equipment. Dealers tend to be expensive, so lower price seems likely to be a good bene- ﬁ t—but will it be good enough to attract customers away from their dealers?

It would be great to test some pricing with existing electric car owners.

Market size • Currently over two million electric vehicles on the road worldwide. We’ve been seeing more and more electric cars on the road, but it’s not clear what the trajectory of growth will be. We’ll want to understand this more before investing heavily.

Market growth rate • A 32 percent compound annual rate occurred in the United States over past four years.

• Industry projections diﬀ er substan- tially on growth projections. Will this growth be sustained? And is the growth of electric car ownership the same in our town as nationally ?

Market share • Share of service business within a twenty-mile radius estimated at 18 percent during the ﬁ rst ﬁ ve years. This is a guess; we’ll need to test it.

Competitors • Primary competition is dealers who get most of the business during war- ranty periods.

• Other new electric specialty shops are likely to open to service the ris- ing demand.

• Few neighborhood garages would have the training or equipment to provide service. These observations seem accurate or likely.

Customer awareness of need • Will become obvious as warranty periods expire and the high cost of dealer service becomes clear. We will deﬁ nitely want to test this projection.

Customers • All owners of electric vehicles of all makes and models. We need to learn more about the demographics of people who buy electric cars. Most who come into the shop tend to be wealthy—early adopt- ers. But will that change if the price of fuel rises?

Reaching customers • Buy list of electric car owners for direct email.

• Use social media.

• Advertise on hyper-local sites.

• Oﬀ er free informational clinics (“ Understanding Your Electric Vehicle”).

• Partner with local environmental groups to get the word out. We have lots to test here—maybe start a Twitter account or Facebook page with electric car care tips and see how many people follow us? Then we’ll be able to market to those cus- tomers as well. H7303-Entrepreneur.indb 27 H7303-Entrepreneur.indb 27 11/2/17 1:14 PM 11/2/17 1:14 PM 28 Deﬁ ning Your Enterprise Experimenting to test your hypotheses Chances are that you, like Cesar, may have some good, informed thoughts about these questions, but your guesses are no more than that. Approaches to entrepreneurship coming from Silicon Valley take into consider- ation these unknowns at the outset of a venture and deliberately expect twists and turns—or pivots—in the entrepreneurial path. In a design- thinking approach to creating a new product or offering, innovators ac- tively experiment with their idea to better understand the market and its needs before proposing a solution. One common formulation of this ap- proach is the lean-startup methodology, which focuses on ﬁ nding a repeat- able and scalable business model for a new offering (see the box “The lean startup”). The lean startup and other similar models of entrepreneurship are iter- ative and nonlinear—not a step-by-step path—but they realistically reﬂ ect how companies change as they grow and learn. Taking an experimental approach from the earliest stages of your evaluation of an opportunity can reduce risk by helping you to home in on the right problem to solve, rather than jumping straight to the opportunity. And while these techniques were originally developed to help rapidly growing tech companies, the practi- tioners who created them see them as equally applicable to other small businesses as well. In particular, the lean-startup approach emphasizes customer devel- opment, or working with and learning about customers from the early stages of building a solution. See the box “Agile, customer-based develop- ment” for an example of how this approach can build your understand- ing of the problem you are solving for customers—and how to build your solution.

Evaluating the opportunity Especially in an experimental approach, evaluation of a business opportu- nity is less of a onetime event and rather a set of questions that you need to ask over and over as you experiment and learn more about your business. H7303-Entrepreneur.indb 28 H7303-Entrepreneur.indb 28 11/2/17 1:14 PM 11/2/17 1:14 PM Shaping an Opportunity 29 The lean startup This methodolog y, named by entrepreneur Eric Ries in his book The Lean Startup, has grown in popularity from its Silicon Valley roots to MBA classrooms. As described by serial entrepreneur and academic Steve Blank for HBR, the lean startup incorporates three elements:

• A business-model canvas: A business-model canvas is a one- page document that captures your hypotheses about your busi- nesses—your guesses about what you do not and cannot know about your business plan in advance. Seeing these unknowns all on one page allows you to imagine how the diﬀ erent parts of your business might ﬁ t together. The standard framework for a busi- ness-model canvas was developed by Alexander Osterwalder and Yves Pigneur in their book Business Model Generation (ﬁ gure 2-1).

Blank business-model canvases are available for free in exchange for registration at Osterwalder’s website, strategyzer.com. (We’ll talk more about business models in the next chapter.) • Customer development: To test your hypotheses, you need to interact with your customers. Gone are the days when you’d keep a product in development a secret from the world, afraid that your competitors would steal it before a big splashy launch.

Instead, as Blank explains, most industries recognize that “cus- tomer feedback matters more than secrecy and . . . constant feedback yields better results than cadenced unveilings.” Go out to your potential customers, vendors, and partners for feedback on the hypotheses in each part of your canvas.

• Agile development: To generate useful feedback from your customers, create prototypes to share with them—and do so quickly. What is the minimum viable product that you can create to test your idea? And once you get feedback, how quickly and ( continued) H7303-Entrepreneur.indb 29 H7303-Entrepreneur.indb 29 11/2/17 1:14 PM 11/2/17 1:14 PM 30 Deﬁ ning Your Enterprise incre mentally can you iterate on your product design to get more feedback without wasting time on the development of unneces- sary elements? (See an example in the box “Agile, customer-based development.”) Source: Steve Blank, “Why the Lean Start-Up Changes Everything,” Harvard Business Review, May 2013.

FIGURE 2-1 The business-model canvas Source: Strateg yzer, “Canvases, Tools and More,” accessed July 12, 2017, w w w.businessmodelgeneration.com/ canvas. Canvas developed by Alexander Osterwalder and Yves Pigneur.

What are the most important costs inherent to our business model?

Which key resources are most expensive?

Which key activities are most expensive? For what value are our customers willing to pay?

For what do they currently pay?

What is the revenue model?

What are the pricing tactics? Value propositions Customer relationships Key partners Key activities Cost structure Revenue streamsCustomer segments What value do we deliver to the customer?

Which one of our customers’ problems are we helping to solve?

What bundles of products and services are we oﬀering to each segment?

Which customer needs are we satisfying?

What is the minium viable product?

How do we get, keep, and grow customers?

Which customer relationships have we established?

How are they integrated with the rest of our business model?

How costly are they?

Who are our key partners?

Who are our key suppliers?

Which key resources are we acquiring from our partners?

Which key activities do partners perform?

What key activities do our value propo- sitions require?

Our distribution channels?

Customer relationships?

Revenue streams? Key resources What key resources do our value propo- sitions require?

Our distribution channels?

Customer relationships?

Revenue streams? Channels Through which channels do our customer segments wants to be reached?

How do other companies reach them now?

Which ones work best?

Which ones are most cost-eﬃcient?

How are we integrating them with customer routines?For whom are we creating value?

Who are our most important customers?

What are the customer archetypes? H7303-Entrepreneur.indb 30 H7303-Entrepreneur.indb 30 11/2/17 1:14 PM 11/2/17 1:14 PM Shaping an Opportunity 31 Agile, customer-based development When Jorge Heraud and Lee Redden started Blue River Technology, they were students in my class at Stanford. They had a vision of building ro- botic lawn mowers for commercial spaces. After talking to over a hun- dred customers in ten weeks, they learned that their initial customer target—golf courses—didn’t value their solution. But then they began to talk to farmers and found a huge demand for an automated way to kill weeds without chemicals. Filling this need became their new product focus, and within ten weeks, Blue River had built and tested a prototype.

Nine months later, the startup had obtained more than $3 million in ven- ture funding. The team expected to have a commercial product ready just nine months after that. By 2017, the company had successfully launched a robotic lettuce thinner and was working on using drone-based tech- nology to add accuracy to its sensing-and-spraying products, as de- scribed on their website at http://about.bluerivert.com.

Source: Adapted and updated from Steve Blank, “Why the Lean Start-Up Changes Every thing,” Harvard Business Review , May 2013.

As you try different elements of your business model in the market, you’ll learn more about the problem you’re trying to solve—and your solution’s viability in the marketplace. What you learn about customers will help you continually evaluate your idea.

Timmons offers the following criteria for an opportunity worth pur- suing:

1. It creates signiﬁ cant value for customers, who are willing to pay a premium to solve a signiﬁ cant problem or ﬁ ll an important unmet need.

2. It offers signiﬁ cant proﬁ t potential to the entrepreneur and inves- tors—enough to meet their risk-versus-reward expectations. H7303-Entrepreneur.indb 31 H7303-Entrepreneur.indb 31 11/2/17 1:14 PM 11/2/17 1:14 PM 32 Deﬁ ning Your Enterprise 3. It represents a good ﬁ t with the capabilities of the founder and the management team—that is, the idea is something they have the experi ence and skills to pursue.

4. It is durable: the opportunity for proﬁ ts will persist—and, indeed, will probably grow—over a reasonable time and is not based on a momentary fad or a quickly disappearing need.

We add a ﬁ fth characteristic to this commendable list, this one sug- gested by A lfred E. Osborne Jr., director of UCL A’s Price Center for Entre- preneurial Studies:

5. The opportunity is amenable to ﬁ nancing. One would think that a promising commercial idea would always ﬁ nd ﬁ nancial backing, but experience teaches us otherwise.

We explored the ﬁ rst criterion in the ﬁ rst half of this chapter; now let’s examine the other segments of this deﬁ nition in more detail.

Will it deliver a signiﬁ cant proﬁ t?

To qualify as a good opportunity, a business must offer the potential for signiﬁ cant proﬁ t. But what amount constitutes signiﬁ cant? Each person will have a different view. Some entrepreneurs and investors will look for something capable of providing a comfortable livelihood—perhaps one that can be passed on to children as they mature. Others will seek much more in terms of ﬁ nancial gains for themselves and their ﬁ nancial backers—but potentially over different periods. For example, venture capitalists typi- cally anticipate a long time horizon before they see a return, but they have higher proﬁ t expectations than do other business investors.

Risk must play a part in every consideration of proﬁ t opportunity be- cause the risk and return tend to go hand in hand. Corporate employees often fret about workplace insecurity: “I could lose my job if the economy doesn’t improve.” For the people who start new businesses, however, the risks are far higher. If things don’t work out, they lose both their employ- ment and the personal savings they’ve invested. Investors are similarly at risk; in the worst case, they can lose all their invested capital. Given the H7303-Entrepreneur.indb 32 H7303-Entrepreneur.indb 32 11/2/17 1:14 PM 11/2/17 1:14 PM Shaping an Opportunity 33 high risks of entrepreneurship, there should be correspondingly high po- tential rewards associated with an opportunity.

There is a very real trade-off between risk and return, as shown in ﬁ gure 2-2. Point A in the ﬁ gure has zero risk and a very low return.

Points B, C, and D provide the investor or entrepreneur with rewards com- mensurate with the risk. But you should avoid opportunities at point E—in fact, any point below the diagonal line—because they do not fully reward the investor or entrepreneur for the risks taken. As a more concrete exam- ple, why invest in a business that promises no more than a 5 percent return when you could do almost as well by investing in ten-year US Treasury bonds, which have no default risk? Every business rests on an economic structure that inﬂ uences the enterprise’s ability to compete and succeed. Some businesses—such as supermarkets—have a very low proﬁ t margin on sales, but the successful ones have very large sales volumes. (Expressed as a percentage, proﬁ t mar- gin is proﬁ t divided by sales revenue.) On the other end of the spectrum, we have, for example, custom furniture makers who don’t sell many items but who generally make a large proﬁ t on each sale.

What is the proﬁ t structure of your business opportunity? Think, too, about the cost structure of the proposed business. Some businesses operate Return Risk 0 A B C E D FIGURE 2-2 The risk-versus-return trade-oﬀ H7303-Entrepreneur.indb 33 H7303-Entrepreneur.indb 33 11/2/17 1:14 PM 11/2/17 1:14 PM 34 Deﬁ ning Your Enterprise with high ﬁ xed costs and low variable costs. Fixed costs stay about the same no matter how many goods or services are produced. For example, an automobile engine plant has high ﬁ xed costs—for debt payments, insur- ance, specialized equipment, and salaried supervisors. These costs remain roughly the same whether the plant produces one hundred engines per year or ten thousand. Variable costs, in contrast, rise or fall with the level of out- put. These include the cost of materials, energy, and, often, labor. Under- standing these costs will help you understand the basis of proﬁ t. And if you know the revenues you’ll receive from each unit sale, you can determine the breakeven point of your operations—that is, the number of units you’ll have to sell before you earn a proﬁ t. (See appendix B for an explanation of the breakeven point and how to calculate it.) Enterprises with high ﬁ xed costs and low variable costs (e.g., high-volume manufacturers) generally have high breakeven points but enjoy high proﬁ tability on sales after they get past that point. Those with low ﬁ xed costs and high variable costs (e.g., a technical service ﬁ rm) have low breakeven points but relatively low prof- itability on sales thereafter. A successful entrepreneur must understand the economics of a busi- ness opportunity. The next set of questions will help you think through and evaluate the economics of your opportunity. Try to provide a complete answer to each.

• Will the business be a price setter or a price taker? What are the constraints on pricing what the business sells?

• What is the supply-and-demand situation for your product or service?

• Is demand elastic or inelastic—that is, would a price increase dra- matically reduce buyer demand (elastic), or would demand be only slightly affected (inelastic) in the short run?

• What substitutes do prospective customers have for your product or ser vice?

• Will the business be dominated by ﬁ xed or variable costs? H7303-Entrepreneur.indb 34 H7303-Entrepreneur.indb 34 11/2/17 1:14 PM 11/2/17 1:14 PM Shaping an Opportunity 35 • To what extent can suppliers and employees enforce cost increases on the proposed business?

You can begin to measure proﬁ t opportunity by means of a pro forma income statement. (If you are unfamiliar with the income statement or other ﬁ nancial statements used in business, see appendix A.) This kind of income statement provides a best estimate of future revenues, expenses, and taxes for one or more years. The net result shown on the statement is the anticipated proﬁ t from the entrepreneur’s measure of opportunity for those years. Because lenders and investors will want to see a set of these statements, let’s create a pro forma income statement using Cesar’s Elec- tric Car Care Center as an example (see table 2-2). Here, Cesar has forecast results during the ﬁ rst three years of operation.

In Cesar’s case, the ﬁ rst year of operation shows a net loss of $21,000, even though he has earmarked a very small salary for himself. The magni- tude of the opportunity grows substantially in succeeding years, however, as the volume of business (i.e., revenues) increases. If volume continues to build in subsequent years, a second facility—if not a regional chain—might be feasible. Naturally, the opportunity reﬂ ected in a pro forma income statement is only as valid as the numbers it contains. A person such as Cesar, who conceives of a business that is closely or directly related to his current expe- rience, can usually develop reliable expense numbers. Labor and beneﬁ ts costs, interest expenses, rent costs per square foot, and so forth are within the scope of his experience. Revenue projections are another matter. In the absence of existing customers, Cesar has to assume revenue ﬁ gures and revenue grow th. And therein lies the most dangerous trap for the entre- preneur. Anything you can do to experiment to get a more realistic view of these numbers will give you a better sense of whether the opportunity is worth pursuing. Is it a good ﬁ t for you and your team?

A good ﬁ t is a situation in which the entrepreneur and management team have the managerial, ﬁ nancial, and technical capabilities, along with the H7303-Entrepreneur.indb 35 H7303-Entrepreneur.indb 35 11/2/17 1:14 PM 11/2/17 1:14 PM 36 Deﬁ ning Your Enterprise TABLE 2-2 The Electric Car Care Center, pro forma income statement for years ending December 31, 2018, 2019, and 2020 2018 2019 2020 Revenues $450,000$700,000$1,000,000 Expenses: Owner’s salary 40,000 70,000 90,000 Employee salaries 140,000 160,000 200,000 Beneﬁ ts 70,000 85,000 100,000 Workers’ insurance 14,000 15,000 20,000 Equipment loan 1 a 42,000 42,000 42,000 Equipment loan 2 b 14,000 Insurance 4,000 4,200 45,000 Shop rent 40,000 40,000 40,000 Utilities 6,000 6,200 6,400 Other 10,000 10,000 10,000 Parts & materials 100,000 185,000 250,000 Advertising 5,000 6,000 7,000 To t a l ex p e n s e s 471,000 623,400 824,400 Proﬁ ts before tax (21,000)76,600 175,600 Ta x 0 2 2 ,9 803 5 , 4 0 0 Proﬁ ts af ter tax (21,000)53,620 140,200 a. $300,000 loan at 9 percent for twelve years. b. $100,000 loan at 9 percent for twelve years.

personal commitment, that are needed to address a business opportunity.

Cesar, the ﬁ ctional character in our electric car service example, appears to have a good ﬁ t with the opportunity he has identiﬁ ed. He already un- derstands the technology and knows how to deal with it. He is also experi- enced in the management of an auto service business. As you consider an opportunity, think about the expertise and skills it will take to run that business. Do you have those competencies? At what point will you be able to hire for them—and are they in high demand and hence very likely to require a high salary? What kind of work can you con- tract out versus bringing in house? H7303-Entrepreneur.indb 36 H7303-Entrepreneur.indb 36 11/2/17 1:14 PM 11/2/17 1:14 PM Shaping an Opportunity 37 Will it last?

Some opportunities are durable—that is, they are opportunities that busi- nesspeople can exploit over long periods. They are long-lasting and des- tined to grow over time. The software industry has demonstrated this durability. Other industries are too ﬂ eeting to sustain proﬁ tability over the long term. From the 1970s pet rock fad to the virtual world Second Life, most opportunities associated with fads and fashion are equally short- lived. By the time customer requirements are deﬁ ned and addressed, the market has lost interest and moved on to the next new thing. Some oppor tunities lack durabilit y even though demand remains high for a long time. Low barriers to entry create these situations. A visible op- portunity with low entry barriers to new competition is a deadly combi- nation. The supply of the product or service can quickly exceed demand, resulting in price reductions and business distress all around. As you evaluate your business idea, consider ﬁ rst whether the need you’ve identiﬁ ed is likely to be sustained. Sometimes, you just need to take the time to see if a new fad has staying power. It can be worth the invest- ment of time to wait before making an investment, according to London Business School entrepreneurship professor Freek Vermeulen, even in dig- ital industries. But speed is often what is called for to achieve one much-lauded source of durability in many industries: network effects. Where the value of a business’s offering depends on the number of users it attracts, being the ﬁ rst to achieve scale in a particular market can create high defensibil- ity; users are less likely to defect to a competitor with fewer users, because it’s less valuable to them. This means that eBay and Etsy become more valuable for sellers as they attract more buyers, and more valuable to buy- ers as they attract a wider variety of sellers. In these kinds of businesses, defensibility comes from growing very, very quickly, becoming the ﬁ rst mover at scale in your target market so that you can be the ﬁ rst to capture those users or customers. But effectively capitalizing on network effects isn’t just about scaling your user base as quickly as you can—you also need H7303-Entrepreneur.indb 37 H7303-Entrepreneur.indb 37 11/2/17 1:14 PM 11/2/17 1:14 PM 38 Deﬁ ning Your Enterprise to be aware of issues like building trust among the participants on your platform, focusing on the right kinds of users, and avoiding disintermedi- ation. (With disintermediation, participants’ trust in one another and the ease of the transactions grow so great that the participants can sidestep you as an intermediary.) Can you defend the solution you are offering? Can you take advantage of network effects? Do other aspects of your offering make it difﬁ cult for competitors to emulate or replace?

What’s the competition?

Now try to answer the next set of questions, which address your compet- itive landscape. If you’re entering an existing market, you’ll be up against competitors. Some may be entrenched and capable. If your market is new and attractive, you can be sure that it will attract other proﬁ t-seekers like you.

• How are customers currently satisfying the need you’ve identiﬁ ed (e.g., going to their auto dealer rather than seeking alternative places to get their car serviced)?

• What are the strengths and weakness of the main competitors (e.g., high quality, poor customer service, high price)?

• How would a smart competitor respond to your entering the mar- ket (e.g., by reducing price, bundling with other desirable offerings, improving customer experience)?

• Are the barriers to market entry high or low? Low barriers usu- ally mean that competitors will continue to enter the market until returns are driven to a low level. If entry barriers are high, how will you surmount them? And will they stay high in the future?

• Have current competitors shown themselves to be agile and respon sive to customer needs and technical change?

• What is the single worst thing that a competitor could do to your business prospects (e.g., drop the price 20 percent)? When you’ve H7303-Entrepreneur.indb 38 H7303-Entrepreneur.indb 38 11/2/17 1:14 PM 11/2/17 1:14 PM Shaping an Opportunity 39 answered this question, think about how that worst thing would affect your prospects for success and how you would respond.

What strategy on pricing, positioning, service, distribution, or product features would give you a sustainable competitive advantage?

Thoroughly examine and answer each of these questions with docu- mentation. If you will be seeking outside capital, this documentation is essential. Is your idea amenable to ﬁ nancing?

A good business opportunity must be amenable to ﬁ nancing. You would think that any promising commercial idea would ﬁ nd ﬁ nancial back- ing—from the idea generator, friends, family, bankers, and so forth. But experience does not bear this out. Between 2000 and 2004, for example, entrepreneurs in the biotech industry had plenty of ideas for new vaccines and therapies. Several years earlier, these great ideas would have found the ﬁ nancing they needed, but they were starved for ﬁ nancing during the period in question because of a lack of investor conﬁ dence.

Two questions to ask yourself After you’ve identiﬁ ed an opportunity and evaluated it in terms of the mar- ket, competition, and economic value, ask yourself two other questions:

• Is it still attractive in terms of the risk-to-return relationship described in ﬁ gure 2-1?

• Is it more or less attractive than other opportunities available to you?

Don’t overlook these questions. Always compare the attractiveness of an opportunity with other prospects you could pursue—including doing nothing. Leaving your capital in a money-market fund earning an anemic 2 percent interest is an alternative, one that you can follow until an oppor- tunity with all the right characteristics appears on your radar. H7303-Entrepreneur.indb 39 H7303-Entrepreneur.indb 39 11/2/17 1:14 PM 11/2/17 1:14 PM 40 Deﬁ ning Your Enterprise Summing up ■A business opportunity (1) solves a real problem for customers, (2) oﬀ ers signiﬁ cant risk-adjusted proﬁ t potential, (3) ﬁ ts well with the capabilities of the leadership team, (4) is potentially proﬁ table over a reasonable time span, and (5) is amenable to ﬁ nancing.

■Entrepreneurs often spend inadequate time considering the problem they are setting out to solve and testing how potential users and customers experience the problem.

■An experimental or lean approach to entrepreneurship lowers your risk and helps you understand customer needs and reactions to your solution before you make signiﬁ cant investment.

■Evaluate promising opportunities by considering the market, the current and anticipated level of competition, the underlying economics, and the resources you’ll need to be successful. H7303-Entrepreneur.indb 40 H7303-Entrepreneur.indb 40 11/2/17 1:14 PM 11/2/17 1:14 PM 3.

Building Your Business Model and Strategy If your initial ﬁ ndings and experiments suggest a business opportunity, you’ll want to start to solidify your business model and strategy. Ask your- self the following questions:

1. How will our new business create value for customers?

2. How will it make a proﬁ t for us and our investors?

3. How will the business differentiate itself from competitors?

4. How will the business defend its assets and position from competitors?

5. How will the business be discovered?

You should have concise answers for anyone who asks these questions.

This chapter’s primer on business models and strategy will help you get started. H7303-Entrepreneur.indb 41 H7303-Entrepreneur.indb 41 11/2/17 1:14 PM 11/2/17 1:14 PM 42 Deﬁ ning Your Enterprise Business executives, consultants, and the business media often use the terms business model and strategy casually and interchangeably. And in- deed, various experts’ deﬁ nitions of the two terms do sometimes intermin- gle. But as an entrepreneur, you will beneﬁ t by thinking of these concepts separately. As this chapter uses the terms, a business model identiﬁ es your customers and describes how your business will proﬁ tably address their needs. Strategy, on the other hand, is about determining how you will do better than your competitors. Both a business plan and a strategy are re- quired for your business to succeed. Deﬁ ning your business model The term business model came into popular use when spreadsheet soft- ware ﬁ rst allowed entrepreneurs and analysts to easily model the costs and revenues associated with any proposed business. After the model was set up, it took only a few keystrokes to observe the impact of individual changes—for example, in unit price, proﬁ t margin, and supplier costs—on a company’s bottom line. Pro forma ﬁ nancial statements were the primary documents of business modeling, but the emphasis was on the idea that a model could tell you something about your business before it launched.

Now, much of the focus of the experimental approach to entrepreneurship is on business models speciﬁ cally.

Understanding the power of the business model In the most basic sense, a business model describes how an enterprise proposes to make money. Strategy expert Joan Magretta has provided a useful introduction to business models in “Why Business Models Matter,” a 2002 Harvard Business Review article in which she views a business model as some variation of the value chain that supports every business.

“Broadly speaking,” she writes, “this chain has two parts. Part one includes all the activities associated with making something: designing it, purchas- ing raw materials, manufacturing, and so on. Part two includes all the ac- tivities associated with selling something: ﬁ nding and reaching customers, transacting a sale, distributing the product or delivering the service.” H7303-Entrepreneur.indb 42 H7303-Entrepreneur.indb 42 11/2/17 1:14 PM 11/2/17 1:14 PM Building Your Business Model and Strategy 43 She goes on to explain that unsuccessful business models fail one (or both) of two tests: the narrative test and the numbers test. Does your model tell a logical, sensible story? And if you were to represent your model on a pro forma income statement with reasonable projections of reve- nues and expenses, would it be proﬁ table? (See the box “Cesar’s business model” to see what this exercise looks like for our entrepreneur in electric car care.) A useful starting point for understanding different possibilities for business models is the list of existing models assembled by Mark W. John- son in his book on business model innovation, Seizing the White Space (s e e table 3-1). How might each of these be applied to the problem you are try- ing to solve? Some of today’s most powerful and proﬁ table companies created new business models that were elegant and compelling in their logic and pow- erful in ﬁ nancial potential. See the box “Airbnb’s business model” for an example. Considering your business model Two Harvard Business School professors, Richard Hamermesh and Paul Marshall, have reﬁ ned the deﬁ nition of a business model as business deci- sions and trade-offs that fall into four groups:

• Revenue sources: This money comes from sales, service fees, advertising, and so forth.

• Cost drivers: Examples are labor, goods purchased for resale, and energy.

• Investment size: Every business needs a measurable level of in- vestment to get off the ground and, in the case of working capital, to keep it operating.

• Critical success factors: Depending on the business, a success factor might be the ability to roll out new products on a sustained basis, success in reaching some critical mass of business within a certain time, and so on. H7303-Entrepreneur.indb 43 H7303-Entrepreneur.indb 43 11/2/17 1:14 PM 11/2/17 1:14 PM 44 Deﬁ ning Your Enterprise Cesar’s business model As described earlier in this book, Cesar, the service manager for a dealer selling new electric cars, sees a proﬁ table business in the repair and maintenance of these vehicles, especially after their manufacturers’ warranties expire. He has some interesting ideas for testing and mar- keting his plan to potential customers, but otherwise, his blueprint is essentially the same one used by auto repair facilities everywhere:

1. Generate customers through local advertising and on-premises in- formational mini-seminars for owners of these unique but increas- ingly popular vehicles.

2. Have the internal capabilities to diagnose and repair damaged and malfunctioning electric engine vehicles of all major manufacturers.

3. Establish a replacement parts pipeline with several regional distributors.

4. Establish outsourcing relationships with a top-quality body shop and an auto air-conditioning service company so that personnel can concentrate on mechanical problems.

This blueprint is Cesar’s model for making money. His experience with electric car repair work and with running a dealer’s service depart- ment has made him an expert in the details of pricing and cost manage- ment. By modeling many types of repairs on a computer spreadsheet and factoring in known costs for labor, parts, equipment loans, rent, and overhead, he is convinced that he can break even with a crew of ﬁ ve employees and eight thousand service-hours per year (roughly forty weeks per year). Everything over that breakeven point should produce a proﬁ t. He has worked these ﬁ gures out in a pro forma income statement. H7303-Entrepreneur.indb 44 H7303-Entrepreneur.indb 44 11/2/17 1:14 PM 11/2/17 1:14 PM TABLE 3-1 Business model analogies Try adapting one of these basic forms.

AnalogyHow it works Example Aﬃ nity club Pay royalties to some large organization for the right to sell your product exclusively to its customers. MBNA Brokerage Bring together buyers and sellers, charging a fee per transaction to one or another party. Century 21 Orbitz Bundling Package related goods and services together. Fast-food value meals iPod and iTunes Cell phone Charge diﬀ erent rates for discrete levels of a service. Sprint Better Place Crowdsourcing Get a large group of people to contribute content for free in exchange for access to other people’s content. Wikipedia YouTube Disintermediation Sell direct, sidestep ping traditional intermediaries. Dell WebMD Fractionalization Sell partial use of something. NetJets Time-shares Freemium Oﬀ er basic services for free, and charge for premium service. LinkedIn Leasing Rent, rather than sell, high-margin, high-priced products. Cars MachineryLink Low-touch Lower prices by decreasing service. Walmart IKEA Negative operating cycle Lower prices by receiving payment before delivering the oﬀ ering. Amazon Pay as you go Charge for actual, metered usage. Electric companies Razor/blades Oﬀ er the high-margin companion product (razor) below cost to increase volume sales of low- margin item (blades). Printers and ink Reverse razor/blades Oﬀ er the low-margin item below cost to encourage sales of the high-margin companion product. Kindle iPod/iTunes Reverse auction Set a ceiling price, and have participants bid as the price drops. Elance.com Product to service Rather than sell a product, sell the service the product performs. Zipcar Standardization Standardize a previously personalized service to lower costs. MinuteClinic Subscription Charge a subscription fee for a service. Netﬂ ix User communities Grant members access to a network, charging both membership fees and advertising. Angie’s List Source:

Adapted from Mark W. Johnson, Seizing the White Space: Business Model Innovation for Growth and Renewal (Boston: Harvard Business Review Press, 2010). H7303-Entrepreneur.indb 45 H7303-Entrepreneur.indb 45 11/2/17 1:14 PM 11/2/17 1:14 PM 46 Deﬁ ning Your Enterprise Airbnb’s business model Consider Airbnb, which upended the hotel industry. Founded in 2008, the company has experienced phenomenal growth: it now has more rooms than either InterContinental Hotels or Hilton Worldwide do. By 2016, Airbnb represented 19.5 percent of the hotel room supply in New York and operated in 192 countries. In these countries the company ac- counted for 5.4 percent of room supply (up from 3.6 percent in 2015). The founders of Airbnb realized that platform technology allowed them to create an entirely new business model that would challenge the traditional economics of the hotel business. Unlike conventional hotel chains, Airbnb does not own or manage property. It allows users to rent any livable space (from a sofa to a mansion) through an online platform that matches individuals looking for accommodations with homeowners willing to share a room or a house. Airbnb manages the platform and takes a percentage of the rent.

How would you describe your company or business concept in terms of these model elements? Have you nailed down your revenue sources and the factors that will drive costs for your business? Do you know which costs will be ﬁ xed and which will vary with sales volume? Have you calculated the capital you’ll need to launch and operate the business? What factors are essential for success? Try to answer each of these questions unambigu- ously, and do so before you approach any investors. Testing your business model Many of these questions are impossible to answer at the outset of a venture.

In his work on what he calls a business-model canvas, Alexander Oster wal- der and others have emphasized that many elements of a business model are not decisions but rather assumptions or hypotheses that may or may not be true—or may not always be true, depending on various conditions. H7303-Entrepreneur.indb 46 H7303-Entrepreneur.indb 46 11/2/17 1:14 PM 11/2/17 1:14 PM Building Your Business Model and Strategy 47 Because its income does not depend on owning or managing physi- cal assets, Airbnb needs no large investments to scale up and thus can charge lower prices (usually 30 perc ent lower than what hotels charge).

Moreover, since the homeowners are responsible for managing and maintaining the property and any services they may oﬀ er, Airbnb’s risks (not to mention operational costs) are much lower than those of tradi- tional hotels. On the customer side, Airbnb’s model redeﬁ nes the value proposition by oﬀ ering a more personal service—and a cheaper one.

Before platform technology existed, there was no reason to change the hotel business in any meaningful way. But after the introduction of this technology, the dominant business model became vulnerable to at- tack from anyone who could take advantage of the technology to create a more compelling value proposition for customers. The new business model serves as the interface between what technology enables and what the marketplace wants. Source: Adapted from Stelios Kavadias, Kostas Ladas, and Christoph Loch, “The 6 Elements of Truly Transformative Business Models,” Harvard Business Review , October 2016.

Of the essential factors that you deﬁ ned earlier, which are you unsure about? If you can ﬁ nd ways to test those factors before developing your product or service offering—or before approaching investors—you can be much more conﬁ dent about your probability of success. And if you under- stand what might change about your hypotheses (e.g., perhaps there are no competitors in this space now , but there may be in the future), you’ll better understand the risks inherent in your plan and be better equipped to mitigate them. Incubators and accelerators To begin testing your idea more formally, especially in a high-growth ﬁ eld, you could join a business incubator (or, if you’re a bit further along, an ac- celerator). These programs provide support for entrepreneurial ventures in H7303-Entrepreneur.indb 47 H7303-Entrepreneur.indb 47 11/2/17 1:14 PM 11/2/17 1:14 PM 48 Deﬁ ning Your Enterprise the early stages of their operation—to experiment and to test their business models and other assumptions, quickly. They give ﬂ edgling entrepreneurs the physical space and the support to learn by doing by providing coaching, mentoring, networking, funding, and educational programming. Often the terms incubator and accelerator are used interchangeably, but while they have many similarities, they also have differences. In this book, an accelerator means a time-limited cohort program that comes with equity investment. An incubator is a less structured and less time- bound program. Incubators can be independent or connected to a bigger ﬁ rm, an academic institution, a government arm, or a nonproﬁ t. They usu- ally either operate as a nonproﬁ t or charge your venture for rent (you share coworking space with other young companies). Work with an incubator is not limited to the early stages of a venture’s development; some incubators specialize in later-phase growth. Accelerators, on the other hand, mostly work exclusively with early-stage businesses. They tend to be more competitive than incuba- tors, particularly for the stronger programs. They offer funding in ex- change for equity (this is described more fully in chapter 6).

A plan for discovery A key element of your business plan is how your customers will ﬁ nd out about you. Marketing, often considered a downstream step of the original business concept, really needs to be at the center of your model from the beginning. If you don’t know your customers well enough to reach them, and if you haven’t built something that’s a good ﬁ t for them, the rest of your model isn’t going to work. That’s why we focused on the problem and the market ﬁ rst in our discussion of the opportunity in the last chapter.

But reaching customers directly isn’t always so simple, especially when you rely on others for the distribution of your product. For example, con- sider a new business idea that is a mobile application. There are only two ways for your customers to get your app at any kind of scale: the Apple and Android app stores. But the Apple iTunes app store has more than 2.2 million products, and Google Play more than 2.8 million. How do you get your app discovered in that busy space? You can engage in app-store H7303-Entrepreneur.indb 48 H7303-Entrepreneur.indb 48 11/2/17 1:14 PM 11/2/17 1:14 PM Building Your Business Model and Strategy 49 optimization—understanding as much as you can about how the stores’ search algorithms work. With this knowledge, you can help make sure your app is ranked high in search results (after all, one in four apps gets discovered through search). You can buy ads on Facebook or Instagram.

But anyone (like your competitors) can do those things as well—they’re table stakes. To be competitive, you also need to be creative about getting broader marketing, endorsements, and interactions with your customers beyond those ecosystems wherever possible.

For example, take the food-delivery app Eat24, which was acquired by Yelp for $134 million. When the founders were just star ting out, they faced a market dominated by GrubHub; potential backers Benchmark, Redpoint, Excel, Insight, and Alibaba turned them down. But the founders got cre- ative about their service and found a niche of small family restaurants that weren’t well served by the behemoth GrubHub. They literally knocked on doors to get the word out and offered features of interest to potential cus- tomers: free fax machines for the restaurants wary of online ordering, no charges for very small orders, assuming the risk if a customer balked at paying. Simultaneously, the company placed relatively cheap ads on sites that were not appealing to most advertisers but that did appeal to young men. Besides being attracted to what these websites offered (we’ll leave the exact nature of these offerings up to the reader to discern), these young men were also frequent users of online food delivery services. As you develop your company’s business plan, you need to be thinking about these kinds of unique features and approaches that will allow your product or service to best connect with your customers.

Deﬁ ning your strategy A business model will help you—and anyone you approach for funding— to understand what your business will do and how all its key parts ﬁ t to- gether. But a well-conceived and promising business model is only half the equation for success, because it doesn’t take into account the market competition. Dealing with competition is the job of strategy. Strategy is a plan to differentiate the enterprise and give it a competitive advantage. A H7303-Entrepreneur.indb 49 H7303-Entrepreneur.indb 49 11/2/17 1:14 PM 11/2/17 1:14 PM 50 Deﬁ ning Your Enterprise successful business has both a solid business model and a good strategy.

Some have argued against the present emphasis on the lean startup. They say that a strong strategy goes further to help a business than does an ex- cess of validating tests.

Bruce Henderson, founder of Boston Consulting Group, has written that competitive advantage is found in differences: “The differences be- tween you and your competitors are the basis of your advantage.” Hen- derson believes that no two competitors could coexist if they sought to do business in the same way. They must differentiate themselves to survive.

He writes: “Each must be different enough to have a unique advantage.” For example, two men’s clothing stores on the same block—one featuring formal attire and the other focusing on leisure wear—can potentially sur- vive and prosper. However, if the same two stores sold the same things under the same terms, one or the other would perish. More likely, the one that differentiated itself through price, product mix, or ambiance would have the greater likelihood of survival. Harvard Business School professor and strategy expert Michael Porter concurs: “Competitive strategy is about being different. It means deliberately choosing a different set of activities to deliver a unique mix of value.” Consider these examples:

• Southwest Airlines became the most proﬁ table air carrier in North America, but not by copying its rivals. It differentiated itself with low fares, frequent departures, point-to-point ﬂ ights, and customer-pleasing ser vice.

• Toyota’s strategy in developing the hybrid engine Prius was to cre- ate a competitive advantage within an important segment of auto buyers: people who want a vehicle that is either environmentally benign, cheap to operate, or the latest thing in auto engineering.

The company also hoped that the learning associated with the Prius would give the company the lead in a technology with huge future potential.

• Apple wasn’t the ﬁ rst company to build a digital music player and bring it to market. But it created a new business model that com- H7303-Entrepreneur.indb 50 H7303-Entrepreneur.indb 50 11/2/17 1:14 PM 11/2/17 1:14 PM Building Your Business Model and Strategy 51 bined its capabilities in hardware, software, and service to create a new kind of ecosystem for customers to purchase digital music and seamlessly listen to it on their devices. iTunes made the iPod a success where the Rio and Cabo failed.

Strategies can be based on low-cost leadership, technical differentia- tion, or focus. They can also be understood in terms of strategic position.

Porter has postulated that strategic positions emerge from three, some- times overlapping, sources:

• Variety-based positioning: Here, a company chooses a narrow subset of product or service offerings from within the wider set offered in its industry. It can succeed with this strategy if it deliv- ers faster, better, or at lower cost than competitors can deliver. For example, Starbucks offers premium coffee products and places its outlets in locations that are convenient for potential customers. But when it started, it didn’t serve breakfast or sell sandwiches. Cus- tomers could get those products elsewhere; its focus was on coffee.

• Need-based positioning: Companies that follow this need-based approach, according to Porter, aim to serve all or most of the needs of an identiﬁ able set of customers. These customers may be price sensitive, may demand a high level of personal attention and service, or may want products or services that are uniquely tailored (customized) to their needs. For example, ﬁ nancial ser- vices company USA A caters exclusively to active-duty and retired military ofﬁ cers and their families. After decades of serving this population, USA A understands its unique banking, insurance, and retirement needs. And it knows how to deal with the frequent transfers of military from post to post around the world and mili- tary assignments to remote locations for extended periods during which the ofﬁ cers are unable to respond to monthly billings.

• Access-based positioning: Some strategies can be based on ac- cess to customers. A discount merchandise chain, for example, might locate its stores exclusively in low-income neighborhoods. H7303-Entrepreneur.indb 51 H7303-Entrepreneur.indb 51 11/2/17 1:14 PM 11/2/17 1:14 PM 52 Deﬁ ning Your Enterprise This positioning reduces competition from suburban shopping malls and provides easy access for its target market of low-income shoppers, many of whom do not have automobiles. Cracker Barrel Old Country Store, in contrast, locates its restaurant and gift store combinations along the US expressway system, where it caters to travelers. Its website even includes a trip planner that identiﬁ es the locations of all Cracker Barrel outlets along any driving route.

What is your strategy for gaining competitive advantage? Will it dif- ferentiate your company in ways that attract customers from rivals? Will it draw new customers into the market? Will it give you a tangible advantage? Simply being different, of course, will not keep you in business; some- thing that is different must be perceived as valuable. And customers deﬁ ne value in different ways: lower cost, greater convenience, greater reliability, faster delivery, or more aesthetic appeal. The list of customer-pleasing val- ues is extremely long. What value does your strategy aim to provide? Can it deliver? Steps for formulating strategy Strategy formulation is a large and deep subject, but this primer can help you get started with six steps to follow. They involve looking outside and inside your organization, thinking about how you will deal with threats and opportunities as they present themselves, building a good ﬁ t with strategy-supporting activities, aligning resources with goals, and organiz- ing for execution. At the heart of these steps are Porter’s classic ﬁ ve forces of competition: the threat of new entrants, the threat of substitute prod- ucts or services, rivalry among existing competitors, the bargaining power of suppliers, and the bargaining power of suppliers.

STEP 1: LOOK OUTSIDE TO IDENTIFY THREATS AND OPPORTUNITIES. At the highest level, strategy is concerned with analyzing the outside environ- ment and determining how the company’s ﬁ nancial resources, people, and capacity should be allocated to create an exploitable advantage. There are always threats in the outside environment: new entrants, demographic H7303-Entrepreneur.indb 52 H7303-Entrepreneur.indb 52 11/2/17 1:14 PM 11/2/17 1:14 PM Building Your Business Model and Strategy 53 changes, suppliers who might cut you off, substitute products that your cus- tomers could turn to, technological advances that could render your solu- t ion—or the customer’s problem!—obsolete, and macroeconomic trends that may reduce the ability of your customers to pay. The business you have in mind may be threatened by a competitor that can produce the same quality goods at a much lower price—or a much better product at the same price. A strategy must be able to cope with these threats.

The external environment also harbors opportunities: a new-to-the- world technology, an unserved market, and so forth. So ask yourself these questions:

• What is the economic environment in which we must operate? How is it changing?

• What opportunities are there for proﬁ table action?

• What are the risks associated with these opportunities?

STEP 2: LOOK INSIDE AT RESOURCES, CAPABILITIES, AND PRACTICES. Re- sources and internal capabilities can be a constraint on your choice of strategy, especially for a small startup with few employees and few ﬁ xed assets. And rightly so. A strategy to exploit an unserved market in the elec- tronics industry, for example, might not be feasible if your ﬁ rm lacks the necessary ﬁ nancial capital and the human know-how to exploit it. A strat- egy can succeed only if it has the backing of the right set of people and other resources. So ask yourself these questions:

• What are our competencies as an organization? How do these give us an advantage over our competitors?

• Which resources support or constrain our actions? STEP 3: CONSIDER STRATEGIES FOR ADDRESSING THREATS AND OPPOR- TUNITIES. Clayton Christensen has recommended that strategists ﬁ rst prioritize the threats and opportunities they ﬁ nd (he calls them “driv- ing forces” of competition) and then discuss each in broad strokes. If you H7303-Entrepreneur.indb 53 H7303-Entrepreneur.indb 53 11/2/17 1:14 PM 11/2/17 1:14 PM 54 Deﬁ ning Your Enterprise follow this advice and develop strategies to deal with them, be sure to do the following:

• Create many alternatives. There is seldom only one way to do things. Sometimes, the best parts of two strategies can be com- bined to make a stronger third strategy.

• Check all facts, and question all assumptions.

• Some information is bound to be missing. To better assess a partic- ular strategy, determine what information you need. Then get the information.

• Vet the leading strategy choices among the wisest heads you know. Doing so will help you avoid groupthink within your team.

STEP \b: BUILD A GOOD FIT AMONG STRATEGY-SUPPORTING ACTIVITIES. Por- ter has explained that strategy is more than just a blueprint for winning customers; it is also about combining activities into a chain whose links are mutually supporting and effective in locking out imitators. He uses Southwest Airlines to illustrate his notion of ﬁ t.

Southwest’s strategy is based on rapid gate turnaround. Rapid turn- around allows the airline to make frequent departures and better utilize its expensive aircraft assets. These advantages, in turn, support the low- cost, high-convenience proposition it offers customers. Thus, each of these activities supports the others and the higher goal. That goal, Porter points out, is further supported by other critical activities, which include highly motivated and effective gate personnel and ground crews, a no-meals pol- icy, and a practice of not making interline baggage transfers. Those ac- tivities make rapid turnarounds possible. “Southwest’s strategy,” writes Porter, “involves a whole system of activities, not a collection of parts. Its competitive advantage comes from the way its activities ﬁ t and reinforce one another.” STEP 5: CREATE ALIGNMENT. After you’ve developed a satisfactory strategy, your job is only ha lf ﬁ nished. The other half is to create alignment between H7303-Entrepreneur.indb 54 H7303-Entrepreneur.indb 54 11/2/17 1:14 PM 11/2/17 1:14 PM Building Your Business Model and Strategy 55 the people and activities of the company and its strategy. Alignment is a condition in which every employee at every level (1) understands the strat- egy and (2) understands his or her role in making the strategy work. Make sure you have this powerful force working in your favor.

Alignment also involves other resources. Marketing must be focused on the right customers—the ones deﬁ ned in the strategy. Compensation and bonuses must be aligned with behaviors and performance that ad- vance the strategy. And physical assets must be deployed—aligned—with the highest goals of the organization.

STEP 6: BE PREPARED TO IMPLEMENT. A powerful strategy is impotent if your organization isn’t prepared to implement it effectively. Unfortu- nately, some people get so carried away with the details of their strategy that they forget about the downstream activities required to make it work.

One beneﬁ t of an entrepreneurial startup is that you’re beginning with a clean slate. After you have a strategy, you have a free hand in organizing around it: hiring people with the necessary competencies, acquiring the right equipment, structuring these resources, and so forth. As UCL A’s Alfred E. Osborne Jr. has put it, “I think of the 4 S’s: structure follows strategy, and stafﬁ ng follows structure, and you hold the strategy together with systems.” Strategy for platform businesses Platform businesses enable exchanges between producers and consum- ers; web-based marketplaces like Uber, Alibaba, Etsy, and Airbnb are platforms that have recently stolen the startup spotlight because of their spectacular growth. The economics of these businesses can be very attrac- tive: because they facilitate the exchange of goods and services rather than producing those goods and services themselves, they have low cost struc- tures and high margins—eBay’s gross margin is 70 percent, for example, and Etsy’s is 60 percent. With these kinds of businesses, different strategic forces come to play because much of the business’s value comes from external sources. See the box “Network effects and strategy” for more on how—and why—you need H7303-Entrepreneur.indb 55 H7303-Entrepreneur.indb 55 11/2/17 1:14 PM 11/2/17 1:14 PM 56 Deﬁ ning Your Enterprise Network eﬀ ects and strategy In supply-side economies, ﬁ rms achieve market power by controlling re- sources, ruthlessly increa sing eﬃ ciency, and fending oﬀ challenges from any of [Porter’s] ﬁ ve forces. The goal of strategy in this world is to build a moat around the business that protects it from competition and chan- nels competition toward other ﬁ rms. The driving force behind the internet economy, conversely, is de- mand-side economies of scale, also known as network eﬀ ects . . . In the internet economy, ﬁ rms that achieve higher “volume” (that is, attract more platform participants) than do competitors oﬀ er a high average value per transaction. That’s because the larger the network, the bet- ter the matches between supply and demand and the richer the data that can be used to ﬁ nd matches. Greater scale generates more value, which attracts more participants, which creates more value—another virtuous feedback loop that produces monopolies. Network eﬀ ects gave us Alibaba, which accounts for over 75 percent of Chinese e-commerce transactions; Google, which accounts for 82 percent of mobile operating systems and 94 percent of mobile searches; and Facebook, the world’s dominant social platform. The ﬁ ve-forces model doesn’t factor in network eﬀ ects and the value they create. It regards external forces as depletive, or extracting value from a ﬁ rm, and so argues for building barriers against them. In demand-side economies, however, external forces can be accretive— adding value to the platform business.

Source: Excerpted from Marshall W. Van Alstyne, Geoﬀ rey G. Parker, and Sangeet Paul Chou- dary, “Pipelines, Platforms, and the New Rules of Strategy,” Harvard Business Review, April 2016. H7303-Entrepreneur.indb 56 H7303-Entrepreneur.indb 56 11/2/17 1:14 PM 11/2/17 1:14 PM Building Your Business Model and Strategy 57 to consider your strategy differently if you’re building a platform business or any other business that relies on the strength of the network it creates.

As you evaluate the importance of network effects to your business, also determine the right time to achieve that scale. If you are building a business that will depend on network effects, you might think you need to scale as soon as possible to capture as much of the market as possible.

But Harvard Business School professor Andrei Hagiu argues otherwise.

He maintains that many of the biggest platform businesses weren’t ﬁ rst in their space: Vacation Rental by Owner (VRBO) existed before Airbnb, and Alibaba followed eBay in China. In fact, growing too early can mean that you won’t have a chance to adequately test your offering and your business model before you’re locked in. As a result, you might be giving up potential revenue, margin, or customers. Usually, LinkedIn founder Reid Hoffman observes, a company should scale when it has already got- ten some data, understands the competition, and has ironed out the ﬁ t between product and market. The company is shifting from between ten and a hundred employees to a hundred or a thousand; from a hundred thousand or one million users to one or ten million; and to revenues of more than $10 million.

Be prepared for change As we’ve seen, the initial strategies of startup companies often fail to hit the mark. Customers don’t value the differentiation, or they don’t respond to it as anticipated. Or the company chooses the wrong target customers.

Companies fail because every startup business is an experiment to some degree. The outcome of this experiment can surprise and disappoint even the best planners. A classic example is a company called Webvan, whose founders and investors looked at the surge in online purchasing in the late 1990s and thought that a web-based grocery-delivery business was a per- fect idea for afﬂ uent, web-sav v y, time-starved households. But those cus- t ome r s b a l k e d a t t he h ig he r pr ic e of bu y i ng t he i r w e e k l y g r o c e r ie s . To t he m , the extra convenience wasn’t worth it. Webvan went bankrupt in 2001. The entrepreneur’s antidote to a disappointing strategy is a willing- ness both to recognize the bad news and to respond quickly with a revised H7303-Entrepreneur.indb 57 H7303-Entrepreneur.indb 57 11/2/17 1:14 PM 11/2/17 1:14 PM 58 Deﬁ ning Your Enterprise strategy, or a pivot. Recognition requires the ability to admit a mistake.

Responding requires an energetic search for what went wrong and the ﬂ ex- ibility to make adjustments and get back into the game. Successful entrepreneurs are adept at both these capabilities. They are also masters of incrementalism—that is, if they ﬁ nd that something is working, they do more of it. If they achieve success in a small, niche mar- ket, they use what they have and what they have learned to enter another niche, altering the product or service as necessary.

Be prepared for competition If your business model and initial strategy are successful, be prepared for company. Other entrepreneurs can introduce copycat businesses and try to Cesar’s strategy for the Electric Car Care Center Strategy is about being diﬀ erent and choosing a diﬀ erent set of activities to deliver a unique mix of value to customers. Let’s consider our hypo- thetical friend Cesar and the strategy of his auto repair and maintenance facility. Cesar has clearly diﬀ erentiated his business from current competi- tors. Every town and city has many automotive service businesses, but few places, if any, have a business that specializes in electric vehicles.

Cesar can use that distinctiveness to gain customer attention and rec- ognition. You can almost hear the advertising: “If your electric car needs maintenance or repair, bring it to the specialists at the Electric Car Care Center. They will do the job right.” Cesar must also deliver on that oﬀ er of greater know-how and high-quality work. To do that, he must acquire the right resources and align them in support of his distinctive oﬀ er. For example, he will have to acquire the tools and diagnostic equipment required by those vehicles.

And he must hire or train mechanics who really know how to deal with H7303-Entrepreneur.indb 58 H7303-Entrepreneur.indb 58 11/2/17 1:14 PM 11/2/17 1:14 PM Building Your Business Model and Strategy 59 the unique problems of electric cars. He has also outlined a marketing plan that involves sharing knowledge about electric car upkeep with potential customers through free seminars and social media. Conse- quently, some of his knowledgeable mechanics must also be able to teach what they know to others, either in front of a room or using the written word.

Finally, Cesar is also thinking ahead to future competition for his business. What happens when self-driving cars gain a foothold in the electric car market? Will Cesar’s mechanics have the capabilities nec- essary to service those vehicles? He has a plan to get his team trained on the new cars once that training is available. He also sees many tra- ditional services being disrupted by web-based platforms—what if someone starts a company that serves auto owners and cuts into his relationship with his customers? And what if car ownership declines in the face of the grow th of ride-share services like Uber and Lyf t? By iden- tifying these competitive challenges early, Cesar can begin working on solutions before it’s too late.

attain dominance in your market, getting to your target customers before you can reach them. Imagine what would happen to your company if a copycat business got $10 million from a venture-capitalist ﬁ rm while you were just starting to put together pitches for a second round of funding.

The box “Cesar’s strategy for the Electric Car Care Center” describes some ways that one entrepreneur considered competition in his strategy. Large incumbents, on the other hand, may have more resources at their disposal to create an offering similar to yours. What would you do if Amazon or Facebook added your product idea as a feature? Incum- bents can also dispatch your efforts in other ways. Venture capitalist Marc Andrees sen gives the example of Silicon Valley: “It’s World War III out here . . . Large tech companies will often move to take over startups with H7303-Entrepreneur.indb 59 H7303-Entrepreneur.indb 59 11/2/17 1:14 PM 11/2/17 1:14 PM 60 Deﬁ ning Your Enterprise no intention of actually buying them, just to screw up their business for 18 months.” Indeed, Columbia Business School professor Rita Gunther McGrath argues that businesses shouldn’t strive for the holy grail of sustainable competitive advantage, because there is no longer any such thing. Rather, she argues, businesses should build themselves to be nimble enough to build and exploit “transient” competitive advantages. Even if your initial strategy is successful and you can scale and exploit it well, you must plan ahead for the day when you’ll need to abandon it for something else. In her formulation, stability isn’t the goal; instead, it’s about deliberate, continu- ous change. If you want your venture to be competitive and proﬁ table, you must have a powerful business model and a sound strategy. Although the market provides the ultimate test for these two important concepts, you should test and verify each of your assumptions before the business is launched.

And remember that many minds are better than one. Explain your busi- ness model and strategy to as many trusted and experienced people as possible. They may spot defects or opportunities for improvement that you have missed.

Summing up ■A business model describes an enterprise’s revenue sources, cost drivers, investment size, and success factors.

■Strategy diﬀ erentiates the enterprise and gives it a competitive advantage.

■According to Michael Porter, strategic positions can be found in variety-based, need-based, or access-based positioning.

■The ﬁ ve steps of strategy formulation are (1) looking outside the enter- prise for threats and opportunities; (2) looking inside at resources, capabilities, and practices; (3) considering strategies for addressing threats and opportunities; (4) building a good ﬁ t among strategy- H7303-Entrepreneur.indb 60 H7303-Entrepreneur.indb 60 11/2/17 1:14 PM 11/2/17 1:14 PM Building Your Business Model and Strategy 61 supporting activities; and (5) creating alignment between the organi- zation’s people and activities and its strategy.

■A startup should be viewed as an experiment. If the experiment fails to produce the desired result, be prepared to change—and to do it quickly. H7303-Entrepreneur.indb 61 H7303-Entrepreneur.indb 61 11/2/17 1:14 PM 11/2/17 1:14 PM H7303-Entrepreneur.indb 62 H7303-Entrepreneur.indb 62 11/2/17 1:14 PM 11/2/17 1:14 PM \b.

Organizing Your Company At the onset of your new venture, you will need to address the legal form your enterprise will adopt. Should it be a sole proprietorship, a partner- ship, a corporation, or a limited-liability company?This decision is driven chieﬂ y by your objectives and those of your in- vestors. But taxation and legal liabilities also play a part. The trade-offs built into the law can make the choice difﬁ cult; to get the most favorable tax treatment, a business must often give up some protection from liabil- ity, some ﬂ exibility, or both. This chapter outlines the choices available to the new enterprise and summarizes the advantages and disadvantages of each.

Sole proprietorships The oldest, simplest, and most common form of business entity is the sole proprietorship, a business owned by a single individual. For tax and legal liability purposes, the owner and the business are one and the same. The proprietorship is not taxed as a separate entity. Instead, the owner reports H7303-Entrepreneur.indb 63 H7303-Entrepreneur.indb 63 11/2/17 1:14 PM 11/2/17 1:14 PM 64 Deﬁ ning Your Enterprise all income and deductible expenses for the business on Schedule C of the personal income tax return. The earnings of the business are taxed at the individual level, whether or not they are actually distributed in cash. In a sole proprietorship, there is no vehicle for sheltering income. And because the individual and the business are one and the same, legal claimants can pursue the personal property of the proprietor and not simply the assets used in the business (see the box “A note about legalities”).

Advantages of a sole proprietorship Perhaps the greatest advantage of this form of business is its simplicity and low cost (see the box “Tips for starting a sole proprietor business”). You are not required to ﬁ le with the government, although some businesses, such as restaurants and child day-care centers, must be licensed by local health or regulatory authorities. Nor is any legal charter required. You can simply begin doing business. The sole proprietorship form of business has other advantages:

• As owner or proprietor, you are in complete control of business decisions.

• The income generated through operations can be directed into your pocket or reinvested as you see ﬁ t.

• Proﬁ ts ﬂ ow directly to your personal tax return; they are not sub- ject to a second level of taxation. In other words, proﬁ ts from the business will not be taxed at the business level. A note about legalities The information given in this chapter is based on US law but should not be considered legal advice. Always consult with an attorney on these matters. Similar structures for businesses exist outside the United States, and readers should consult their local legal and tax sources. H7303-Entrepreneur.indb 64 H7303-Entrepreneur.indb 64 11/2/17 1:14 PM 11/2/17 1:14 PM Organizing Your Company 65 Tips for starting a sole proprietor business You can start a sole proprietorship by simply doing it: you might oﬀ er your services as a consultant, buy and resell merchandise, write a subscription newsletter, and so forth. It’s simple. Here are some useful tips:

• Keep your household and business ﬁ nances separate. You can do that by setting up a separate bank account for your business; run all the business’s checks and receipts through that account.

• Use QuickBooks or other accounting software to keep track of the many business expenses you’ll encounter during the tax year. If you track them under the same categories used in the business expenses section of IRS form Schedule C, it will be simple to item- ize these expenses and deduct them from taxable income. And scan, snap, or save every receipt—most small-business account- ing software allows you to enter receipts straight into your ﬁ les with your phone.

• If you run the business under a name other than your own—for example, Surfside Management Consulting—you may need to ﬁ le a “ﬁ ctitious name” or “doing business as” certiﬁ cate in the city where the business is domiciled. Before you ﬁ le, check that the name you want to use is not already taken by another business.

• Most US states prohibit the use of the words Corporation, Corp., Incorporated, Inc.—and even Company and Co.—after the busi- ness’s name if it is not incorporated. H7303-Entrepreneur.indb 65 H7303-Entrepreneur.indb 65 11/2/17 1:14 PM 11/2/17 1:14 PM 66 Deﬁ ning Your Enterprise • You can dissolve the business as easily and informally as you began it.

These advantages account for the widespread adoption of the sole pro- prietorship in the United States. Any person who wants to set up shop and begin dealing with customers can get right to it, in most cases without the intervention of government bureaucrats or law yers. Disadvantages of a sole proprietorship This legal form of organization, however, has disadvantages:

• The amount of capital available to the business is limited to your personal funds and whatever funds you can borrow. This disad- vantage limits the potential size of the business, no matter how attractive or popular its product or service.

• Sole proprietors have unlimited liability for all debts and legal judgments incurred in the course of business. Thus, a product lia- bility lawsuit by a customer will not be made against your business but rather against you.

• Your business may not attract high-caliber employees whose goals include a share of business ownership. Sharing the beneﬁ ts of own- ership, other than simple proﬁ t-sharing, would require a change in the legal form of the business.

• Some employee beneﬁ ts, such as your life, disability, and medical insurance premiums, may not be deductible—or may be only partly deductible—from your taxable income.

• The entity has a limited life; it exists only as long as you are alive. Upon your death, the assets of the business go to your estate.

• As you will see later in this book, venture capitalists and other out- side investors of equity capital will not participate in a sole propri- etorship business. H7303-Entrepreneur.indb 66 H7303-Entrepreneur.indb 66 11/2/17 1:14 PM 11/2/17 1:14 PM Organizing Your Company 67 General partnerships A partnership is a business entity having two or more owners. In the United States, a partnership is treated as a proprietorship for tax and liability pur- poses. Earnings are distributed according to the partnership agreement and are treated as personal income for tax purposes. Thus, like the sole proprietorship, the partnership is simply a conduit for directing income to its partners, as in this example:

Matthew and Mathilde formed a partnership and started a restau- rant called the Mat Café. By agreement, they split the proﬁ ts of the business equally, the total of which amounted to $140,000 last year. Matthew, who had no other source of earnings last year, reported $70,000 in income on his personal tax return. Mathilde, who earned another $20,000 from a part-time job, had to report $90,000 on her personal income tax return ($70,000 in partner- ship income plus $20,000 from her other job).

Partnerships have a unique liability situation. Each partner is jointly and severally liable. Thus, a damaged party can pursue a single partner or any number of partners—and that claim may or may not be proportional to the invested capital of the partners or the distribution of earnings. This means that if Matthew did something to damage a customer, that cus- tomer could sue both Matthew and Mathilde even though Mathilde played no part in the problem. Organizing a partnership is not as effortless as with a sole proprietor- ship. You and your partner must determine, and should set down in writ- ing, your agreement on a number of issues:

• The amount and nature of your respective capital contributions (e.g., one partner might contribute cash; another partner a patent; and a third, property and cash) • How the business’s proﬁ ts and losses will be allocated H7303-Entrepreneur.indb 67 H7303-Entrepreneur.indb 67 11/2/17 1:14 PM 11/2/17 1:14 PM 68 Deﬁ ning Your Enterprise • Salaries and draws against proﬁ ts • Management responsibilities • The consequences of the withdrawal, retirement, disability, or death of a partner • The means of dissolution and liquidation of the partnership Advantages of a partnership Partnerships have many of the same advantages of the sole proprietorship, along w ith others: • Except for the time and the legal cost of preparing a partnership agreement, it is easy to establish.

• Because there is more than one owner, the entity has more than one pool of capital to tap in ﬁ nancing the business and its operations.

• Proﬁ ts from the business ﬂ ow directly to the partners’ personal tax returns; they are not subject to a second level of taxation.

• The entity can draw on the judgment and management of more than one person. In the best cases, the partners will have comple- mentary skills.

Disadvantages of a partnership As mentioned earlier, partners are jointly and severally liable for the ac- tions of the other partners. Thus, one partner can put other partners at risk without their knowledge or consent. Other disadvantages include the following:

• Proﬁ ts must be shared among the partners.

• With two or more partners being priv y to decisions, decision mak- ing may be slower and more difﬁ cult than in a sole proprietorship.

Disputes can tie the partnership in knots. H7303-Entrepreneur.indb 68 H7303-Entrepreneur.indb 68 11/2/17 1:14 PM 11/2/17 1:14 PM Organizing Your Company 69 • As with a sole proprietorship, the cost of some employee beneﬁ ts may not be deductible from income taxes.

• Depending on the partnership agreement, the partnership may have a limited life. Unless otherwise speciﬁ ed, it will end upon the withdrawal or death of any partner. Limited partnerships The type of partnership entity described thus far is legally referred to as a general partnership. It is what we normally think of when describing a partnership. There is another partnership form, however: the limited part- nership. This hybrid form of organization has both limited and general partners. The general partner (there may be more than one) assumes man- agement responsibility and unlimited liability for the business and must have at least a 1 percent interest in proﬁ ts and losses. The limited partner or partners have no voice in management and are legally liable only for the amount of their capital contribution plus any other debt obligations speciﬁ cally accepted.

The usual motive behind a limited partnership is to bring together in- dividuals who have technical or management expertise (the general part- ners) and well-heeled investors who know little about the business—or who lack the time to participate—but who wish to participate in an opportunity for ﬁ nancial gain.

In a limited partnership, proﬁ ts and losses can be allocated differently among the partners. That is, even if proﬁ ts are allocated 20 percent to the general partner and 80 percent to the limited partners, the limited part- ners may get 99 percent of the losses. (Well-heeled limited partners often favor this arrangement when they can use the partnership’s losses to offset taxable earnings from other sources.) Losses, however, are deductible only up to the amount of capital at risk. The distribution of proﬁ t is subject to all sorts of creative structuring, such as those observed in certain venture- capital and real estate partnerships. In some of those arrangements, the limited partners get 99 percent of the proﬁ t s u nt i l t he y have got t en ba ck a n H7303-Entrepreneur.indb 69 H7303-Entrepreneur.indb 69 11/2/17 1:14 PM 11/2/17 1:14 PM 70 Deﬁ ning Your Enterprise amount equal to their entire capital contributions, at which point the gen- eral partner begins to receive 30 percent and the limited partners’ share drops to 70 percent.

C corporations The C corporation is synonymous with the common notion of a corpora- tion. When a business incorporates, it becomes a C corporation unless it makes a special election to become an S corporation, which is described later in this chapter. Although C corporations are vastly outnumbered by sole proprietorships in the United States, they account for over 60 percent of all US sales. Corporations dominate in this way because they constitute the vast majority of the nation’s major companies.

In the United States, a corporation is an entity chartered by the state and treated as a person under the law. This means that it can sue and be sued, it can be ﬁ ned and taxed by the state, and it can enter into contracts.

The C corporation can have an inﬁ nite number of owners. Ownership is evidenced by shares of company stock. The entity is managed on behalf of shareholders—at least indirectly—by a board of directors. The corporate form is appealing to entrepreneurs for several reasons.

First, in contrast to the sole proprietorship, the C corporation’s owners are personally protected from liability. To appreciate this protection, consider the case of the massive Deepwater Horizon oil spill in the Gulf of Mexico in 2010. Even if the damages against British Petroleum, Halliburton, and Transocean had exceeded the companies’ net worth, the courts could not have pursued the companies’ individual shareholders for further damages.

An individual owner’s liability is limited to the extent of his or her invest- ment in the ﬁ rm. This corporate shell, or veil, can be pierced only in the event of fraud. (Ofﬁ cers, however, can be held personally liable for their actions, such as the failure to withhold and pay corporate taxes.) Another appealing feature is the corporation’s ability to raise capital.

Unlike the sole proprietorship and partnership, both of which rely on a single owner or a few partners for equity capital, a corporation can tap the H7303-Entrepreneur.indb 70 H7303-Entrepreneur.indb 70 11/2/17 1:14 PM 11/2/17 1:14 PM Organizing Your Company 71 capital of a vast number of investors: individuals as well as institutions, such as pension funds and mutual funds. Equity (or ownership) capital is c ont r ibut e d by sha reholder s when t he y pu rcha se st ock i s sue d d i re c t ly f rom the company. In return they receive a fractional ownership share in the assets and future fortunes of the company. A successful and growing com- pany can often raise capital through successive public offerings of its stock.

The corporation can also borrow money.

Advantages of a C corporation The advantages of the C corporation, then, can be summarized as follows:

• Shareholders have limited liability for the corporation’s debts and judgments against it.

• Corporations can raise funds through the sale of stock.

• Corporations can deduct the cost of certain beneﬁ ts they provide to ofﬁ cers and employees.

• Theoretically, a corporation has an unlimited life span.

• Because a corporation can compensate employees with company shares, it is in a better position than proprietorships and partner- ships to attract and retain talent.

• Ownership shares are transferable. Shareholders can sell some or all of their interests in the company (assuming that there’s a mar- ket for them). They can also give their shares to family members or charities.

Disadvantages of a C corporation The C corporation has several clear disadvantages. Perhaps the greatest is the problem of double taxation. The C corporation is taxed on its earnings (proﬁ ts). Whatever is left over after taxes can be distributed to sharehold- ers in the form of dividends or can be retained in the business to ﬁ nance operations or growth. But consider what happens to after-tax dividends H7303-Entrepreneur.indb 71 H7303-Entrepreneur.indb 71 11/2/17 1:14 PM 11/2/17 1:14 PM 72 Deﬁ ning Your Enterprise that are distributed to shareholders. These dividends must be reported by shareholders as taxable dividend income. Thus, earnings are taxed twice:

once at the corporate level and again at the shareholder level.

To understand this double-taxation problem, consider this example:

Amalgamated Hat Rack earned $647,500 before taxes and paid a little more than 46 percent of this ($300,000) in state and fed- eral corporate income taxes, leaving it with $347,500 in after-tax proﬁ t. If the company paid $10,000 of that in the form of a div- idend to Angus McDuff, its founder and CEO, McDuff would be required to add that amount to his personal taxable income, which might be taxed by both the state and the federal government. Thus, the same income is taxed twice. (Note: There is a minor exception to this double-taxation issue for corporations that receive dividend income from other corporations.) Other disadvantages include the following:

• The process of incorporation is often costly. The corporation must create a set of rules for governing the entity, including stockholder meetings, board of directors meetings, the election of ofﬁ cers, and so forth.

• Corporations are monitored by federal, state, and some local agen- cies. Public corporations must publish their results quarterly.

Adopting the corporate form allows you to liquefy your personal eq- uity in the company; paper wealth can be turned into real money. And it is a great way to raise the capital needed for growth. But every share sold dilutes your share of ownership and personal control.

S corporations The S corporation is another creature of US tax law. It is a closely held corporation whose tax status is the same as the partnership’s, but its par- ticipants enjoy the liability protections granted to corporate shareholders. H7303-Entrepreneur.indb 72 H7303-Entrepreneur.indb 72 11/2/17 1:14 PM 11/2/17 1:14 PM Organizing Your Company 73 In other words, it is a conduit for passing proﬁ ts and losses directly to the personal income tax returns of its shareholders, whose legal liabilities are limited to the amount of their capital contributions. In exchange for these favorable treatments, the law places several restrictions on the types of corpora tions that can elect S status. To qualify for S corporation status, an organization must meet the following requirements:

• Have only one class of stock, although differences in voting rights are allowed • Be a domestic corporation, owned wholly by US citizens, and de- rive no more than 80 percent of its revenues from non-US sources • Have thirty-ﬁ ve or fewer stockholders (husbands and wives count as one stockholder) • Derive no more than 25 percent of revenues from passive sources, such as interest, dividends, rents, and royalties • Have only individuals, estates, and certain trusts as shareholders (i.e., no corporations or partnerships) The last provision excludes venture capitalists as potential sharehold- ers because most venture-capitalist ﬁ rms are partnerships.

Limited-liability companies The limited-liability company (LLC) is a hybrid entity designed to afford the same beneﬁ ts in terms of liability protections as those accorded to the S corporation, but with the tax ﬂ ow-through beneﬁ ts of a sole proprietor- ship or partnership. Although state laws differ somewhat, an LLC is like an S corporation but with none of the restrictions on the number or type of participants. Owners are neither proprietors, partners, nor shareholders; instead, they are called members. The LLC is similar to a partnership in that the LLC’s operating agree- ment (the equivalent of a partnership agreement) may distribute proﬁ ts H7303-Entrepreneur.indb 73 H7303-Entrepreneur.indb 73 11/2/17 1:14 PM 11/2/17 1:14 PM 74 Deﬁ ning Your Enterprise and losses in a variety of ways, not necessarily in proportion to capital con- tributions. Law ﬁ rms are often organized as LLCs.

Aside from its taxation and limited-liabilities protections, the LLC is simple to operate. Like a sole proprietorship, for example, there is no stat- utory requirement to keep minutes, hold meetings, or make resolutions— requirements that often trip up corporation owners. The disadvantages of a LLC include some of the same hassles asso- ciated with a partnership. The company will dissolve upon the death of the member (or one of the members), and the members must pay self- employment taxes.

Which form makes sense for you?

As you have no doubt gathered, tax implications are an important fac- tor in the choice of a business entity. Indeed, the incentives of the US tax code give rise to certain tactics that can be risky. For example, the double taxation of a corporation’s distributed earnings provides an incentive for owner-employees to pay all proﬁ ts to themselves as compensation. Unlike dividends, compensation is deductible as an expense to the corporation and thus is not taxed twice. However, the Internal Revenue Service has certain rules on what is considered reasonable compensation; these rules are designed to discourage just such behavior. Note too that the tax on individuals in so-called ﬂ ow-through entities such as partnerships and LLCs is on the income earned and not on the actual cash distributed. The income of the partnership is taxed at the per- sonal level of the partners, whether or not any cash is actually distributed.

Thus, earnings retained in the business to ﬁ nance growth or to create a monetary nest egg are taxed even though they are not distributed to the owners. If your venture is projected to create large losses in the early years, then there may be some beneﬁ t to passing those losses through to inves- tors, assuming that the investors are in a position to use them to offset other income and thus reduce their own taxes. This situation would favor H7303-Entrepreneur.indb 74 H7303-Entrepreneur.indb 74 11/2/17 1:14 PM 11/2/17 1:14 PM Organizing Your Company 75 the partnership or LLC. Similarly, if the business intends to generate sub- stantial cash ﬂ ow and return it to investors as the primary means of cre- ating value for investors, then a partnership or LLC is still attractive. If, however, the business will require cash investment over the long term and if value is intended to be harvested through a sale or public offering, then a C corporation is the most attractive option. Of course, a business may move through many forms in its lifetime.

A sole proprietorship may become a partnership and ﬁ nally a C corpora- tion. A limited partnership may become an LLC and then a C corporation.

Each transition, however, requires considerable legal work and imposes an administrative burden on the management and owners of the ﬁ rm. The advantages of the right form of organization at each stage certainly may warrant these burdens. On the other hand, high-potential ventures on the fast track should avoid losing time and focus by jumping through these hoops. For them, the corporate form is almost always best. As corpora- tions, they can use stock and options to lure an experienced managem ent team and to conserve cash. They can even use stock in lieu of all-cash ar- rangements in paying for consulting services. Also, venture capitalists may not take these businesses seriously if they are not incorporated, because these investors will want a block of ownership. Consequently, if you are an entrepreneur, consider the likely evolution of your business before selecting a particular form of organization, and consult with a qualiﬁ ed tax attorney or accountant before making this im- portant choice.

Summing up Table 4-1 summarizes the types of businesses discussed in this chapter. H7303-Entrepreneur.indb 75 H7303-Entrepreneur.indb 75 11/2/17 1:14 PM 11/2/17 1:14 PM 76 Deﬁ ning Your Enterprise TABLE 4-1 Forms of business Form of business Key beneﬁ ts Key disadvantages Sole proprietorship• Simple to organize and operate • One level of taxation • Full liability of the owner • Cannot raise outside equity capital, thus limiting poten- tial size of the business General partnership • Can bring in additional talent and personal capital • One level of taxation • Full liability of partners • Capital limited to the pockets of the partners and their abil- ity to borrow • Unless addressed through the partnership agreement, busi- ness dissolves with the death or withdrawal of any partner Limited partnership • Limited liability • One level of taxation • Complex to set up C corporation • Theoretically capable of attracting equity capital through share ownership • Preferred form of venture capitalists • Able to deduct many beneﬁ t payments to employees • Shareholders enjoy limited liability • Complex to set up and operate • Income subject to double taxation S corporation • Like a proprietorship and partnership, subject to only one level of taxation • Shareholders enjoy limited liability • Complex to set up and operate • Limited in the number of shareholders • Venture capitalists cannot be shareholders Limited-liability company (LLC) • Simpler to set up and operate than a corporation • Limited liability for members • One level of taxation • Inﬁ nite number of possible members • Cannot attract outside equity capital H7303-Entrepreneur.indb 76 H7303-Entrepreneur.indb 76 11/2/17 1:14 PM 11/2/17 1:14 PM 5.

Writing Your Business Plan A business plan is a document that explains a business opportunity, iden- tiﬁ es the market to be served, and provides details about how the entre- preneur ial organization plans to pursue it. To be ef fective, a good plan also describes the unique qualiﬁ cations that you and your management team bring to the effort. It explains the resources you’ll need and forecasts ﬁ nan- cial results over a reasonable time horizon. For many years, anyone starting a business was encouraged to write a business plan, and most entrepreneurs took that advice. Those who didn’t quickly learned that obtaining outside funding was almost impossible without a business plan. And of course, lenders and investors want to see a logical and coherent plan before putting their money at risk. Who wouldn’t?

But business plans are evolving, and today some observers argue that other tools work better for obtaining funding—and creating a roadmap for your business to follow. H7303-Entrepreneur.indb 77 H7303-Entrepreneur.indb 77 11/2/17 1:14 PM 11/2/17 1:14 PM 78 Deﬁ ning Your Enterprise In this chapter, we’ll discuss the merits of a business plan and explain s ome of t he a lt er n at ive s b e for e we de s c r ib e t he element s t h at go i nt o a go o d plan and the stylistic best practices for creating them. The beneﬁ ts of a business plan Ask most entrepreneurs why they need a good business plan, and they’re likely to tell you, “You can’t get funding without one.” This observation is true, and it explains why many books, advisory services, websites, and even MBA courses have been developed to help people write bulletproof, knock- ’e m - de a d bu s i ne s s pl a n s .

Any business that seeks outside funding from banks, angel investors, venture capitalists—even relatives—must have a solid business plan. With- out it, creditors and investors won’t take you seriously. They will conclude (perhaps correctly) that you haven’t done the thinking necessary to suc- cessfully start and run a business, namely, identifying your customers and ﬁ guring out how you will deal proﬁ tably with them. The most tolerant funders will say, “Come back and see us when you’ve put together a com- plete business plan.” The less tolerant will not give your business a sec- ond look. But seeking funding is not the only reason to develop a solid plan.

There are several other important ones:

• A deep reality check and blueprint: The act of writing a plan will force you and your team to think through all the key elements of your business. Even as your business evolves through experimen- tation, you need to consider and capture your assumptions about value proposition, competitive differentiation, stafﬁ ng, partner- ships, ﬁ nances, and so forth.

• Advice: Exposing the details of your business idea to trusted and experienced outsiders who review your initial plan will help you identify missed opportunities, unsupportable assumptions, overly optimistic projections, and other weaknesses. By ﬁ nding and ﬁ xing H7303-Entrepreneur.indb 78 H7303-Entrepreneur.indb 78 11/2/17 1:14 PM 11/2/17 1:14 PM Writing Your Business Plan 79 these problems on paper, you will improve your prospects with funders and reduce the chance of future operational failure.

• Financial projections that can be used as an initial budget: Actual results that fall short of planned results will prompt you to investigate and take corrective action.

Keep all these uses in mind as you build your plan. How business plans are changing Business plans—traditionally long, text-heav y, and numbers-heav y docu- ments—originally developed from strategic planning in the US military during World War II. They became popular for would-be entrepreneurs in the 1980s, and by the turn of the millennium, there were hotly competitive business-plan contests at top business schools and the most sought-after VC ﬁ rms. The appeal was partly the sense of opportunity and security that come from having a plan: if the plan predicts that your business will make a lot of money, who won’t want to invest? Today, there is a movement in the entrepreneurial community to re- think the role of the business plan. For one reason, the numbers in a busi- ness plan are not a strong predictor of success. “No business plan survives ﬁ rst contact with customers,” warns serial entrepreneur and lean-startup expert Steve Blank. And indeed, no matter how well crafted, a business plan is full of untested assumptions, at least some of them probably inac- curate. Between the entrepreneur’s deliberate padding and honest enthu- siasm, the numbers—especially the detailed month-by-month projections over years into the future—are rarely realistic. Even as early as 1997, Har- vard Business School professor William Sahlman was writing that the best business plans focus not on those numbers but rather on the people and the business model behind them. Those more knowable factors go into deter- mining how a company will achieve its success. To Blank, building a busi- ness plan is still a valuable exercise in thinking through how your business might work, but you shouldn’t mistake it for fact. And serial entrepreneurs H7303-Entrepreneur.indb 79 H7303-Entrepreneur.indb 79 11/2/17 1:14 PM 11/2/17 1:14 PM 80 Deﬁ ning Your Enterprise Evan Baehr and Evan Loomis suggest that there are better tools (the business-model canvas, for example) to help you do this thinking.

Other experts argue against the traditional business plan because a long, dry document is no longer the only way (or the best way) to grab the attention of potential investors. In the tech sector in particular, entrepre- neurs are opting for shorter, less formal, more narrative, and highly visual ways of seeking funding. They use newer formats such as pitch decks and demos. These documents often overtly reﬂ ect the spirit of experimentation and acknowledge that the future of a startup cannot be predicted accu- rately. You will need to determine the right approach for the type of busi- ness you are building. Whatever the length and style of the document that you create—we’ll call it a business plan in this chapter—you’ll want to think through several core elements, including descriptions of the opportunity, the solution, the market, the model, and the team involved. This chapter will describe those key elements, but there are other resources available for building and re- ﬁ ning your plan. You’ll ﬁ nd some in the “Further Reading” section of this book, but business plan coaching and mentoring are also available.

Key elements Many VC ﬁ rms review more than a thousand business plans every year— and fund only a few. This means that they have little time to ﬁ gure out what you’re trying to say. Nor do they have time to deal with people who haven’t given them the information they need. The same is true of banks and angel investors. Assuming that you have a worthy idea, you will im- prove the odds of success if you can grab the reader’s attention and keep it.

To do this, you must address the reader’s concerns in a well-organized way, whatever the format of your plan. And remember that the numbers, while important to think through, are likely to be inaccurate. That’s why you must show your work: the plan must demonstrates your professionalism, expertise, and trustworthiness, and not just your optimism. H7303-Entrepreneur.indb 80 H7303-Entrepreneur.indb 80 11/2/17 1:14 PM 11/2/17 1:14 PM Writing Your Business Plan 81 Figure 5-1 contains a prototype format for a company we will call Lo-Sugar Foods Company, a new manufacturer of unsweetened pack- aged breakfast and snack foods. It aims to capitalize on the popularity of low-sugar diets in North America and Europe. The company’s research estimates that 4.5 million Americans and 1.2 million Europeans are now following low-sugar diets, which US government studies have conﬁ rmed to be effective in weight reduction and weight control and in improving overall health. They see an opportunity to continue growing their business and developing new products. There is nothing sacred about the format shown in the ﬁ gure. In fact, you would be w ise to tailor your plan’s format to the likely interests of your readers, just as you would customize your résumé when you’re looking for a job. Thus, you should follow the ﬁ rst rule of every form of writing: know your audience. The goal is always to give readers the information they need to make a decision. Let’s consider each major section of this document in more detail. Contents and executive summary The contents section (or table of contents) makes it easy for readers to see at a glance what the plan has to offer and how to navigate it.

FIGURE 5-1 Prototype business plan format Lo-Sugar Foods Company ContentsI. Executive summary .......................................................................................................... ............... 2 II. The opportunity ........................................................................................................... .................. 5 III. The company and its oﬀ ering and strategy ........................................................................................ 12 IV. The team .................................................................................................................. .................... 15 V. Marketing plan ............................................................................................................. ................. 18 VI. Operating plan ............................................................................................................ .................. 22 VII. Financial plan ........................................................................................................... .................... 25 Appendix Résumés of management team members ......................................................................................... 30 Supporting market research ........................................................................................................... 32 Sales projections for initial products ................................................................................................ 40 H7303-Entrepreneur.indb 81 H7303-Entrepreneur.indb 81 11/2/17 1:14 PM 11/2/17 1:14 PM 82 Deﬁ ning Your Enterprise The contents should be followed by an executive summar y. In terms of capturing the attention of potential ﬁ nancial backers, the executive sum- mary is the most important part of the entire document, so take the time to get it right. Financial backers and those who might give you advice may never make it fur ther than this—af ter all, they probably have an enormous pile of other proposals v ying for their attention. Assume you have just a minute or two—if that—to convince them to keep reading. In a traditional business plan, the executive summary is a short section of two to three pages. It isn’t a preface or an introduction; instead, it is a snapshot of the entire plan, something that explains your business to an intelligent reader in only a few minutes. Newer approaches include even shorter elevator pitches—a hundred words or even just a sentence—and are often more story-based to speak to the reader’s emotions. In a pitch deck, you’ll want an overview slide that announces what your company is and what problem it solves in a big-picture way. Some entrepreneurs create a separate two-minute video elevator pitch and post it on a private You- Tube channel to make their pitch more easily sharable. Whatever form you choose, you want the pitch to be something memorable that the reader can easily recount to others as well. The opportunity There is no point in starting or expanding a business unless you have iden- tiﬁ ed a lucrative opportunity. Use the opportunity section of the business plan to describe this prospect. First, outline the problem, its scope, and the market trends that may affect how your market experiences this problem in the years ahead, and then introduce the solution you are proposing. You need to help readers see and appreciate the business opportunity you have identiﬁ ed. So describe the opportunity in clear and compelling terms.

For the Lo-Sugar Foods Company, for example, you would use this section to describe the latest ﬁ gures about rampant obesity in the United States and signs of the same in Western Europe—and how obesity is af- fecting people’s health, their quality of life, and the costs of care for indi- viduals, companies, and governments. You would point to research you’ve found estimating that twenty-nine million Americans and eight million H7303-Entrepreneur.indb 82 H7303-Entrepreneur.indb 82 11/2/17 1:14 PM 11/2/17 1:14 PM Writing Your Business Plan 83 Europeans are now following low-sugar diets, and you would cite indepen- dent scientiﬁ c studies that conﬁ rm the effectiveness of low-sugar diets. You could also provide an overview of consumer spending on health foods and weight-control foods. Also use the opportunity section of your business plan to highlight the economics underlying the problem and the factors that will drive your solution’s success, such as market penetration and product innovation. But don’t get carried away. Keep it brief, focused, and upbeat. This is also a suitable place to cite the magnitude of the funding you are seeking and to explain how it will be used in pursuing the opportunity.

For example, the Lo-Sugar plan might include something like this:

Lo-Sugar is seeking $2.75 million in funding to pursue this opportunity. The bulk of those funds will be used to exploit the com pany’s current success and the growing interest of another company (a national vendor of high-protein/low-carbohydrate foods) in Lo-Sugar’s existing products.

Although it is important to document the opportunity with objective data, don’t turn this section into a boring data dump. Don’t bury your compelling story under a mountain of facts. Instead, summarize the data, and explain its implications for investors. Put any additional detail into an appendix.

The company and its oﬀ ering and strategy Use this section of your business plan to expand on your proposed solution to the problem you have identiﬁ ed: the product or service itself as well as your company and how it is organized. Include any data you have on your solution’s traction in the market thus far. Here is an example:

Lo-Sugar is a Colorado-based corporation founded in 2018 with the goal of serving individuals following a low-sugar diet. Its experienced management team has developed and test- marketed several products with low natural and added sugars, primarily breakfast and snack foods. These products are not merely low in H7303-Entrepreneur.indb 83 H7303-Entrepreneur.indb 83 11/2/17 1:14 PM 11/2/17 1:14 PM 84 Deﬁ ning Your Enterprise sugar; tests have conﬁ rmed that they are also tasty and satisfy- ing—qualities that differentiate them from other similar offerings.

The products are as follows:

• Mellow Mornings, a whole wheat and barley breakfast cereal with 90 percent less sugar than leading conventional breakfast cereals. Mellow Morning meets the speciﬁ cations of the leading low-sugar advocates.

• Crackle Brackle, a crisped, steel-cut oatmeal product for break- fast and for baking. Like Mellow Morning, Crackle Brackle meets the speciﬁ cations of leading low-sugar diets.

• Yesgurt, the company’s dairy offering. It too meets low-sugar diet requirements while being ﬂ avorful and smooth.

Each of these products was well received in market tests [here the business plan would refer the reader to the plan’s appendix for details] and is currently being sold through two regional health food stores: Nutrimarket Stores and Vitamins & Veggies. Other products are in development. Goals Investors will want to know how you plan to grow, so include a section on your goals for the company. If there is a chance that the company will be- come a tempting acquisition target for a larger, less innovative competitor, mention this possibility. Here is an example:

Lo-Sugar has three goals:

1. To broaden its product line.

2. To expand market penetration through stores and through a private labeling agreement with one of the major diet companies (currently in negotiations).

3. To expand the business to where it either becomes a dominant player in the healthy-food niche or is acquired by one of the H7303-Entrepreneur.indb 84 H7303-Entrepreneur.indb 84 11/2/17 1:14 PM 11/2/17 1:14 PM Writing Your Business Plan 85 giants in the packaged-food industry. In this industry, small companies with one or two successful products are often bought out at premium prices.

If your company’s products are not yet market-ready, you should describe your plans for product rollouts. Include snapshots of any via- ble prototypes you’ve created, as well as an artist’s rendering of the ﬁ nal physical product. If your products are market-ready, include high-quality photos. Business model and strategy In a separate section, discuss the company’s business model and strategy.

A business model is about how you plan to make money; strategy is about differentiation and competitive advantage. What are your costs? Where will your revenue come from?

Explain what is different about your company’s approach to the mar- ketplace and how that difference will give the company a sustainable competitive advantage. Differentiation may reside in the product or ser- vice—for example, a technically superior way of servicing electric cars to provide greater value to customers. On the other hand, differentiation may come from your approach to customers, as in Uber’s model of a platform that connects drivers and passengers, bypassing traditional taxicabs. (The box “Intellectual property” discusses the importance of protecting your in- novative ideas.) What makes your product or service, or means of delivery, different— and more desirable—in the eyes of customers? How will that difference translate into a competitive advantage that will produce proﬁ ts and grow- ing equity value? Investors want clear answers to these questions. Spell them out here. Also describe your competitors. In addition to explaining why cus- tomers will choose your product or service instead, show that you clearly understand how your industr y operates. A lso consider how your competi- t or s may rea c t t o your suc c e ss—what happens if t hey c opy your be st- sel ling product? How will you maintain your customers’ loyalty? H7303-Entrepreneur.indb 85 H7303-Entrepreneur.indb 85 11/2/17 1:14 PM 11/2/17 1:14 PM 86 Deﬁ ning Your Enterprise Ownership The company section of a business plan is also a ﬁ tting location for owner- ship information:

• Who are the current owners, and what percentages do they control?

• How is ownership evidenced—for example, in terms of common and preferred stock?

• Have you issued any options, warrants, or convertible bonds that could expand ownership?

• Which owners are involved in the day-to-day workings of the business?

The team A description of your team is one of the most important parts of your plan.

Investors are keen to know about the people behind the business—the Intellectual property Is your competitive advantage based on a proprietary technology or process? Is the technology or process patented or patentable? Does the company own patents, copyrights, or valuable trademarks? If it does, when will they expire? Many businesses are formed around one or another piece of intel- lectual property. Some of these key assets aﬀ ect competitive advantage over time. Readers of your plan will want to know what steps you’ve taken to protect that property and to keep technical and market know- how within the organization, where it will produce revenues and proﬁ ts for investors. This might mean legal protections like patents—or other strategic forms of defense like ﬁ rst-mover advantage (being ﬁ rst to scale in a market) or creating a business model that is diﬃ cult to replicate. H7303-Entrepreneur.indb 86 H7303-Entrepreneur.indb 86 11/2/17 1:14 PM 11/2/17 1:14 PM Writing Your Business Plan 87 indi vid uals they see as its core assets. “Without the right team,” Sahlman writes of business plans, “none of the other parts really matter.” Without giving lengthy biographies of each team member, highlight the experiences or qualiﬁ cations the key team members bring to the enterprise. Why are they (and you) the right individuals to accomplish the mission? (See the box “Questions about your team every business plan should answer.”) Beyond its current members, how do you anticipate the team will need to grow? What capabilities will you need to achieve your strategy? Here’s how Lo-Sugar’s business plan describes its people:

Our leadership team is made up of Joanne Galloway, Philip Lind- strom, Gunther Schwartz, and Carlos Talavera. Together, they bring exceptional technical expertise and business experience to our company.

• Joanne Galloway has ﬁ fteen years of product and general management experience with packaged-food companies, most recently with Gigantic Foods Corporation.

• Philip Lindstrom has a PhD in nutrition. He joined the com- pany in 2016 after working for ten years in product develop- ment for Behemoth Foods.

• Gunther Schwartz, the team’s manufacturing expert, has been in the processed-foods business for twelve years with both Behemoth Foods and Food Science Laboratories, a food-research consulting organization. Among Mr. Schwartz’s accomplish- ments is the extrusion process used to manufacture Snacka- rinos and Caloritos, two highly successful packaged-snack brands owned by Behemoth Foods.

• Carlos Talavera left his position as vice president of marketing at Healthtone, a leading packaged-foods company, to join Gallo- way and Lindstrom in founding Lo-Sugar.

[Here, the business plan mentions that complete résumés can be found in the business plan’s appendix.] H7303-Entrepreneur.indb 87 H7303-Entrepreneur.indb 87 11/2/17 1:14 PM 11/2/17 1:14 PM 88 Deﬁ ning Your Enterprise Questions about your team every business plan should answer • Where are the founders and other key team members from?

• Where did they go to school?

• Where have they worked—and for whom? What are their current roles?

• What have they accomplished—professionally and personally— in the past?

• What is their reputation within the business community?

• What aspects of their experience are directly relevant to the oppor tun ity they are pursuing?

• What skills, abilities, and knowledge do they have?

• How realistic are they about the venture’s chances for success and the tribulations it will face?

• Who else needs to be on the team?

• Are they prepared to recruit high-quality people?

• How will they respond to adversity?

• Do they have the mettle to make the inevitable hard choices?

• How committed are they to this venture?

• What are their motivations? Source: Adapted from William A. Sahlman, “How to Write a Great Business Plan,” Harvard Business Review , July–August 1997.

A table indicating your key team members’ names, titles, and salaries is also useful, as in table 5-1. Most plans use an org chart to indicate the report ing relationships between employees if the connections aren’t straightforward. H7303-Entrepreneur.indb 88 H7303-Entrepreneur.indb 88 11/2/17 1:14 PM 11/2/17 1:14 PM Writing Your Business Plan 89 Assuming that your company is a corporation, the team section of the plan is also an appropriate place to identify the board of directors (see the box “The board of directors”). You should indicate the names of board members, their positions on the board, their professional backgrounds, and their history of involvement with the company. Marketing plan If t he t e a m se c t ion of you r bu si ne s s pla n ge t s t he mo s t at t ent ion f r om r e a d- ers, the marketing plan runs a close second. Investors know that marketing is the activ ity most associated w ith success or failure. A ll ventures need an attractive product or service, but a company will fail if its potential cus- tomers never hear of it. A sound and realistic marketing plan is the best as- surance that your company will have a solid connection with its customers.

Be clear about all aspects of marketing, including the following:

• Who your customers or your primary market is—the type of cus-tomer you have to reach to capture your full market potential • Market size, namely, the number of potential customers and your projected potential sales revenues • The requirements of various customer segments—for example, the importance of purchase convenience, rapid delivery, product cus- tomization, and so on • Ways to effectively access each segment through, for example, dis- tributors, e-commerce, and a captive sales force TABLE \b-1 Lo-Sugar key team members Team member Position Salar y Joanne GallowayCEO $100,000 Philip Lindstrom VP Product Development 95,000 Gunther Schwartz VP Manufacturing 95,000 Carlos Talavera VP Sales & Marketing 95,000 Diane Johnson Financial consultant Day rate Mikhail Wolfe Administrative assistant 50,000 H7303-Entrepreneur.indb 89 H7303-Entrepreneur.indb 89 11/2/17 1:14 PM 11/2/17 1:14 PM 90 Deﬁ ning Your Enterprise The board of directors Every corporation must, by law, have a board of directors. But it’s not just an empty legal requirement—a good board can be an invaluable sounding board for ideas and a source of sage advice.

Put some of your best eﬀ orts into recruiting board members. You want people who have abundant business experience and, if technology is essential to the business, considerable scientiﬁ c or engineering know- how. Board members should also be respected in the broader business community. Their capabilities and integrity will speak volumes to who- ever reads your business plan, ﬁ nanciers in particular.

• Appropriate sales and promotion approaches—social media cam- paigns, a creative content marketing strategy, a freemium model, direct email • An analysis of how your customer makes purchase decisions • Customer price sensitivity • Acquisition cost per customer, and the cost of retaining customers • The strengths and weaknesses of competitors and how they are likely to react when the company enters the market To make your plan credible, you should support these issues with solid market intelligence. Summarize the supporting intelligence here, and refer readers to whatever market research you’ve provided in the business plan’s appendix. Operating plan Whether you’re in the business of manufacturing or distributing physical products or running a website, an app, or a platform business, you face H7303-Entrepreneur.indb 90 H7303-Entrepreneur.indb 90 11/2/17 1:14 PM 11/2/17 1:14 PM Writing Your Business Plan 91 a host of operational issues. What supplier relationships do you have or envision? How much inventory will be required? Which day-to-day oper- ating tasks will be handled internally, and which will be outsourced? An operating plan considers the many details of converting inputs to outputs that customers value.

Financial plan If a company is already operating, it will have (or should have) a set of ﬁ - nancial statements: a balance sheet, an income statement, and a cash-ﬂ ow statement. I n a nutshell, the balance sheet describes what the company owns—its assets—and how those assets have been ﬁ nanced (through liabil- ities and the funds of the current owners) as of a particular date. The income statement reveals the company’s revenues, what it spent to gain those revenues, and the interest and taxes it paid over a speciﬁ ed period. Finally, the cash-ﬂ ow statement tells readers the sources and uses of cash during the same period. Together, these three ﬁ nancial statements reveal much to the trained eye of potential investors. (Note: If you are not familiar with these statements, see appendix A for an explanation of the basics.) Generally it’s best to place the full ﬁ nancial statements in the appen- dix to your business plan. Use this space for key data from those state- ments—data that will give readers the big picture of your business and its intended future. Key among this data are your sales and expense projec- tions, described earlier in this book as a pro forma income statement. For a company such as Lo-Sugar, lenders and investors will be interested in a breakout of key items in the statement, such as the anticipated revenues from various channels of distribution, as shown in table 5-2. Here we see anticipated sales and sales growth by channel and the percentage of sales represented by each. Consider doing the same for key categories of operat- ing expenses, such as marketing costs (see table 5-3). Naturally, sales projections and other items in these pro forma state- ments are based on assumptions. Experienced investors are keenly aware of these limitations and will want to know what those assumptions are and why you made them. Make that part of your discussion. H7303-Entrepreneur.indb 91 H7303-Entrepreneur.indb 91 11/2/17 1:14 PM 11/2/17 1:14 PM 92 Deﬁ ning Your Enterprise TABLE \b-2 Forecasted revenues by distribution channel (percentage of sales) H7303-Entrepreneur.indb 92 H7303-Entrepreneur.indb 92 11/2/17 1:14 PM 11/2/17 1:14 PM Writing Your Business Plan 93 reason that a drawing should have no unnecessary lines and a machine no unnecessary parts. This requires not that the writer make all his sentences short, or that he avoid all detail and treat his subjects only in outline, but that every word tells.

This quote from Strunk and White is itself a perfect model of their rule. They use no unnecessary words; every word makes a contribution.

Economy of words has two big beneﬁ ts for the business plan writer: your key messages will stand out, and conciseness saves your reader’s valuable time in a world that pulls our attention in every direction and in which our attention spans get shorter and shorter. This is even more true if you are writing your plan in a pitch deck for- mat. See the box “Pitch deck style” for more on how to tailor your deck’s style to your audience. Use simple sentences The sentence, the basic unit of written expression, usually makes a state- ment. The statement can be simple or complex. Consider the following two sentences:

1. On the one hand, we witness rising levels of obesity among children and adults, both in North America and in Western Europe, which in turn have increased the popularity of low-sugar diets, which in turn have created a business opportunity for Lo-Sugar Company and other makers of low-sugar foods.

2. The growing popularity of low-sugar diets has created a business opportunity for makers of low-sugar foods.

The second sentence, unlike the ﬁ rst, is spare and to the point. It’s more likely to register with readers. It does not contain all the information found in the ﬁ rst. If that infor mation is impor tant , it should be prov ided in a separate sentence. Packing more information into each sentence is not necessarily bad; nor does it necessarily violate rules of grammar. However, complex H7303-Entrepreneur.indb 93 H7303-Entrepreneur.indb 93 11/2/17 1:14 PM 11/2/17 1:14 PM 94 Deﬁ ning Your Enterprise Pitch deck style In their book Get Backed, Evan Baehr and Evan Loomis describe the writ- ing style and design of two kinds of pitch decks: presentation decks and reading decks.

WRITING STYLE FOR PRESENTATION DECKS A deck used as a visual aid during a presentation should have very few words—no more than one sentence per slide. Nor do presentation decks need to have complete sentences. Often, one word or a short phrase is enough to introduce the idea that you will carry forward. If you have al- ready completed your reading deck, try deleting every word in it except for the headers, and see if the words give enough context to still convey what the slide is about.

WRITING STYLE FOR READING DECKS With decks you plan to send to others to read, the slides have to do a lot of work to communicate everything you would have said in person. The printed words have to catch their attention quickly, clearly communicate the basic point you want to put forth, back that point up with evidence, and then move on. Watch out for sentences that sound impressive but mean nothing. “We plan to pursue an eﬀ ective marketing strategy” is a waste of time to read. If you create a slide for your marketing strategy, put the words “Marketing Strategy” in the corner, and then write out your s trateg y in a sentence of ﬁ f teen or fewer words. If your s trateg y ha s multiple phases, create headings that describe each phase, and then add short, straightforward explanations after those headings. Reading decks should also be “scanning” decks. If the reader only has ﬁ fteen seconds to look through the whole thing, he or she should still be able to get a pretty good idea of what it is about.

Source : Adapted from Evan Baehr and Evan Loomis, Get Backed: Craft Your Story, Build the Perfect Pitch Deck, Launch the Venture of Your Dreams (Boston: Harvard Business Review Press, 2015), 66. H7303-Entrepreneur.indb 94 H7303-Entrepreneur.indb 94 11/2/17 1:14 PM 11/2/17 1:14 PM Writing Your Business Plan 95 sentences make the reader work harder and may create confusion. As a writer, your challenge is to know when a sentence has reached its optimal carrying capacity.

Use design elements to lighten the reader’s load Readers of your business plan are busy people who have learned to skim; they drill down only to relevant details. You can facilitate their skimming through the use of design elements. These elements include headings, sub- heads, lists, and graphics. Even white space can be used as a design ele- ment. All are useful in long documents. Used judiciously, design elements have a few beneﬁ ts:

• They make your written documents more inviting to the reader.

• They improve reader comprehension.

• They help speed the reader through your material.

Use headings and subheads Headings and subheads signal that a new or related topic is about to begin.

They give your work greater eye appeal and “skimmability.” You can also use headings and subheads to impart key ideas. For example, our heading “Use headings and subheads” is also a key idea. A time-constrained reader can gather the key points of any section in your business plan by simply reading these headings and subheads.

Break up long blocks of text Long, uninterrupted blocks of text are off-putting to readers and are dif- ﬁ cult to skim. Headings and subheads can help you break those blocks into identiﬁ able small bites. So can short paragraphs. Some experts recom- mend that paragraphs average no more than two hundred words. Lists are another effective way to break up long, intimidating blocks of text and to increase the impact. You can use lists to summarize key points or to get your ideas across quickly. If you are describing something in which sequence is important, use a numbered list, as in the following example: H7303-Entrepreneur.indb 95 H7303-Entrepreneur.indb 95 11/2/17 1:14 PM 11/2/17 1:14 PM 96 Deﬁ ning Your Enterprise Our study of the market for low-sugar foods uncovered four steps that those wishing to lose weight typically follow:

1. Eat less.

2. Exercise more.

3. Try speciﬁ c (and often short-lived) diet programs like Atkins or We ight Wa tc h e rs .

4. Home in on a speciﬁ c diet, such as a low-sugar diet, to adopt for the long term.

Notice how the list breaks up the page and gets conclusions across in a way that they cannot be missed. A bulleted list can also break up a long paragraph, and it need not be limited to a sequence. For example, you might use a bulleted list when you:

• Need to organize a list of items • Need to list parts of a whole • Want to call out three key ideas But don’t translate all your ideas into long, complex bullets, either.

Such lists just become additional big blocks of text. Let graphics tell part of the story Business plans inevitably contain lots of numerical data. When it comes to transmitting data quickly, simple charts are hard to beat—especially if you are presenting your business plan in the form of a pitch deck. Readers can see at a glance what they would otherwise have to extract from many lines of text and numbers. Which of the following two examples would make a more memorable, sharable impression?

Te x t - o n l y e x a m p l e :

Our survey found that 2 percent of the people who come downtown in a typical day do so by bicycle. Some 9 percent arrive by public H7303-Entrepreneur.indb 96 H7303-Entrepreneur.indb 96 11/2/17 1:14 PM 11/2/17 1:14 PM Writing Your Business Plan 97 transportation. Thirty-ﬁ ve percent respond that they walk to the downtown, while the largest single group—54 percent—arrive by car.

Text and graphics example (ﬁ gure 5-2):

According to our survey, people arrive downtown by various means, mostly by car.

To create effective visuals, says Scott Berinato, Harvard Business Review editor and author of Good Charts , you should ﬁ rst consider the point you want the chart to make before you click “insert chart” in Excel or Google Sheets. Experiment with different formats by ﬁ rst sketching by hand to see which of these formats makes your point most clearly—a pie chart, a bar chart, a tree map? What data do you really need to include? Keep the text in the graphic minimal, and don’t try to cram in too much information—each chart should convey a single message. You want readers to get your point at a glance. For example, in ﬁ gure 5-3 the ﬁ rst chart is ac- curate and attractive, but the point is unclear. If you’re trying to show that growth in national health spending is falling, don’t get distracted by other data that you have, like gross domestic product, or in detailed data labels.

The second chart is much more effective at getting the message across. Public transport 9% Bike 2% Walk 35% Car 54% FIGURE 5-2 How people get downtown H7303-Entrepreneur.indb 97 H7303-Entrepreneur.indb 97 11/2/17 1:14 PM 11/2/17 1:14 PM 98 Deﬁ ning Your Enterprise Similarly, don’t get carried away with design elements. Microsoft Word and PowerPoint give you an arsenal of design features: boldface, italics, fonts, color palettes, 3-D effects, clip art, animations, and so forth. Used judiciously, these add to the appearance and readability of your text. Over- use them, however, and you will create the opposite effect—they’ll be a dis- traction and they’ll make your work appear amateurish. So keep it simple. Consider your reader As you develop your business plan, always keep the interests of your readers in mind. Put yourself in their place. Your audience is looking for convincing evidence that you have found a real business opportunity—one with sub- stantial growth possibilities. Considering the risks they will be taking with their money, they want to see major upside potential.

Your readers will also be looking for clear indications that you have done your homework—that you understand the market, have targeted the right customers, and have developed a sound strategy for proﬁ tably trans- acting business with them. Prospective investors want assurance that you and the management team have the knowledge, experience, and drive to turn an opportunity into a proﬁ table business. And what is important to FIGURE 5-3 Persuasive charts The chart on the right makes a much clearer, easier-to-digest point.

Source: Scott Berinato, “Visualizations That Really Work,” Harvard Business Review, June 2016. 2003 2005 2007 2009 20112013 +10% 8.6% 3.6% 8 64 2 +\b4%+12% +10% +8% +6% +4% +2% 0% -2% -4% -6% 1990 1995 2000 2005 2010 2015 ANNUAL GROWTH IN HEALTH CARE SPENDINGAnnual Growth is Declining National Health Spending GDP PERCENTAGE CHANGE OVER PREVIOUS YEAR Change in Health Spending and GDP VS H7303-Entrepreneur.indb 98 H7303-Entrepreneur.indb 98 11/2/17 1:14 PM 11/2/17 1:14 PM Writing Your Business Plan 99 potential lenders and investors should be just as important to you. So as you write your plan, stop periodically and ask yourself, Is this a real oppor- tunity? Do I understand the market and the customers I hope to attract?

Can we really make this thing work?

Finally, tell your readers how they will get their money out of the com- pany. Investors want an exit strategy: a buyout by management, an acqui- sition by another company, an IPO of shares, and so on. Even if you plan to be in the business for the long haul, your investors want liquidity at some point—and the sooner the better.

Summing up ■When creating a business plan, choose a format that makes sense for your audience, your business, and the industry.

■Whatever format you choose, your business plan should tell readers in a persuasive way everything they need to know to make a decision.

■Obtaining outside funding is only one reason to write a business plan.

Perhaps just as important, the act of writing a plan will force you to think through all the key elements of the business.

■The executive summary should, in compelling terms, explain the opportu- nity, why it is timely, and how your company plans to pursue it. The sum- mary should also describe your expected results and provide a thumbnail sketch of the company and the management team.

■Among other things, the business plan should state the company’s goals and explain how investors will eventually cash out.

■Pay attention to style. Use as few words as necessary to get your points across. Avoid long, complex sentences whenever possible.

■Make your document easy to skim by using simple data visualizations, headings, subheads, white space, and numbered and bulleted lists to break up blocks of text. H7303-Entrepreneur.indb 99 H7303-Entrepreneur.indb 99 11/2/17 1:14 PM 11/2/17 1:14 PM H7303-Entrepreneur.indb 100 H7303-Entrepreneur.indb 100 11/2/17 1:14 PM 11/2/17 1:14 PM PART THREE Financing Your Bu sine s s H7303-Entrepreneur.indb 101 H7303-Entrepreneur.indb 101 11/2/17 1:14 PM 11/2/17 1:14 PM H7303-Entrepreneur.indb 102 H7303-Entrepreneur.indb 102 11/2/17 1:14 PM 11/2/17 1:14 PM 6.

Startup-Stage Financing Money greases the wheels of enterprise. Without it, even the best- conceived business plan would remain nothing more than a document.Financing is an essential ingredient of enterprise at every size—from the corner bookstore to Amazon. It is also needed at every stage of business development: at the launch and again when the startup forges through var- ious levels of growth. Even a mature business with annual sales in billions of dollars needs continued ﬁ nancing to stay on the cutting edge of its ﬁ eld.

This chapter describes the typical phases of the business life cycle, from startup to maturity. It then focuses on the ﬁ rst phase, describing the ﬁ nancing requirements that early-stage businesses typically encounter and providing an overview of the sources you can turn to in securing funding.

Types of business and their life cycles Of course, not every business is the same, and businesses’ life cycles and ﬁ - nancing needs vary accordingly. Harvard Business School’s Karen Gordon H7303-Entrepreneur.indb 103 H7303-Entrepreneur.indb 103 11/2/17 1:14 PM 11/2/17 1:14 PM 104 Financing Your Business Mills (former administrator of the SBA) and Fundera Inc.’s Brayden Mc- Carthy have conducted research on the state of small business and ﬁ nanc- ing; unless otherwise noted, the numbers in this section describing the distribution and types of US businesses come from their working paper on this topic. The majority—roughly 70 percent—of small-employer businesses in the United States are what Mills and McCarty call Main Street ﬁ rms: the dry cleaners, mechanics, medical clinics, and similar companies that play an important role in local communities. Often, these companies aim to serve the personal or family income needs of the owner, and once these businesses are established, they are more focused on sustaining this in- come than they are interested in growing it. This type of business has a startup phase, followed perhaps by a pe- riod of gradual growth, followed by a no-growth or slow-growth phase of maturity. The owner requires startup ﬁ nancing to purchase or lease equip- ment, rent a workplace, establish an inventory and ﬁ xtures, and provide working capital. In some cases, the entrepreneur is simply purchasing an existing business from someone else. (This approach to entrepreneurship is described in the HBR Guide to Buying a Small Business .) Roughly 17 percent of small multi-employee businesses in the United States are supply-chain ﬁ rms. These niche enterprises serve a focused need in a particular industry, geographical area, or area of an existing supply chain. Supply-chain ﬁ rms are particularly important to the economy: they provide job and wage growth, innovation, and important support for larger ﬁ r ms. Some 37 percent of US employ ment ca n be at tr ibuted to these ﬁ rms, and 80 percent of US patents in 2013. After the startup phase, these busi- nesses continue to focus on growth. Just 3 percent of small multi-employee ﬁ rms in the United States qualify as high-growth. These companies are most likely to be found in high-tech sectors and have a disproportionate contribution to job creation and to the US economy generally. The little company started by Steve Jobs and Steve Wozniak in Jobs’s garage is one of these high-growth companies; its Apple II launched the era of the personal computer and propelled the H7303-Entrepreneur.indb 104 H7303-Entrepreneur.indb 104 11/2/17 1:14 PM 11/2/17 1:14 PM Startup-Stage Financing 105 little company to big-company status, where it holds court as the ﬁ rm with the highest market capitalization today. Facebook, Amazon, Airbnb, and Uber also began small but grew very rapidly from their inception. For these companies, too (and for everything in between), there is a startup phase, a period of growth, and a mature phase. What varies is the scale of the growth and the length of the growth period. Rapidly grow- ing companies typically require more successive phases of ﬁ nancing at ever-higher levels. Remarkably few entrepreneurial companies make it through all three phases. Many enterprises fail within a few years. Still others succeed and are acquired by larger corporations before they reach their full potential.

Startup-phase ﬁ nancing For the startup phase (the earliest phase of the business life cycle), the ini- tial ﬁ nancing typically comes from personal sources:

• Personal savings • A second mortgage on the founder’s home • Credit card lines of credit Many people refer to these sources as bootstrap ﬁ nancing because all the sources rely on the entrepreneur’s own resources, and there is no big money involved. In this stage, you might also begin to seek some early outside, or seed, investment:

• Loans from friends and relatives • Bank debt from small banks and online lenders (particularly impor tant to Main Street ﬁ rms) • Short-term trade credit from suppliers • Crowdfunding • Equity investment from an accelerator program H7303-Entrepreneur.indb 105 H7303-Entrepreneur.indb 105 11/2/17 1:14 PM 11/2/17 1:14 PM 106 Financing Your Business If the founder and the management team have strong reputations in the business or scientiﬁ c community, they may attract capital from angel investors, private equity, or even a VC ﬁ rm or hedge fund. This is especially true if the founding team has enjoyed past entrepreneurial success. Finan- ciers love people with a demonstrated Midas touch, and they pursue such people actively. In these cases, the company may attract investors long be- fore it has a marketable product or service and certainly before it enters the grow th phase. This early-stage equity investment has become increasingly common in the past few years as access to ﬁ nancing has decentralized.

Venture capital used to be an exclusive club of formal ﬁ rms, but now an- gels, accelerators, and crowdsourcing offer a broader array of options even for early-stage entrepreneurs looking for equity capital. But selling equity has its downsides—you are selling away pieces of ownership of your venture. You’re giving up some control and some poten- tial proﬁ ts. But if you have to generate funds quickly, equity capital may be worth the trade-offs. And early-stage equity investment is still rare. According to the Kauff- man Foundation, 40 percent of initial startup capital, even for fast- growing companies, is instead debt that originates from banks, with an almost equal amount of owner equity. Figure 6-1 shows the different sources of ﬁ nancing for Inc. magazine’s ﬁ ve thousand fastest-growing companies in America in 2014. To better understand this phase of ﬁ nancing, consider the case of a ﬁ ctitious company that we read about earlier . When Angus McDuff started a woodworking business, he was well prepared for self-employment. He had been a supervisor at a small shop that made wooden lamps, and he knew all about shaping and ﬁ tting lumber into commercial products. He knew the material suppliers on a ﬁ rst-name basis, and he was often in contact with wholesale and retail distributors of his company’s ﬁ nished products. He had also gotten to know many of the lamp shop’s end customers over the years. McDuff used the ﬁ nal year of his employment productively. In his spare time, he designed a small line of wooden hat racks, used his expe- rience in the lamp business to calculate his production costs, and learned H7303-Entrepreneur.indb 106 H7303-Entrepreneur.indb 106 11/2/17 1:14 PM 11/2/17 1:14 PM Startup-Stage Financing 107 a great deal about the channels of distribution through which he’d sell his new products.

Starting the venture, however, required more than knowledge: he also needed ﬁ nancial and production assets. McDuff calculated that he would need enough cash—say, $8,000—to tide him over during a three-month startup period in which his costs were likely to outstrip his revenues. He’d also need an inventory of lumber, hardware ﬁ xtures, and other materials, which would cost him roughly $7,500. Those items of material inventory would be transformed into ﬁ nished-goods inventory over time.

He would also have to pay for an annual property and liability insur- ance policy and the ﬁ rst three months of rent on a small workshop. He calculated that he’d need $6,500 for these assets (table 6-1). \f0% 70% 60% 50% \b0% 30% 20% 10% 67.2% 13.6% 51.\f% 34.0% 20.9% 11.9% 7.7 % 7. 5 % 6.5% 3.8% 0 Have not used ﬁnance Personal savings Bank loans Credit card Family Business acquaintances Angel investorsClose friends Venture capitalists Government grants FIGURE 6-1 Sources of funding for Inc. magazine’s ﬁ ve thousand fastest-growing US companies in 2014 Source: “How Entrepreneurs Access Capital and Get Funded,” Entrepreneurship Policy Digest , Kauﬀ man Foundation, June 2, 2015. H7303-Entrepreneur.indb 107 H7303-Entrepreneur.indb 107 11/2/17 1:14 PM 11/2/17 1:14 PM 108 Financing Your Business TAB LE 6-1 Current asset requirements Cash$8,000 Inventory Lumber 4,000 Hardware 2,500 Other 1,000 Total inventory 7,500 Prepaid expenses Insurance (1 year) 1,500 Rent (3 months) 5,000 Total prepaid expenses 6,500 Total current assets 22,000 McDuff ’s business, which he decided to call Amalgamated Hat Rack Company, also needed some ﬁ xed assets: a wood lathe, a few power and hand tools, workbenches for the shop, and a panel truck for picking up ma- terials and making customer deliveries. Fortunately, McDuff ’s employer offered to sell him an old panel truck and many of the required tools, two used wood lathes, and several surplus workbenches for a total price of $10,000. With these purchases, McDuff completed the ﬁ xed-asset section of his balance sheet (table 6-2). When the ﬁ xed assets were added to his current asset requirements, he ﬁ gured that he’d need assets totaling $32,000 to launch his venture. So how was he going to ﬁ nance these startup costs? Fortunately, Mc- Duff and his wife, Alice, had $25,000 available in a savings account. Alice’s uncle offered to contribute $5,000 in the form of a zero-interest loan. “You can pay me back at a thousand per year,” he told them. “And good luck with the business.” Angus also knew that a number of his customers from the lamp busi- ness wore hats and were enthusiastic about his work, so he launched an Indie gogo crowdfunding page with pictures of several hat racks he had made and posted it to his Facebook page. As news of his new business H7303-Entrepreneur.indb 108 H7303-Entrepreneur.indb 108 11/2/17 1:14 PM 11/2/17 1:14 PM Startup-Stage Financing 109 spread, he raised another $2,000—and, as a bonus, he started getting feedback on the kinds of hat racks people really wanted.

This gave him $32,000. He was ﬁ nally ready to step away from his role at the lamp company and begin making hat racks full-time. And that’s how Amalgamated was initially ﬁ nanced. You’ve al- ready seen the asset side of the balance sheet. Table 6-3 is the liabilities and owners’ equity side, which spells out how the company’s assets were ﬁ nanced.

Many, if not most, small businesses are initially ﬁ nanced in a manner similar to the Amalgamated case—mostly with the owner-operator’s per- sonal savings and with contributions from friends and family members.

Some entrepreneurs also resort to using their credit card or home lines of credit for startup capital, as expensive as this practice is. Once your bootstrapped company has begun to show some signs of success, there are also some limited external sources of capital available to startup-stage ventures—often called the seed stage. Let’s look at some of these sources more closely.

Tr a d e c r e d i t Many small-business owners obtain thirty- to sixty-day trade credit from their suppliers as one component of their startup (and ongoing) ﬁ nancing.

For example, a shoe-store owner may be able to obtain $3,000 worth of shoes from a wholesaler, with payment due in sixty days. By having picked TABLE 6-2 Fixed asset requirements Used panel truck $7,500 Lathes 900 Other tools 800 Shop ﬁ xtures 800 Total ﬁ xed assets 10,000 Total current assets (from table 6-1) 22,000 Total current and ﬁ xed assets 32,000 H7303-Entrepreneur.indb 109 H7303-Entrepreneur.indb 109 11/2/17 1:14 PM 11/2/17 1:14 PM 110 Financing Your Business TABLE 6-3 Liabilities and owners’ equity Current liabilitiesCurrent portion of ﬁ ve-year loan $1,000 Long-term liabilities Balance of ﬁ ve-year loan 4,000 Total liabilities 5,000 Original owners’ equity 25,000 Crowdfunding proceeds 2,000 Total owners’ equity 27,000 Total liabilities and owners’ equity 32,000 inventory wisely, the owner may be able to sell all or most of the shoes during that sixty-day period and use the proceeds to pay the wholesaler’s bill in full when it comes due. In effect, the supplier will have ﬁ nanced the store’s inventory without charge—a better deal for the owner than using a bank line of credit or another device that involves interest charges.

Commercial bank loans Some startups may ﬁ nd limited ﬁ nancing from commercial banks, which are covered in detail in the next chapter. Entrepreneurial debt funding from banks has been tight since the 2008 recession, despite attempts by lawmakers to lower the risk for banks. Because of these limitations, other options—be they crowdfunding, angel syndication, or online lending—are increasingly important options for early-stage startup needs.

Crowdfunding If your business idea truly has a broad consumer reach—or deep reach into a narrow market—it can generate early capital using crowdfunding sources like K ick star ter or Indiegogo. In 2015 a lone, over $2 billion of f unding wa s generated through crowdfunding in the United States alone. With many types of crowdfunding, people give money in exchange for rewards, which are often early sales of your product. By offering such rewards, you also get H7303-Entrepreneur.indb 110 H7303-Entrepreneur.indb 110 11/2/17 1:14 PM 11/2/17 1:14 PM Startup-Stage Financing 111 feedback on a product, validate market interest, and test messaging and pricing.

Crowdfunding may allow you to bypass traditional funding completely.

The Wharton School’s Ethan Mollick describes how a hot technology of the moment—virtual reality—was largely ignored by venture capitalists and investors after the cringe-worthy hype of the 1990s. But then, in 2012, a member of a virtual-reality fan message board asked the group for help raising funds, reﬁ ning the technology, and designing the business plan around a product called Oculus Rift. His Kickstarter campaign raised nearly $2.5 million, and the product was purchased by Facebook for $2 bil- lion less than two years later. Crowdfunding can also level the playing ﬁ eld between men and women. Traditional fund-raising often relies on established networks and unwritten rules, so there is a bias toward funding white men—in fact, less than 8 percent of venture-capital-backed companies have female cofounders. But crowdfunding tends to favor women; Mollick’s research shows that women are 13 percent more likely to succeed in raising money on Kickstarter than men. In equity crowdfunding, people buy actual ownership of your busi- ness. These buyers no longer need to be accredited. Thanks to the Jump- start Our Business Startups (JOBS) Act of March 2015, the Securities and Exchange Commission (SEC) now allows almost anyone to be an equity investor, with certain restrictions. But equity crowdfunding also raises some problems, says entrepreneurship professor Dan Isenberg. Equity is sufﬁ ciently complex, he explains, that successes from typical crowdfund- ing can’t be extrapolated to equity fund-raising, and, furthermore, the due diligence required for equity investments renders the system too high-cost to be effective. Still, with other options for small-business funding hard to come by, an increasing number of businesses are choosing this option.

Accelerators Accelerator programs such as Y Combinator at TechStars typically offer ﬁ xed-term, cohort-based support for new companies through ﬁ nancing, H7303-Entrepreneur.indb 111 H7303-Entrepreneur.indb 111 11/2/17 1:14 PM 11/2/17 1:14 PM 112 Financing Your Business TABLE 6-4 The four institutions that support startups IncubatorsAngel investors Accelerators Hybrid Duration 1 to 5 years Ongoing 3 to 6 months 3 months to 2 years Cohorts NoNoYes No Business model Rent; nonproﬁ t Investment Investment; can also be nonproﬁ tInvestment; can also be nonproﬁ t Selection Noncompetitive Competitive, ongoingCompetitive, cyclical Competitive, ongoing Venture stage Early or late Early EarlyEarly Education Ad hoc, human resources, legalNone Seminars Various incubator and accelerator practices Mentorship Minimal, tactical As needed by investorIntense, by self and others Staﬀ expert support, some mentoring Venture location On-site Oﬀ -site On-site On-site Source: Susan Cohen, “What Do Accelerators Do? Insights from Incubators and Angels,” Innovations 8, no. 3–4 (2013):

20. Adaptations by Ian Hathaway.

immersive education, and customized mentorship. These highly competi- tive programs aim to accelerate the company’s experiments and hypothesis testing so that they can become a proﬁ table business more quickly. Accel- erator graduates Airbnb and Dropbox exemplify the success of this path. The process often includes honing a pitch or demo, with the program culminating in a “demo day” in which participants showcase their offer- ings. Table 6-4 demonstrates how accelerators differ from other sources of funding and support for early-stage businesses. While accelerators are appealing, they have some downsides. Ian Hathaway, a fellow at the Brookings Institution, warns that not all acceler- ators are made alike: his research subjects at top programs did raise ven- ture capital, gain customer traction, and exit by acquisition faster than participants at other programs. But subjects at other programs generally did not see such a strong impact on their companies’ performance. And H7303-Entrepreneur.indb 112 H7303-Entrepreneur.indb 112 11/2/17 1:14 PM 11/2/17 1:14 PM Startup-Stage Financing 113 as with other forms of equity investment, you’re giving away part of your company in return for the funding when you use an accelerator.

Indeed, most businesses never grow large and won’t be a good ﬁ t for accelerators or equity funding; Angus McDuff ’s hat rack company may be one of these companies. It may expand over the years to the point of gener- ating $10 million to $20 million in annual revenue, but that’s the limit. In the next chapter, we’ll describe funding options if your business does face the prospect of a substantial growth phase.

Summing up ■Startup-phase ﬁ nancing is initially bootstrapped from personal savings, credit cards, and other personal sources of income, followed by friends and family and, in some cases, by small bank loans.

■Trade credit from suppliers is another low-cost source of ﬁ nancing.

■Other early sources of ﬁ nancing include online banks, accelerators, and crowdfunding. H7303-Entrepreneur.indb 113 H7303-Entrepreneur.indb 113 11/2/17 1:14 PM 11/2/17 1:14 PM H7303-Entrepreneur.indb 114 H7303-Entrepreneur.indb 114 11/2/17 1:14 PM 11/2/17 1:14 PM 7.

Growth-Stage Financing During the growth stage, your business expands its sales and develops a growing base of customers. As a result, you’ll need more capital—for ex- panding your operation, hiring and training new employees, and even ac- quiring other small businesses. Your company may already be generating some positive cash ﬂ ows that can help ﬁ nance these initiatives, but you’ll p r o b a b l y n e e d m o r e c a s h i f y o u r g r o w t h i s s t r o n g o r i f y o u r s t r a t e g y i s t o b u i l d brand visibility. Having now proven your business’s credibility, though, you can generally tap external capital more easily than you could in the startup phase. For slow- to moderate-growth ﬁ rms, much of that capital comes from bank debt. If your business is likely to grow large quickly, on the other hand, you will need to obtain equity capital, a topic covered in chapter 8.

Debt When your company is growing, you often obtain your debt capital from local banks. Banks are often reluctant to offer long-term loans to small H7303-Entrepreneur.indb 115 H7303-Entrepreneur.indb 115 11/2/17 1:14 PM 11/2/17 1:14 PM 116 Financing Your Business ﬁ rms. Bankers are justiﬁ ably nervous about making long-term or un- secured loans to startup businesses, because the failure rate is high. They a r e mor e e a g e r t o e x t e nd s hor t - t e r m de m a nd lo a n s , s e a s on a l l i ne s of c r e d it , and single-purpose loans for machinery and equipment. Small businesses tend to be more successful getting loans from small community banks rather than from larger banks, and they report more satisfaction work- ing with these local lenders as well. Even then, small businesses typically take out fairly small bank loans: 54 percent of small ﬁ rms hold less than $100,000 in debt. Most local banks will extend loans to a startup only if they are com- fortable with the situation and the qualiﬁ cations of the borrower. What makes bank lenders comfortable? Bankers ask three questions before they lend money, and they rarely part with their capital if they cannot obtain satisfactory answers to all three:

1. Will the borrower be able to pay me back?

2. Is the borrower’s character such that he or she will pay me back?

3. If the borrower fails to repay me, what marketable assets can I get my hands on?

In seeking an answer to the ﬁ rst question, a banker will evaluate the entrepreneur’s skills and the business plan:

• Does the applicant understand the market and have a feasible plan for satisfying it?

• Does the entrepreneur have the experience or knowledge—or both—required to operate this type of business?

• Is the business plan realistic, complete, and based on reasonable assumptions?

• Are the plan’s revenue and cost projections realistic and conser- vative? Because loan repayments will be made from cash ﬂ ow, a lender will be particularly interested in projected cash ﬂ ow. H7303-Entrepreneur.indb 116 H7303-Entrepreneur.indb 116 11/2/17 1:14 PM 11/2/17 1:14 PM Growth-Stage Financing 117 If the business is already operating, the banker will look to the pro- spective borrower’s current ratio to get a sense of his or her ability to repay the loan. The current ratio is represented by this simple formula: Current Ratio = Current Asse ts ÷ Current Liabilities Because current assets (cash, securities, accounts receivable, inven- tory) can be turned readily into cash, this ratio imparts a sense of a com- pany’s ability to pay its bills (current liabilities) as they come due. The size of the current ratio that a healthy company needs to maintain depends on the relationship between inﬂ ows of cash and demands for cash payments.

A company that has a continuous and reliable inﬂ ow of ca sh or other liquid assets, such as a public utility or a taxi company, may be able to meet cur- rently maturing obligations easily despite a small current ratio—say, 1.10 (which means that the company has $1.10 in current assets for every $1.00 of current liabilities). On the other hand, a manufacturing ﬁ rm with a long product-development and manufacturing cycle may need to maintain a larger current ratio. To c o n ﬁ rm the absolute liquidity of an organization, a bank credit an- alyst can modify the current ratio by eliminating from current assets all the assets that cannot be liquidated on very short notice. Typically then, this ratio, called the acid-test ratio, consists of the ratio of so-called quick assets (cash, marketable securities, and accounts receivable) to current lia- bilities. Inventory is left out of the calculation. Acid-Test Ratio = Quick Assets ÷ Current Liabilities Paradoxically, a company can have loads of choice assets—ofﬁ ce build- ings, ﬂ eets of delivery trucks, and warehouses brimming with ﬁ nished- goods inventory—and still risk insolvency if its ratio of current (or quick) assets is insufﬁ cient to meet bills as they come due. Creditors don’t take payment in used delivery trucks; they want cash. Lenders generally answer the second question—“Is the borrower’s character such that he or she will H7303-Entrepreneur.indb 117 H7303-Entrepreneur.indb 117 11/2/17 1:14 PM 11/2/17 1:14 PM 118 Financing Your Business pay me back?”—by examining your credit history. Whether it’s a car loan, a home mortgage, or a business loan, a banker will want to see evidence that you pay your bills on schedule.The third question—“What assets can I get my hands on?”—is about collateral. Collateral is an asset pledged to the lender until such time as the loan is satisﬁ ed. In an automobile loan, for example, the lender retains title to the vehicle and makes sure that the buyer has made a sufﬁ ciently large down payment so that the lender can repossess the car, sell it, and fully reimburse itself from the proceeds if the borrower fails to make timely loan payments. Business loans are similar. The lender wants to see assets that can, if your business fails, be sold to satisfy the loan. Those assets might be cur- rent assets such as cash, inventory, and accounts receivable; they might also include ﬁ xed assets such as vehicles, buildings, and equipment. Loans backed by the SBA offer these kinds of guarantees in the business owners’ stead. For more on these US government–backed loans, see the box “SBA loans.” Debt is one of the lowest-cost sources of external capital because in- terest charges (in the US tax system) are deductible from taxable income.

This deductibility, of course, doesn’t do a company much good if it has no taxable income to report yet.

Online lenders Over the past decade, a growing number of online lenders such as Kabbage, OnDeck, and Funding Circle have begun to compete for local banks’ share of the small business and entrepreneurial lending market both in the US and throughout the world, most markedly in China. By 2015, some 20 per- cent of small-employer ﬁ rms in the US reported applying for funding from an online lender. Though most were approved for at least some credit, they reported lower satisfaction than those who had worked with a small bank or credit union. Other new and growing forms of ﬁ nancing come from peer-to-peer lending networks such as Lending Club and Prosper. H7303-Entrepreneur.indb 118 H7303-Entrepreneur.indb 118 11/2/17 1:14 PM 11/2/17 1:14 PM Growth-Stage Financing 119 The right amount of debt Carefully consider how much bank debt your company can handle. The degree to which the activities of a company are supported by liabilities and long-term debt as opposed to owners’ capital contributions is called lever- age. A ﬁ rm that has a high proportion of debt relative to owner contribu- tions is said to be highly leveraged. For owners, the advantage of having high debt is that returns on their actual investments can be disproportion- ately higher when the company makes a proﬁ t. On the other hand, high leverage is a negative when cash ﬂ ows fall, because the interest on debt is a contractual obligation that must be paid in bad times as well as good. A company can be forced into bankruptcy by the crush of interest payments due on its outstanding debt. SBA loans The SBA manages three loan programs intended to help small businesses owned by US citizens obtain ﬁ nancing. The administration itself does not grant loans; rather, it sets guidelines for loans, and its partners (lenders, community development organizations, and microlending institutions) make the loans. What makes these deals palatable to ﬁ nancial institu- tions is that the SBA guarantees repayment up to certain levels, elimi- nating some of the lender’s risk. Certain legislation passed in the wake of the 2008 recession to stimulate small-business development made these loans even more attractive to both lenders and borrowers. Information about the SBA loan program can be found at www.sba .gov, along with abundant information about starting and managing a small business.

Source: Karen Gordon Mills and Brayden McCarthy, “The State of Small Business Lending: Inno- vation and Technology and the Implications for Regulation,” working paper, Harvard Business School, Boston, 2016. H7303-Entrepreneur.indb 119 H7303-Entrepreneur.indb 119 11/2/17 1:14 PM 11/2/17 1:14 PM 120 Financing Your Business The debt ratio is widely used to assess the degree of leverage used by companies and its attendant risks. It is calculated in different ways, two of which are illustrated here. The simplest is this: Debt Ratio = Total Debt ÷ Total Assets Alternatively, you can calculate the debt-to-equity ratio by dividing the total liabilities by the amount of shareholders’ equity: Debt-to-Equity Ratio = Total Liabilities ÷ Owners’ Equity In general, as either of these ratios increases, the returns to owners are higher, but so too are the risks. Creditors understand this relationship extremely well and often include speciﬁ c limits on the debt levels beyond which borrowers may not go without having their loans called in. Creditors also use the times-interest-earned ratio to estimate how safe it is to lend money to individual businesses. The formula for this ratio is as follows:

Times-Interest-Earned Ratio = Earnings Before Interest and Taxes ÷ Interest Expense The number of times that interest payments are covered by pretax earnings, or EBIT (earnings before interest and taxes), indicates the de- gree to which income could fall without causing insolvency. In many cases, EBIT is not so much a test of solvency as it is a test of staying power under a dversit y. For exa mple, if EBIT were to be cut in ha lf bec ause of a recession or another cause, would the company still have sufﬁ cient earnings to meet its interest obligations? Equity and beyond The counterweight to heav y debt is owners’ equity. Equity capital is ob- tained through the sale of shares to investors, including the entrepreneur. H7303-Entrepreneur.indb 120 H7303-Entrepreneur.indb 120 11/2/17 1:14 PM 11/2/17 1:14 PM Growth-Stage Financing 121 The typical entrepreneurial enterprise in the growth phase is neither large enough nor proven enough to become a public company—that is, to launch an initial public offering (IPO) of shares. As a result, it cannot tap broader equity markets. If the company is in a hot growth industry, or if it is close to producing a breakthrough with some game-changing product, it may gain the attention of a VC ﬁ rm or an angel investor. If this private investor likes the looks of the business, it may make a sizable capital contribution. These sources of equity are covered in chapter 8. But it is relatively unusual for an early-phase company to generate this kind of capital. Most companies never get beyond this early phase of growth. They ei- ther fail or are acquired. But those that succeed have access to a broader spectrum of ﬁ nancing opportunities—in particular, the public stock mar- ket. The prospect of even greater grow th is a power ful lure to equity inves- tors, who hope to buy shares while shares are still cheap and the company is unrecognized. Local banks are also important sources of external ﬁ nancing as growth continues. The business now has a conﬁ dence-inspiring record of produc- ing revenues and paying its bills. Its current and times-interest-earned ratios are favorable. And it has assets that it can pledge as collateral for asset-based loans or leases. The company may also have grown so much that it has outgrown the lending capacity of its local bank, in which case the company can move upstream to a large money-center bank. The major milestone in the growth phase for those few enterprises that show exceptional promise is the IPO. These offerings are managed by one or more investment banking ﬁ rms selected by the issuing company. The investment bankers help the issuing company navigate through the strict regulatory requirements of issuing shares to the public. More important, the investment bank and its syndicate of broker-dealers (stockbrokers) pro- vide direct access to millions of potential investors: individual investors, mutual funds, pension funds, and private money managers. Subsequent chapters will provide you with more information on investment bankers.

Table 7-1 summarizes the pros and cons of various forms of capital sources during the growth phase. We’ll cover angels and VCs in more detail in chapter 8 and IPOs in chapter 9. H7303-Entrepreneur.indb 121 H7303-Entrepreneur.indb 121 11/2/17 1:14 PM 11/2/17 1:14 PM 122 Financing Your Business TABLE 7-1 Sources of capital for growth-stage ﬁ nancing Internal cash ﬂ ow from operations • Cost-free if shareholders aren’t anxious for dividends.

• May not be enough to ﬁ nance substantial growth in the productive base of the business.

Debt capital • Costly, but interest payments are deductible from taxable income (if there is any income).

• Interest rate is a function of prevailing rates, the term of the loan, and the creditworthiness of the borrower.

• Debt increases the riskiness of the enterprise.

Venture capital • The most expensive capital available, since the VC will take a signiﬁ cant share of ownership—and of future prospects for the company.

• The entrepreneur must share power with the VC.

• Unlike any other form of capital, this one comes with business advice that may be valuable.

Initial public oﬀ ering • Perhaps the only way to round up a large bundle of money. But like venture capital, the IPO dilutes the ownership interests of the entrepre- neur and earlier investors. Also, the duties of being a public company are often onerous.

Maturity-phase ﬁ nancing Companies cannot continue growing forever. Eventually, grow th tapers off for one or more reasons:

• Success and proﬁ tability draw competitors into the market.

• Demand for the product or service is largely satisﬁ ed (market saturation).

• There is a shift in the technology used in the company’s products— or the technology used by your customers.

• As the organization grows larger, it loses ambition, agility, or the ability to innovate.

Whatever the cause, few companies sustain high growth rates for more than a decade. This does not mean that growth necessarily stops and that continued ﬁ nancing is not needed. Even saturated markets for mature products, such as automobiles, continue to expand incrementally as the H7303-Entrepreneur.indb 122 H7303-Entrepreneur.indb 122 11/2/17 1:14 PM 11/2/17 1:14 PM Growth-Stage Financing 123 population increases and as people in developing countries become more afﬂ uent and demand them. For a $1 billion enterprise, even a 3 percent grow th in revenues may require additional ﬁ nancing. Then, too, mature companies are often involved in mergers, acquisitions, restructuring, or other activities, all of which have important ﬁ nancing implications.

Assuming that the mature company is creditworthy, it has many op- tions for obtaining additional external funds. For short-term needs, it can issue commercial paper (explained later in the chapter), tap its bank line of credit, or negotiate a term loan with a bank or other ﬁ nancial institutions, such as insurance companies and pension funds. The mature company can use its existing assets and cash ﬂ ow as collateral to lower the cost of loans.

Alternatively, the company can obtain signiﬁ cant funds through sale-and- leaseback arrangements. The healthy, mature company also enjoys access to public capital markets for debt (bonds) and equity capital (stock). Here, timing is all- important. The company naturally wants to sell its bonds when interest rates are low and sell its shares when share prices are high.

Financing growth at eBay To better appreciate the sequence of ﬁ nancing experienced by growing en- trepreneurial enterprises, consider eBay, perhaps the most successful com- pany of the dot-com age. It exploded from a home-based hobby business to a sizable corporation in only a few years. The company’s early history (1995 through 2000) illustrates the role played by various forms of ﬁ nancing.

eBay was started in 1995 by Pierre Omidyar, a young man with ex- perience in software development and online commerce. Omidyar set up his business on a free website provided by his internet service. His only business assets then were a ﬁ ling cabinet, an old school desk, and a lap- top. When Omidyar’s hobby business grew quickly, he had to buy his own server, hire someone to handle billings and the checks that came in the mail, and eventually move the operation from his apartment to a small ofﬁ ce. Omidyar and his business partner, Jeff Skoll, soon began paying themselves annual salaries of $25,000. H7303-Entrepreneur.indb 123 H7303-Entrepreneur.indb 123 11/2/17 1:14 PM 11/2/17 1:14 PM 124 Financing Your Business This early period of growth was essentially self-ﬁ nanced: the cash coming in the mail from transaction fees was sufﬁ cient to cover the busi- ness’s expenses and investments. But a period of hypergrowth was right around the corner. By the end of December 2000, this little online com- pany had grown from serving a handful of auction devotees to dealing with the transactions of twenty-two million registered users. By then, it offered more than eight thousand product categories; on any given day, the com- pany listed more than six million items for sale in an auction-style format and another eight million items in a ﬁ xed-price format.

An infrastructure of ofﬁ ce space, customer support, proprietary soft- ware, information systems, and equipment was required to host a business with this volume and keep it churning. eBay developed systems to operate its auction service and to process transactions, including billing and col- lections. Those systems had to be continually improved and expanded as the pace of transactions on the site increased. To keep the wheels of growth turning, the company spent liberally on new site features and categories. eBay reported $4.6 million in product- development expenses in 1998, $24.8 million in 1999, and $55.9 million in 2000. Even larger sums were spent on marketing, brand development, and acquisitions aimed at broadening the company’s services and extending its reach to other parts of the world. Before long, eBay had expanded its balance-sheet assets dramatically.

Here are a few highlights (rounded to millions) from the company’s annual report to the SEC for the ﬁ scal year ending December 31, 2000:

Cash and cash equivalents: $202 million Short-term investments: $354 million Long-term investments: $218 million Total assets: $1,182 million With total assets of nearly $1.2 billion, eBay was light-years away from Omidyar’s apartment operation. Where did the money come from to ﬁ - nance those assets? eBay’s remarkable growth was principally ﬁ nanced in H7303-Entrepreneur.indb 124 H7303-Entrepreneur.indb 124 11/2/17 1:14 PM 11/2/17 1:14 PM Growth-Stage Financing 125 two ways: ﬁ rst, by cash ﬂ ows from operations (self-ﬁ nancing) and second, by loans and the sale of ownership shares (external ﬁ nancing). Let’s ex- amine these sources individually, because they are important to growing companies.

eBay’s cash ﬂ ows from operations In the early days, cash ﬂ ow from operations was an important source of growth ﬁ nancing. The company’s cash-ﬂ ow statement—which totals the cash ﬂ ow entering and leaving the enterprise through operations, invest- ments, and ﬁ nancing activities—documents the effect of internally gen- erated ﬁ nancing. (If you are unfamiliar with the cash-ﬂ ow statement, see appendix A.) Table 7-2 contains the highlights of eBay’s cash-ﬂ ow state- ment for 1998 through 2000. The ﬁ rst row, net cash provided by operating activities, shows that the company ran some portion of its operations and paid people’s salaries, taxes, and other bills (operating activities) from operating cash ﬂ ow. What’s more, the level of positive cash ﬂ ow from operations grew substantially from year to year, helping to fund growth. Thus, an important portion of TABLE 7-2 eBay’s cash ﬂ ow, 1998 through 2000 (in thousands of dollars) H7303-Entrepreneur.indb 125 H7303-Entrepreneur.indb 125 11/2/17 1:14 PM 11/2/17 1:14 PM 126 Financing Your Business eBay’s asset growth was ﬁ nanced internally, from its successful and proﬁ t- able operations. Instead of returning even a cent of that cash to sharehold- ers in the form of dividends, the company plowed everything back into the business. This practice is typical of fast-growing companies.

eBay’s external ﬁ nancing Internally generated cash was sufﬁ cient to ﬁ nance operations in the early days, but not nearly sufﬁ cient to fund eBay’s meteoric growth. Large as they were, eBay’s operating cash ﬂ ows paled in comparison with the cash outﬂ ows caused by in vestments during the same period. In the best of those years (2000), cash ﬂ ow from operations covered slightly less than half of the investment outﬂ ow. To make up the difference, the company resorted to external ﬁ nancing (depicted in the line labeled “Net cash provided by ﬁ nancing activities” in table 7-2). eBay’s ﬁ nancial statements, which are too voluminous to show here, indicate that almost all its external ﬁ nancing took the form of stockhold- ers’ capital; that is, the company and its subsidiaries raised cash by selling shares (almost all common shares) to investors. The ﬁ rst of these sales was a $5 million private placement with Benchmark Capital, a Silicon Valley VC ﬁ rm. In return for its cash, Benchmark was given a 22 percent equity interest in eBay. The next big capital-raising event in eBay’s history was its 1998 IPO.

An IPO is a major milestone in a corporation’s life cycle in that the offering marks the company’s transition from a private to a public enterprise. As you’ll see in a later chapter, this new status opens up much larger opportu- nities to raise equity capital. The universe of potential capital contributors expands from the small and clubby circle of private investors to a much broader group of individual investors, mutual funds, and pension funds. An IPO also enables the existing investors, including the venture capi- talists and shareholding employees, to cash in some or all of their shares— turning paper certiﬁ cates into real money. eBay’s Omidyar, for example, held more than forty-four million shares of his company’s common stock before its IPO. In the wake of the offering and the stock price run-up in H7303-Entrepreneur.indb 126 H7303-Entrepreneur.indb 126 11/2/17 1:14 PM 11/2/17 1:14 PM Growth-Stage Financing 127 the months that followed, Omidyar became a billionaire four times over.

The value of Benchmark’s shares rose to the point that it could claim a 49,000 percent return on its investment—one for the record books!eBay’s ﬁ nancial managers and investment bankers used the company’s high stock price and public appetite for shares to ﬂ oat yet another common stock issue in 1999. This one netted the company more than $700 million, most of which was used in the company’s campaign of expansion.

Other forms of external ﬁ nancing Thus far in this chapter, we’ve described supplier trade credit, bank loans, and common stock issues as important forms of external ﬁ nanc- ing. Today’s mature corporations also use a few other important forms of ﬁ nancing:

• Commercial paper: Large corporations with high credit ratings often use the sale of commercial paper to ﬁ nance their short-term requirements. They use it as a lower-cost alternative to short-term bank borrowing. Commercial paper is a short-term debt security, generally reaching maturity in 2 to 270 days. Most paper is sold at a discount from its face value and is redeemable at face value on maturity. The difference between the discounted sale price and the face value represents interest to the purchaser of the paper. Inves- tors having temporary cash surpluses are the usual purchasers of commercial paper; for them it is a reasonably safe way to obtain a return on their idle cash.

• Bonds: A bond is also a debt security (an IOU), usually issued with a ﬁ xed interest rate and a stated maturity date. The bond issuer has a contractual obligation to make periodic interest payments and to redeem the bond at its face value on maturity. Bonds may have short-, intermediate-, or long-term maturities (e.g., from one to thirty years). Generally, they pay a ﬁ xed interest rate on a semi- annual basis. H7303-Entrepreneur.indb 127 H7303-Entrepreneur.indb 127 11/2/17 1:14 PM 11/2/17 1:14 PM 128 Financing Your Business • Preferred stock: This type of equity security is similar to a bond in that it pays a stated dividend to the shareholder each year, and after the shares begin trading in the secondary market, then the share prices, like bonds, ﬂ uctuate with changes in market interest rates and the creditworthiness of the issuer. Also like bonds, pre- ferred stock is used by some corporations as an external form of equity ﬁ nancing. Matching assets and ﬁ nancing One of the principles of ﬁ nancing—whether the funding is to start a com- pany, maintain its operations, or advance its growth—is to make a proper match between the assets and their associated forms of ﬁ nancing. The general principle is to ﬁ nance current (short-term) assets w ith short-term ﬁ nancing, and long-term assets with long-term or permanent ﬁ nancing.

The use of supplier trade credit for ﬁ nancing inventory, as described in chapter 6, is an example of matching short-term assets with short-term ﬁ nancing. The shoe-store owner matched sixty-day ﬁ nancing against an asset expected to be sold within that period. Similarly, companies ﬁ nance their infrastructure of ofﬁ ce space, systems, and equipment with either long-term debt or capital supplied by shareholders—more permanent forms of ﬁ nancing.

Countless enterprises follow this principle. When states and munic- ipalities build bridges, hockey stadiums, water treatment plants, and so forth, they typically ﬁ nance them with twenty- to thirty-year bonds— ﬁ nancing vehicles whose maturities roughly match the productive life of the assets. To understand why this principle is important, consider ﬁ rst what might happen if you tried to ﬁ nance the purchase of your new home (a long- term asset) with an 8 percent, nonamortizing $200,000 loan that came due in only three years. Under the terms of the loan, you’d pay $16,000 in annual interest and then would be obligated to repay the $200,000 at the end of the third year. This would be feasible if you could negotiate another H7303-Entrepreneur.indb 128 H7303-Entrepreneur.indb 128 11/2/17 1:14 PM 11/2/17 1:14 PM Growth-Stage Financing 129 loan at the end of three years to replace the one that’s due and if interest rates were still affordable. But that’s two ifs. Money might become so tight that you could not locate a new lender when you needed one, or the lender you found might want 10 or 12 percent. In either case, foreclosure would be likely. You couldn’t operate with such a situation, and neither can a busi- ness enterprise.The opposite mismatch situation—borrowing long to ﬁ nance a short- ter m a sset—is just a s bad. Some people ta ke out second mor tgages on their homes to ﬁ nance a dream vacation. Such are the temptations of home eq- uity loans. The vacation will soon be over, but the payments will go on and on. In business, we expect that the assets we acquire with borrowed money will produce incremental revenues (or cost savings) at rates and over peri- ods more than sufﬁ cient to pay their ﬁ nancing costs. The same can be said for owners’ capital.

Summing up ■Growth-phase entrepreneurs look to internally generated cash ﬂ ow, asset-based loans, and external equity capital for ﬁ nancing.

■Bankers look to a borrower’s ability to repay, character, and collateral before making a loan.

■The current ratio, the acid-test ratio, and the times-interest-earned ratio give lenders insights into the ability of a prospective borrower to repay a loan.

■Debt is generally the lowest-cost form of capital because interest pay- ments are tax deductible; however, carrying debt makes an enterprise riskier.

■A public issuing of shares (initial public oﬀ ering, or IPO) is a major mile- stone for the few entrepreneurial ﬁ rms that reach it. An IPO provides a major infusion of cash to fuel growth. H7303-Entrepreneur.indb 129 H7303-Entrepreneur.indb 129 11/2/17 1:14 PM 11/2/17 1:14 PM 130 Financing Your Business ■Maturity-phase ﬁ nancing for creditworthy companies may include bank loans and the sale of commercial paper, bonds, and stock.

■It’s best to ﬁ nance short-term assets with short-term ﬁ nancing, and long- term assets with long-term debt or shareholders’ contribution. H7303-Entrepreneur.indb 130 H7303-Entrepreneur.indb 130 11/2/17 1:14 PM 11/2/17 1:14 PM \f.

Angel Investment and Venture Capital Many businesses never get to the point of needing or wanting outside eq- uity capital. The founders can use internally generated cash and loans to expand the enterprise to a size that, to them, is manageable and satisfac- tory. Best of all, this route avoids selling a share of ownership to outsiders.Other businesses, however, have broader opportunities for grow th.

To realize this growth, these ﬁ rms must at some point seek equity capital from outside investors to ﬁ nance that growth. Debt ﬁ nancing and inter- nally generated cash are rarely feasible solutions. Equity capital provides rights of ownership; it gives its contributor an ownership interest in the assets of your enterprise and a share of its future fortunes. In most cases, it also gives the contributor a voice in how your bu si ne s s shou ld b e r u n. Ma ke no m i s t a ke , by a c c ept i ng e qu it y f u nd i ng , you are ceding some measure of the control of your business. H7303-Entrepreneur.indb 131 H7303-Entrepreneur.indb 131 11/2/17 1:14 PM 11/2/17 1:14 PM 132 Financing Your Business For these grow th-potential ﬁ rms, a new vocabulary has emerged from Silicon Valley. Your startup phase of fund-raising is called the seed stage. As you’re gearing up to release your ﬁ rst product, you may need to raise more funds, often from angel investors—this is your Series A round of funding.

Finally, if your company keeps growing, you’ll need yet more funds—your Series B. For this round, you’ll probably turn to venture capital. This chapter describes in more detail these two most immediate sources of equity capital that come from people outside the business after friends and relatives have been considered: angel investors and venture capitalists. It explains how you can connect with them and discusses the pros and cons of taking their money. Angel investors The attention paid to venture-capital ﬁ rms (VCs) might lead you to be- lieve that these ﬁ rms provide most of the equity funding used by entre- preneurial companies during their developmental stages—that is, before these companies issue their ﬁ rst shares to the public. A few ﬁ rms having huge growth potential do connect with VCs almost immediately—long before they have marketable products or services. But many small and midsize ventures never show up on the radar of VCs. And only a small percentage of high-potential businesses obtain VC funding—fewer than 1 percent of US companies have raised capital from VCs. Instead, many, if not most, middle- and high-potential ventures obtain equity capital from angel investors. These high-net-worth individuals fund more than sixteen times as many companies as VCs do, and the share of companies that VCs fund is shrinking. Angel deals represent less in dollars than VC deals do— approximately $24.1 billion and $48.3 billion, respectively, in 2014—but angels dwarf VCs in the number of deals per year—73,400 versus 4,356. Who are these angels? These high-net-worth individuals are usu- ally successful businesspeople or professionals who provide early-stage capital to startup businesses in the form of either debt, equity capital, or both. They provide ﬁ nancing for the following types of startup and early-stage ﬁ rms: H7303-Entrepreneur.indb 132 H7303-Entrepreneur.indb 132 11/2/17 1:14 PM 11/2/17 1:14 PM Angel Investment and Venture Capital 133 • Those that are too small to get the attention of VCs • Firms often too limited in their revenue potential at maturity to interest VCs • Firms considered too risky for bank loans and for most VC appetites Thus, business angels ﬁ ll a huge ﬁ nancing void and are a good ﬁ t for a ﬁ rst stage of serious equity—your Series A round of funding. Companies that began with angel investments include Google, Amazon, Starbucks, and PayPal. Angels are often self-made millionaires and are accustomed to taking calculated risks with their own money—risks that have the potential of producing exceptional returns. Many enjoy the game of ﬁ nding and ex- ploiting commercial opportunities. And they don’t live only in Silicon Val- ley. Nor do they look only for tech companies. Consider this example:

Jack, a sixty-two-year-old Minneapolis businessman, owns a prof- itable short-haul trucking and truck maintenance company with $43 million in annual revenues. He built the business from the ground up. He also owns minority interests in two other successful businesses in the area and is an active member of their boards.Financially secure and conﬁ dent of his business acumen, Jack enjoys learning about investment opportunities in the Minneapo- lis area and taking active investment positions in the ones that he likes and understands. Occasionally, Jack has joined forces with two close friends—both wealthy businesspeople—in these invest- ments. One is a longtime friend and an accountant, the owner of a local CPA ﬁ rm. The other, a former employee, owns and manages several apartment buildings in the city. “Three minds are better than one,” he says.

Jack is one of an estimated three hundred thousand business angels in the United States. According to research by the University of New Hamp- shire’s Center for Venture Research, angels invested nearly $25 billion in H7303-Entrepreneur.indb 133 H7303-Entrepreneur.indb 133 11/2/17 1:14 PM 11/2/17 1:14 PM 134 Financing Your Business over seventy-one thousand ventures in 2015. Angel investing is also grow- ing outside the United States: in Europe, the total market doubled between 2011 and 2016, and in Canada, it tripled.Assuming that you have a solid business plan and the know-how to launch and operate a successful company, people like Jack represent your best opportunity to secure substantial outside capital. And money is not the only thing they have to offer. These successful businesspeople can offer advice and feedback when you need it. They also have valuable local net- works that can be helpful to you. Whether you need to ﬁ nd a good attorney, accounting services, a banker, a supplier, a key employee, or ofﬁ ce space, your angel can usually put you in touch with reliable people.

Connecting with angels Angels aren’t always easy to spot. Unlike VC ﬁ rms, angels do not advertise themselves, and they tend to keep their investment activities to themselves and their circle of trusted associates. One way to connect with angel investors is to join the online platform AngelList; startups now raise more than $10 million a month through the platform. Like other social networks, it allows you to post a proﬁ le— in this case, outlining your company’s merits—and then connect with other inﬂ uencers.

Serial entrepreneurs Evan Baehr and Evan Loomis suggest posting your proﬁ le on ly when you’ve r a i se d at le a s t a t h i rd or e ven a ha l f of t he t ot a l amount you are looking for from quality investors. When a potential inves- tor sees this funding and recognizes that those other investors have done their due diligence, the angel will be more quickly interested in your ﬁ rm.

I f y ou r bu s i ne s s i s lo c a l or r e g ion a l , y ou’ l l w a nt t o ﬁ nd a local angel. The Angel Capital Association website also provides a directory of angel groups and platforms by region. Another way to reach local angels is to ﬁ nd a way into their network—through your law yer, your accountant, or other entre- preneurs of your acquaintance. Talk with patent attorneys, and share your business plan. Ask successful entrepreneurs in your area, “Whom should I approach about private ﬁ nancing?” If the person they suggest cannot help H7303-Entrepreneur.indb 134 H7303-Entrepreneur.indb 134 11/2/17 1:14 PM 11/2/17 1:14 PM Angel Investment and Venture Capital 135 you, ask that person the same question: “Do you know anyone who might want to invest in my company?” Follow every lead until you connect with the right person. Doing these things may get the word out to the right peo- ple in the local angel network.

Angel groups and networks Business angels traditionally have operated individually or in small, in- formal, and collegial groups that are now giving way to more-formal or- ganizations and networks both in the United States and in Europe. These groups are making angel investing more professional, more formal, and— for the angels—more efﬁ cient. They have more depth and breadth in their expertise and more investing power than solo angels have. In some ways, they are becoming more like VC ﬁ rms, with professional screeners doing some of the legwork and initial analysis. On the upside, these organiza- tions make the chore of ﬁ nding and contacting a potential ﬁ nancier less time-consuming and less hit-or-miss for entrepreneurs. On the downside, angel groups are more bureaucratic and make decisions less quickly.

Getting angel funding Even as angel-deal totals are rising, the number of angel deals slightly de- creased in 2015–2016. The Center for Venture Research suggests that the increasing selectivity of angels has caused the decrease. So once you have connected w ith an angel, how do you persuade them to f und your venture?

• Target angels in professions related to your enterprise. For exam-ple, if yours is an information systems startup, hunt for people whose wealth was made in that industry. For example, one of the founders of Sun Microsystems saw a prelaunch demonstration of Google’s search engine and gave that company’s grad student entrepreneurs a check for $100,000. As a seasoned veteran of the tech industry, he could appreciate the technology’s potential. If you hope to build a business around a new medical device, get the word out to local physicians. H7303-Entrepreneur.indb 135 H7303-Entrepreneur.indb 135 11/2/17 1:14 PM 11/2/17 1:14 PM 136 Financing Your Business • Have your act together: either a working prototype, a well- managed and lean operation, or, at a minimum, a rock-solid business plan.

• Be ready with a well-rehearsed, right-to-the-point verbal presen- tation. You should be prepared to explain clearly and speciﬁ cally how the angel’s money will be used to fuel proﬁ table growth.

• Have a credible exit plan for your investors. Angels want to eventu- ally convert their paper ownership interests into real money.

• Focus on your team. Shai Bernstein (assistant professor of ﬁ nance at Stanford’s Graduate School of Business), Arthur Korteweg (University of Southern California’s Marshall School of Business), and Kevin Laws (chief operating ofﬁ cer of AngelList) have studied angel investors’ motivation. They found that what matters most for these investors is the people. More important than your ﬁ rm’s ini- tial traction and its initial investors are the proﬁ les of the founders:

where they went to school, their previous work experience at pres- tigious ﬁ rms, and so forth. The researchers hypothesize that inves- tors want to know about the founders because of credibility: if a graduate of Harvard Business School is choosing to devote their career to this venture—rather than any number of other attrac tive opportunities—then there must be something to it. Other research has also shown that potential angels heavily consider the founders in their decisions. In particular, the investors look at the founders’ coachability and weigh their trustworthiness and character over their competence . Venture capital As a high-risk investor, a VC or a VC ﬁ rm seeks an equity position in a startup or an early-growth company with high potential. In return for capital, the VC typically takes a signiﬁ cant percentage of ownership of the business and a position on its board. VCs take part in the strategic man- H7303-Entrepreneur.indb 136 H7303-Entrepreneur.indb 136 11/2/17 1:14 PM 11/2/17 1:14 PM Angel Investment and Venture Capital 137 agement of their ﬂ edgling companies and often help connect them with suppliers and potential business allies through their networks. In many cases, VCs also help recruit the technical and managerial personnel these companies need to succeed. They also prov ide usef ul adv ice. (For informa- tion on a related form of funding, see the box “Corporate venture capital.”) Venture capital is your Series B funding. Angels and VCs can provide the capital that growth businesses need to scale to their full potential. For any company that looks forward to an IPO, having a VC on its side is almost essential. A good VC ﬁ rm has the sophis- tication, connections, and experience to get an IPO off the ground and on terms that maximize shareholder value. Generally, VCs seek out small ﬁ rms that have the potential to return ten times the investors’ risk capital within ﬁ ve to ten years. Most aim to harvest their investments during the IPO or follow-up issues of company share and then to move on to the next opportunity. Whereas business angels generally stay in the shadows of new busi- ness ﬁ nancing, VCs have a far more visible presence. What is hot with VCs Corporate venture capital Aside from VC ﬁ rms, another source of venture capital exists: large orga- nizations. Some ﬁ rms traditionally have approached investment in new businesses as a strategic move. By considering such an investment, they get information about what’s new in the industry and a ﬁ rst look at a com- pany they might want to acquire. This approach is growing: from 2011 to 2015, the number of corporate VCs in the United States increased from 1,068 to 1,501, with the amount these ﬁ rms invested quintupling to $75 bil- lion. These ﬁ rms, however, are increasingly looking for ﬁ nancial perfor- mance as well as a strategic investment.

Source: Excerpted from “Corporate VCs Are Moving the Goalposts,” Harvard Business Review , November 2016. H7303-Entrepreneur.indb 137 H7303-Entrepreneur.indb 137 11/2/17 1:14 PM 11/2/17 1:14 PM 138 Financing Your Business changes with the times; the majority of enterprises that attract VCs today are in industries connected to the tech world: software, hardware, biotech, medical devices, and media and entertainment.The businesses that most attract VCs tend to be risky ones with proven management and substantial growth potential. For these ﬁ nanciers, a ﬁ rst- rate person with a good idea is far more attractive than a good idea with second-rate management. Many of the companies VCs focus on haven’t yet developed a marketable product or service. And because investments in these companies lack immediate liquidity, the VCs anticipate that their funds will be tied up for several years. In the investor’s mind, high risk and illiquidity are offset by high potential payoffs. For example, Arthur Rock’s $1.5 million investment in ﬂ edgling Apple Computer was risky, but it was valued at $100 million three years later, when the company went public.

Such lucrative payoffs are what VCs live for. Consequently, if your venture lacks the potential to take them to the moon, your search for VC ﬁ nancing will probably be fruitless. And for all the heat and light that VC funding gets, venture funding is actually a rarity for startups. Fewer than 1 percent of US companies have raised money from VCs historically, and the number of VCs and dollars invested by them is trending downward. Instead, companies are turning to the growing list of alternatives such as angels, crowdfunding, and their own customers. (See the box “An alternative to venture capital” for a brief example.) A fast-growing business with huge growth potential can hardly avoid using outside equity capital, but others can avoid it—or can delay its necessity while they build real value for themselves. Here are a few tips for doing so:

• Rely as heavily as possible on bootstrap ﬁ nancing. This type of ﬁ nancing doesn’t force you to give up ownership.

• Manage growth at a pace you can handle with existing ﬁ nancing.

• Be tightﬁ sted with the money you have. Keep expenses low, and ﬁ nd every opportunity for doing more with less. H7303-Entrepreneur.indb 138 H7303-Entrepreneur.indb 138 11/2/17 1:14 PM 11/2/17 1:14 PM Angel Investment and Venture Capital 139 • Outsource nonessential functions whenever possible. Farming out will allow you to do more with less capital. The modern economy is ﬂ ush with contractors for every part of a business. The venture-capital process If venture capital is a realistic prospect for you, you’ll want to know where the money comes from, how the capital ﬂ ow to high-potential ﬁ rms is managed, and how returns are distributed. Scholar-practitioners William Bygrave and Jeffry Timmons show how the funds ﬂ ow in ﬁ gure 8-1. The VC ﬁ rm shown here is a limited partnership in which passive limited partners contribute most of the capital. These partners may be wealthy individuals, pension funds, university endowments, or corporations. For them, risky venture ﬁ nancing constitutes a small part of their overall portfolios.

The VC ﬁ rm acts as the (active) general partner, employing a cadre of bright new MBAs, securities law yers, and experienced deal makers to identify, screen, and invest in high-potential ﬁ rms identiﬁ ed in ﬁ gure 8-1 An alternative to venture capital Take Claus Moseholm, cofounder of GoViral, a Danish company created in 2005 to harness the then-emerging power of the internet to deliver advertisers’ video content in viral fashion. Funding his company’s steady growth with the proceeds of one successful viral video campaign after another, Moseholm and his partners built GoViral into Europe’s leading platform to host and distribute such content. In 2011, GoViral was sold for $97 million, having never taken a single krone or dollar of investment capital. The business had been funded and grown entirely by its custom- ers’ cash.

Source: Excerpted from John Mullins, “VC Funding Can Be Bad for Your Start-Up,” HBR.org, August 4, 2014. H7303-Entrepreneur.indb 139 H7303-Entrepreneur.indb 139 11/2/17 1:14 PM 11/2/17 1:14 PM 140 Financing Your Business as portfolio companies. The wise VC ﬁ rm will diversify its bets among many deals, knowing that some will fail and others will only break even, but maybe one in ﬁ fteen will be the bonanza that makes them rich. As a practical approach to diversiﬁ cation, VC ﬁ rms form small syndicates in which the lead investor conducts the due diligence and takes a seat on the entrepreneurial company’s board. Other members of the syndicate con- tribute smaller amounts to the total ﬁ nancing and generally take a passive approach to the investment. The VC’s capital contribution often takes the form of convertible pre- ferred stock. This stock has voting rights—something that gives the VC a Investors Portfolio companies • Use capital • Provide capital Venture-capital ﬁrms • Identify and screen opportunities • Transact and close deals • Monitor and add value • Raise additional funds Money Money Limited partners General partners Entrepreneurs • Pension funds • Individuals • Corporations • Insurance companies • Foreign • Endowments • Opportunity –Creation and recognition –Execution • Value creation • Harvest Return of principal plus 75%–85% of capital gain Equity IPOs/mergers/alliances 15%–25% of capital gains 2%–3% annual fee Gatekeepers 1% annual fee FIGURE 8-1 The ﬂ ow of venture capital Source: William D. Bygrave and Jeﬀ ry A. Timmons, Venture Capital at the Crossroads (Boston: Harvard Businees School Press, 1992), 11. Reproduced with permission. H7303-Entrepreneur.indb 140 H7303-Entrepreneur.indb 140 11/2/17 1:14 PM 11/2/17 1:14 PM Angel Investment and Venture Capital 141 m easure of control over the enterprise and its ofﬁ cers. The terms of the deal also give preferred shareholders the right to convert their securities to common shares at their discretion. Conversion will be stipulated at 1:1 or some other ratio. As preferred shareholders, they are entitled to cumulative dividends that must be paid before any dividends can be paid to common shareholders. VCs love this type of arrangement because preferred shareholders stand ahead of common shareholders in the event of liquidation. This sta- tus reduces some of their risk. Meanwhile, the conversion feature allows them to participate in the upside potential of the company. In effect, con- vertible preferred shareholder status gives VCs the best of both worlds:

some protection in case the business fails and the right to enjoy whatever success the company produces. (A common alternative to convertible pre- ferred shares is convertible debt with warrants.) After an investment is made, the VC does three things:

1. Monitors the progress of its portfolio companies 2. Uses its network of contacts to help portfolio companies strengthen their technical and management teams 3. Shapes company plans and strategies through its inﬂ uence on their boards The end of the VC process comes when the VC harvests part or all of its investment, usually when its portfolio companies go public or are pur- chased by other corporations. Typically, harvest comes after four or ﬁ ve years. The investors and the VC ﬁ rms share in harvested proﬁ ts according to the terms of their partnership.

Connecting with venture capitalists If your enterprise meets a VC ﬁ rm’s criteria, the ﬁ rm might ﬁ nd you before you ﬁ nd it. Competitive VCs go hunting for promising deals. They keep in touch with connections in high-tech spawning beds such as MIT’s re- search labs, Stanford University, and startup accelerators and incubators, and they work entrepreneurial networks in Silicon Valley, North Carolina’s H7303-Entrepreneur.indb 141 H7303-Entrepreneur.indb 141 11/2/17 1:14 PM 11/2/17 1:14 PM 142 Financing Your Business Research Triangle, San Diego’s biotech community, and so forth. But if you need venture capital, you cannot wait for VCs to ﬁ nd you. And you can- not wait until you really need a cash infusion; you should line up venture money six or eight months before it is actually needed. To connect with a VC, you could search for ﬁ rms that are a good match for your enterprise (or use a directory like Pratt’s Guide—see the box “VC locators”). Then you could email your executive summary, your YouTube pitch link, or a brief pitch deck of your business plan to each ﬁ rm that specializes in your industry (some have speciﬁ c application instructions on their websites). Don’t bother sending the entire plan; investors don’t have time to read it. If the VC is intrigued by your executive summary, he or she will ask for a more thorough plan. The limited time a prospect has to spend on your plan underscores the importance of crafting a clear, compelling, and creative pitch. Unfortunately, sending out blind emails is about as effective as send- ing out blind résumés when you’re hunting for a job. To the VC, you are only one of thousands of faceless supplicants. To change this perception and improve your odds, you need to ﬁ nd a way to personally meet the VC or have your case recommended by someone the VC respects. Here are a few techniques to make such contacts:

• Go through a highly regarded accelerator program. Accelerators are an indirect way to get the attention of VCs; research has shown that companies that graduate from top accelerator programs are able to raise VC funding more quickly. (That wasn’t true of com- panies coming out of accelerator programs across the board, how- ever, so be selective.) • Attend entrepreneurial forums. Cities with many high-tech start- ups periodically hold events that bring entrepreneurs and ﬁ nan- ciers together. Typically, each of many VC ﬁ rms has a separate table, and each eager entrepreneur is given a ﬁ ve- to ten-minute opportunity to visit the table and make the pitch. Attend these forums whenever possible. But be totally prepared. Have a brief H7303-Entrepreneur.indb 142 H7303-Entrepreneur.indb 142 11/2/17 1:14 PM 11/2/17 1:14 PM Angel Investment and Venture Capital 143 but compelling elevator speech about the opportunity you’ve iden- tiﬁ ed and how your team intends to exploit it.

• Be ready with a presentation that you can customize for the length of your meeting and the audience. Whenever you do make contact with a VC, ask for an opportunity to come to the ofﬁ ce to make your pitch. Your presentation should be brief, well organized, compelling, and well rehearsed. Deliver the highlights, and be prepared to supply the details if asked.

• Have well-connected people on your team. The VC may not know you or your company, but if the ﬁ nancier knows and respects some- one on your team or your board of directors, you may get a face- to-face meeting. Keep this in mind as you form your management team and select advisers and board members. Use an attorney who is highly respected by local VCs. All other things being equal, select board members who have personal connections to ﬁ nanciers. VC locators Pratt’s Guide to Private Equity & Venture Capital Sources, edited by Stan- ley E. Pratt and available at online and specialist bookstores and in an entirely digital online version, is a comprehensive list of VC sources. It is organized in a way that you can quickly locate VCs having the desired characteristics and interests. This $1,000 book is updated periodically. The website VCgate oﬀ ers an extensive directory of VC, private- equity, merchant banking, and other investment ﬁ rms from around the world. The VCgate database, which purports to include some thirty-eight hundred listings from the United States, Canada, Europe, and Asia, makes searching quick and eﬃ cient. Finally, Forbes ranks the world’s individual VCs annually on its Midas List, available on its website. H7303-Entrepreneur.indb 143 H7303-Entrepreneur.indb 143 11/2/17 1:14 PM 11/2/17 1:14 PM 144 Financing Your Business Making a presentation Assuming that you contact an angel or a VC and have been invited to make a presentation about your company, how can you make it as successful as possible?Babson College professor and researcher Lakshmi Balachandra says to remember that your audience will have read your materials before decid- ing to call you in. You’re there in main not to present your idea as if it’s the ﬁ rst time your audience is hearing it, but rather to answer their questions, to assuage any concerns they might have, and to let them get to know you better. Here are three broad tips that come from her research:

• Maintain a calm demeanor. While expressing your passion for the business helps with some less formal funding sources, research from Balachandra and others suggests that professional funders equate equanimity with leadership strength.

• Build trust. Your audience is looking to learn about your charac- ter even more than they want to assess your competence. Skills are teachable or hirable, but your personality will change very little.

Prospective ﬁ nanciers want to work with someone who isn’t going to make a risky proposition even more volatile through dishonesty or other bad behavior. Balachandra’s research shows that entrepre- neurs who projected trustworthiness increased their odds of being funded by 10 percent.

• Listen actively, and express openness to new ideas. Early-stage investors in particular are going to be interested in molding you and giving you advice that they hope will help their investment pan out. They’re looking for someone who is open to outside coach- ing and who won’t let their ego get in the way.

Overall, preparation is key. Rehearse your presentation until you have it down cold. You must convey the impression that you are in control of the facts and that you have great conﬁ dence in the company and its future. H7303-Entrepreneur.indb 144 H7303-Entrepreneur.indb 144 11/2/17 1:14 PM 11/2/17 1:14 PM Angel Investment and Venture Capital 145 After you have made the presentation, expect some pointed questions from your audience. Anticipate key questions, and have rock-solid answers for each one. The downsides of taking venture capital Because outside capital carries a heav y cost, you are well advised to ﬁ nd a way to self-fund. London Business School professor John Mullins de- scribes some of the downsides of taking venture capital:

• Distraction from your day job: Getting a business off the ground is hard enough without having to seek funding—another full-time job.

• Onerous terms: VCs are wary of risk and will require terms that protect them and are hard on you. Be particularly careful as the concise language of their term sheet gets turned into the details of the legal agreement: those details may be more unfavorable than you expected.

• Burdensome advice: You’ll be required to take the advice of your funder—whether or not you agree. Mullins also sees a lack of evi- dence pointing to the efﬁ cacy of that advice.

• Dilution of ownership and returns: When you raise equity capital, you’re giving away ownership of part of your company. Venture capital speciﬁ cally can be the most expensive form of capital you can use.

Consider, for example, eBay, which in 1997 took $6.7 million from Bench mark Capital in return for 22 percent of company ownership.

Whereas a commercial bank might have made $2 million in interest from a loan of that size over three years, eBay’s VCs chalked more than $2 bil- lion in the same period. Certainly, Benchmark did help the young company recruit an effective and experienced CEO and other members of the man- agement team, but a good executive recruiter would have done the same H7303-Entrepreneur.indb 145 H7303-Entrepreneur.indb 145 11/2/17 1:14 PM 11/2/17 1:14 PM 146 Financing Your Business for less than $200,000. The VC also played a major role in arranging for the company’s successful IPO, but was that work worth $2 billion, when investment banking advice can be obtained on a consulting basis for a rea- sonable fee? The lesson: venture capital can be enormously costly to you, especially if your business succeeds. The box “How much of your company should the VC ﬁ rm get?” helps you avoid such disproportionate sharing of your hard-earned proﬁ ts.

There is also the matter of control and possible conﬂ icts of interest.

VCs with a major stake in your business can make your life miserable if you How much of your company should the VC ﬁ rm get? If a VC ﬁ rm likes your company and your prospects, it might agree to making a cash infusion via convertible preferred stock or some type of convertible debt, as described earlier. But because the VC can convert to common shares as its option, it is really taking a share of ownership.

The question is, What share of total ownership should the VC receive in return for its money? Should $5 million entitle the VC to a 20 percent share of ownership? Or 40 percent? Or 51 percent?

This critical issue for you as an entrepreneur hinges on the estimated value of the ﬁ rm. If the VC says, “We’ve estimated the value of your com- pany at $6 million,” ask for a detailed explanation of how that ﬁ gure was determined. Valuation is part science and part art. And because the VC ﬁ rm is much more experienced in both, it has a negotiating advantage over you. To level the playing ﬁ eld, bring in professional assistance to develop your own assessments of enterprise value. This is the best way to be sure that you’re dividing the ownership equitably. The methodologies used in business valuation can be very com- plex—too complex to cover in this chapter. Nevertheless, you owe it to yourself to be acquainted with them. (For an overview of the methods typically used, see appendix C of this book.) H7303-Entrepreneur.indb 146 H7303-Entrepreneur.indb 146 11/2/17 1:14 PM 11/2/17 1:14 PM Angel Investment and Venture Capital 147 cannot work together harmoniously. The VC ﬁ rm may even have enough control to ﬁ re you. Also, the VC might plan to quickly ﬂ ip the company through an IPO or to sell the business to a big corporation, cash in its investment, and move on, whereas you may wish to remain private for a while longer and build the enterprise in line with a long-term vision. For these reasons many entrepreneurs look on VCs as a necessary evil or, in the worst cases, as “venture vultures.” The more solid your business is when you negotiate with outside inves- tors, the better deal you will make for yourself. Instead of giving away the company—and control—you’ll keep more of it for yourself. A viable busi- ness that isn’t desperate for money can obtain much better terms.

Summing up ■The most likely source of outside venture funding comes from so-called angel investors.

■Angels are high-net-worth individuals who provide early-stage capital to startup businesses.

■Networking is often the best way to connect with angels.

■Venture capital comes from an individual or a ﬁ rm that seeks large cap- ital gains through early-stage equity or equity-linked ﬁ nancing of high- potential entrepreneurial enterprises.

■Entrepreneurs should not waste their time pursuing venture capital unless they have all the characteristics VCs look for.

■Most venture capital takes the form of convertible preferred stock or some- thing similar, such as convertible debt with warrants.

■Venture capital is nice to have, but it is costly both in economic terms and in loss of control of the enterprise.

■When giving a pitch presentation to an angel investor or a VC, choose calm over passion, and build your audience’s trust in your character and coachability. H7303-Entrepreneur.indb 147 H7303-Entrepreneur.indb 147 11/2/17 1:14 PM 11/2/17 1:14 PM H7303-Entrepreneur.indb 148 H7303-Entrepreneur.indb 148 11/2/17 1:14 PM 11/2/17 1:14 PM 9.

Going Public Growing ﬁ rms with exceptional revenue potential have another option to achieve a signiﬁ cant cash infusion: they can seek ﬁ nancing through an IPO. This process presents ownership shares to the world of individual investors and institutional investors such as pension funds and mutual funds and results in a signiﬁ cant exchange of paper ownership shares for the hard cash the company needs for stability and expansion. An IPO marks a major milestone in the life of a company. It signals that your enterprise has earned the conﬁ dence of people outside its inner circle of participants—it has “made it.” Going public also makes your com- pany accountable to a much broader universe of stakeholders, analysts, and regulators. Perhaps fewer than 5 percent of readers will have any direct use for the information contained in this chapter, because only a tiny fraction of startup companies ever go public. The requirements are high—the con- ventional rule of thumb is that a company needs around $100 million in annualized revenue as well as several consecutive proﬁ table quarters. Few entrepreneurial companies ever reach this bar and get to the point where an IPO is either necessary or feasible. Nevertheless, the rewards of this H7303-Entrepreneur.indb 149 H7303-Entrepreneur.indb 149 11/2/17 1:14 PM 11/2/17 1:14 PM 150 Financing Your Business form of ﬁ nancing make IPOs intensely interesting to company founders, key employees, and early-stage contributors of capital. This chapter examines the pros and cons of becoming a public com- pany and explores what it takes to be a candidate for this form of ﬁ nancing.

You’ll get an overview of the IPO process itself, from planning to the actual deal, including the role of investment bankers. We’ll also touch on the post- deal environment. Note that this chapter is written from the perspective of US companies and US securities laws and procedures. Readers outside the United States should consult their own securities laws and procedures.

Weighing the decision to go public You’ve probably read many accounts of founders and key employees of en- trepreneurial companies who had quite ordinary ﬁ nancial circumstances the day before their ﬁ rms went public. By the end of the next day, those same individuals were millionaires. Founder Pierre Omidyar, for example, owned the equivalent of forty- four million common shares on the eve of eBay’s IPO in 1998—pieces of paper for which there was no market. He was living in a rented house and driving an old Jetta. The next day, those shares began trading on NASDAQ and began a long upward ascent. Before long, Omidyar’s paper shares had a market value north of $4 billion. Other employees and early-stage inves- tors shared in the wealth. But the process wasn’t without its challenges, and any company contemplating an IPO should understand both the promise and the negative implications.

Pros Gaining personal wealth (and liquidity of that wealth) is one of the bene- ﬁ ts of going public, but it is not the only advantage. At the same time, the cash that ﬂ ows onto the company’s balance sheet from the IPO has these positive effects: H7303-Entrepreneur.indb 150 H7303-Entrepreneur.indb 150 11/2/17 1:14 PM 11/2/17 1:14 PM Going Public 151 • Costly interest-bearing debt can be paid off.

• The company has the ﬁ nancial capacity to develop new products and the marketing capabilities to sell them.

• An improved debt-to-equity ratio enables the company to obtain debt ﬁ nancing on better terms than otherwise would have been possible, if the company needs this ﬁ nancing.

• The company can use cash and its own marketable share to ﬁ nance strategic acquisitions.

• The ﬁ nancial stability of the enterprise is improved, enabling it to attract talent, suppliers, and joint-venture partners.

• Becoming a public company opens the door to future rounds of ﬁ nancing through stock and bond sales.

Note: An IPO does not give absolute liquidity to company insiders.

US securities regulations place certain restrictions on the sale of insider- owned shares. Cons The proceeds from an IPO provide important beneﬁ ts for owners and in- vestors, but as many CEOs and chief ﬁ nancial ofﬁ cers (CFOs) will attest, public company status is a mixed blessing. Here are the most important drawbacks of becoming a public corporation:

• The IPO expense: Just getting the IPO through SEC registration and off the ground generates major legal, accounting, printing, and advisory expenses. Then there are SEC and state securities ﬁ ling fees and payments to the exchange that lists the stock. A company should expect to pay $2 million in out-of-pocket expenses when preparing for an IPO; the amount can soar to $100 million for larger deals. These expenses cover legal fees, a commission to the underwriter, and any improvement of internal business processes H7303-Entrepreneur.indb 151 H7303-Entrepreneur.indb 151 11/2/17 1:14 PM 11/2/17 1:14 PM 152 Financing Your Business to meet regulatory requirements as a public company going forward.

• Management time and attention: The preparation that goes into an IPO absorbs an enormous amount of top management time and attention over several months. So too does the road show, which takes the CEO and CFO on a time-consuming and costly jaunt to investor meetings around the country. Even after the deal, these two ofﬁ cers must devote part of their time to handling inquiries from investors and security analysts. The company may have to create a position for an investor relations manager to deal with these new stakeholders.

• Public scrutiny: The company is now an open book. Its ﬁ nancial results and the compensation of key executives are available to anyone who is interested. The company’s 10-K ﬁ ling will con- tain information that competitors are bound to ﬁ nd valuable:

the names of key suppliers, product-development plans, overall strategy, and so forth.

• Loss of control: When an enterprise sells shares to the public, the founder and key managers usually lose a major portion of their ownership. Outsiders—mostly institutional investors—now own blocks of your company’s stocks. And there may be thousands of small owners with fewer than one thousand shares.

• Pressure for short-term gain: Although most CEOs deny it, the expectations of analysts and investors for predictable year-to-year earnings gains can put decision makers in a difﬁ cult position. They may be reluctant to take steps to ensure long-term beneﬁ ts if doing so will jeopardize short-term results. The making of an IPO candidate Do the beneﬁ ts of being a public company outweigh the drawbacks? Some- times they do, and sometimes they don’t. Even if they do, your enterprise H7303-Entrepreneur.indb 152 H7303-Entrepreneur.indb 152 11/2/17 1:14 PM 11/2/17 1:14 PM Going Public 153 may not be a candidate for an IPO. In fact, an IPO is a pipe dream for all but a small percentage of corporations. This section recounts some of the factors you need to consider before counting your enterprise as an IPO candidate.

Through most of the post–World War II era, US companies didn’t go public until they had established a solid record of sales and earnings. After all, investors in an IPO are asked to buy shares of a money-making ma- chine; they want evidence that the machine actually works. The conservative practice of requiring a record of sales and earnings is occasionally set aside when a company owns proprietary technology and has a tested management team. In these cases, investors are willing to gamble that the company’s potential will produce proﬁ table results.

During rare periods—the dot-com boom of the middle to late 1990s being one—companies w ith nothing more than a clever idea were able to sell ini- tial public shares. Many of these companies failed to demonstrate their worth in the years that followed, and the effects of that experience still affect the IPO process today. Thus, the ability to launch a public offering is partly a function of in- vestor moods and expectations, combined with the ability to meet regu- latory requirements. Typically, however, entrepreneurial ﬁ rms need these characteristics to be viable IPO candidates:

• A reasonable deal size. Given the cost of launching an IPO, there’s little point in seeking less than $10 million. And if you’re raising that much money, you must have a solid plan for using it.

• Evidence of growth. The ﬁ rm should have growing sales, with evi- dence that earnings will follow. Investors expect rising stock prices from double-digit growth in sales and from a higher rate of earn- ings growth. If the earnings record isn’t yet there, all signs should point to substantial proﬁ tability in the years ahead. This growth should support a price-earnings multiple (also called the P/E ratio) higher than the historical S&P 500 or the Russell 2000.

• Outstanding products or services that are difﬁ cult to copy. H7303-Entrepreneur.indb 153 H7303-Entrepreneur.indb 153 11/2/17 1:14 PM 11/2/17 1:14 PM 154 Financing Your Business • A credible CEO who can communicate the enterprise’s vision to cautious outsiders.

• At least three years of audited ﬁ nancial statements (if you don’t have them now, you can create them through a “look-back,” pro- vided you have solid enough records).

• High-quality employees.

• A logical strategy for growth and a predictable revenue stream . In a study of successful IPOs, Ernst & Young found another trait that few would consider a condition of making the transition from private to public company. It found that successful companies began acting like pub- lic companies long before they did the deal: “[These companies] made improvements in their employee incentive programs . . . in strategic plan- ning, internal controls, ﬁ nancial accounting and reporting, executive com- pensation, and investor relations policies.” Investors in these ﬁ rms were buying ownership in a ﬁ rm that already had the hallmarks of professional management. Preparing for an IPO One of the big questions for a growing company is when to ﬁ le for an IPO.

Too soon, and you may not make the most of your company’s potential; too late, and you may miss a bullish investment market. The box “When to go public” presents the story one successful CEO told about deciding when to do it and how the company made the most of its preparation period.

The IPO process in a nutshell Now that you understand the pros and cons of going public and whether your ﬁ rm is a candidate, let’s take a look at the process itself. That process has several steps; some must be conducted sequentially, whereas others can be handled in parallel. Very brieﬂ y, these steps are as follows: H7303-Entrepreneur.indb 154 H7303-Entrepreneur.indb 154 11/2/17 1:14 PM 11/2/17 1:14 PM Going Public 155 When to go public By Scott Dietzen, CEO of Pure Storage The Pure Storage IPO, in October 2015, was the culmination of a long process. The company [a vendor of data storage solutions] was six years old and had completed six rounds of private funding. Pure Storage had nearly twelve hundred employees, an d its annualized revenue was nearly $500 million. We’d waited longer and grown larger than many startups do before going public. We could have done it a year or so earlier, and there were risks in waiting: by the time we ﬁ nally listed on the New York Stock Exchange, the IPO market had cooled—in fact, some companies pulled their oﬀ erings in the face of market weakness.

But in retrospect, the timing worked out, and we wouldn’t have changed it if we could have. For a young growth company, ﬁ guring out when to go public is com- plex—and the conventional wisdom (along with some steps in the pro- cess) has changed signiﬁ cantly in recent years. Companies often face pressure from multiple stakeholders—employees, customers, inves- tors—who want liquidity sooner rather than later. At the same time, some startups are coming to realize that staying private longer may have signiﬁ cant advantages (see ﬁ gure 9-1). Here’s how we approached the choice.

BETTER TO WAIT In theory, we could have gone public in 2013. We were certainly big enough—by that point we had tens of millions of dollars in revenue. But we saw reasons to wait.One was that Sarbanes-Oxley [act by US Congress in 2002] has made it more expensive to be a public company. And although other compa- nies were interested in acquiring us, we wanted Pure to be a long-term (continued ) H7303-Entrepreneur.indb 155 H7303-Entrepreneur.indb 155 11/2/17 1:14 PM 11/2/17 1:14 PM 156 Financing Your Business play; as a small public company, we would ﬁ nd it harder to fend oﬀ M&A [mergers and acquisitions] interest than if we stayed private and main- tained control. But the biggest reason stemmed from the precedents set by Google and Facebook, which both stayed private much longer than venture-backed companies have historically. (Google was nearly six years old at its IPO, and Facebook was eight, whereas Netscape went public sixteen months after its founding.) The delay worked out extremely well for both companies, and it drove a change in the conven- tional wisdom. Companies used to do an IPO as soon as they possibly could; now many choose to wait. A couple of things were driving us to go public, however. For one, our customers encouraged us; many of them prefer to do business with a publicly traded company. They want to be able to see your ﬁ nancials and to understand how your business is doing. They know that public Source: “Pure Storage’s CEO on Choosing the Right Time for an IPO,” NVCA Yearbook, June 2016.

FIGURE \f-1 Waiting game Over the past decade, venture-capital-backed companies have tended to stay private longer. The higher regulatory requirements imposed by Sarbanes-Oxley are responsible in part for this trend.

0 1995 2000 2005 20102015 2 4 6 8Median time to IPO in years H7303-Entrepreneur.indb 156 H7303-Entrepreneur.indb 156 11/2/17 1:14 PM 11/2/17 1:14 PM Going Public 157 companies are subjected to a higher level of scrutiny. It gives them a sense of security and trust.

The other thing was valuation. Priv ate companies’ valuations have skyrocketed in recent years—and that has created complications when coupled with a wary public market. No one wants to go public at a valu- ation below the last private round. As we approached our ﬁ nancing, we tried to create win-win situations; I believe that the job of the CEO is not to aim for the highest possible valuation every time you seek ﬁ nancing but instead to craft a fair deal with investors who will be good advisers.

Going public would let us avoid another private round, one at a valuation we couldn’t match with our IPO.

PREPARATION AND LUCK After I arrived at Pure, we did two more venture rounds and then two rounds of private funding led by Fidelity and T. Rowe Price, mutual fund companies that ordinarily invest in public companies. This form of ﬁ - nancing is relatively new and is the result of Facebook and other compa- nies’ delaying their IPOs. Mutual fund portfolio managers missed some of the growth of such companies because they couldn’t invest before the IPO, so they’ve started making private placements. That’s advantageous for everyone. The funds get in on a period of higher growth, and they also get intelligence on what’s happening in an industry. We were able to build a relationship with important public-market investors; not only were they great sources of advice in the time leading up to our IPO, but we expected that they would remain big investors afterward. This new source of investment allows companies like ours to stay private longer. We also took steps to give our employees ﬂ exibility with their Pure shares. It can be easier to retain employees when a company is private, because they’re waiting for the liquidity that comes with the IPO—they don’t want to leave before they can cash in stock options. At the same time, that may create pressure to do an IPO early. To avoid that pressure, (continued ) H7303-Entrepreneur.indb 157 H7303-Entrepreneur.indb 157 11/2/17 1:14 PM 11/2/17 1:14 PM 158 Financing Your Business we gave employees selective liquidity when we did our ﬁ nancing rounds.

They could liquidate a certain percentage of their vested shares while providing a source of supply for institutional investors. More companies are allowing their workers to diversify their portfolios in this way, espe- cially as they stay private longer.We had to get ready to go public. The ﬁ rst step was to expand the board. We had strong directors, including our VCs, but we needed to add people with operating experience at large companies. In particular, we wanted someone with ﬁ nance experience at a publicly traded company to chair our audit committee; we brought in Mark Garrett, the CFO at Adobe Systems, to ﬁ ll the role. We needed a relationship with an invest- ment bank, and we were fortunate to be working with Allen & Company, which handled our ﬁ fth and sixth private rounds. We created a two-class structure for our stock, to help the founders and the management team maintain control if a hostile buyer tried to acquire us. Finally, we needed the right chief ﬁ nancial oﬃ cer. In 2014 we hired Tim Riitters, a former Google ﬁ nance exec, who helped us put in new systems to give us the better visibility into our ﬁ nancial performance that we’d need to operate in the public markets. By early 2015, it was clear that we had all the pieces in place. During our last private round, in 2014, the business had been valued at more than $3 billion. I couldn’t see any advantage to doing another private round, so we began planning for the IPO. But a key consideration is that once you start the process, you can become vulnerable. When you ﬁ le an S-1 form with the SEC disclosing your IPO plans, you enter a “quiet period,” with strict limits on what you may say publicly. If you’re in a 1. Select an underwriter. The underwriter—the investment banker you choose—will handle the details in collaboration with the man- agement team (see the section “The role of the investment bank,” below). In larger deals, there will be one lead underwriter and one or several comanagers. H7303-Entrepreneur.indb 158 H7303-Entrepreneur.indb 158 11/2/17 1:14 PM 11/2/17 1:14 PM Going Public 159 competitive space, as we are, you run the risk that competitors will spread “fear, uncertainty, and doubt” at a time when you can’t easily respond. Our business is a frontal assault on established storage com- panies such as EMC and HP (now Hewlett Packard Enterprise). But as it turned out, our timing was fortunate: in the months surrounding our IPO, Dell agreed to buy EMC, and HP announced its plan to split into two companies, which meant that key competitors were distracted by internal events.

Every CEO worries about the economic climate. While we waited to go public, we deﬁ nitely saw a deterioration in market receptivity to IPOs.

You just try to keep the ball rolling, complete all the steps to be ready, and hit while the IPO window is open. Not every company gets it right: at least ﬁ ve that had planned to do an IPO around the time we did ended up delaying or pulling out. We went public at a share price of $17 and an overall valuation of just over $3 billion. Since then our stock price has ﬂ uctuated—a reﬂ ec- tion of the turbulent market rather than any negative surprises at Pure.

We’re still reporting losses, but we’ve been able to make the case to investors that when you look at our growth rate, improving margins, and increasing operating eﬃ ciency, you see that this is a very healthy business. Pure is one of the fastest-growing enterprise technology companies the world has ever seen. We have to invest to maintain that—which is one reason that doing our IPO when we did made sense.

Source: Reprinted from Scott Dietzen, “Pure Storage’s CEO on Choosing the Right Time for an IPO,” Harvard Business Review , June 2016.

2. Prepare the registration statement for ﬁ ling with the SEC. The registration statement, a document required by federal law, forces the applicant company to disclose past business results, information about the company, and the intended use of the proceeds of the IPO. H7303-Entrepreneur.indb 159 H7303-Entrepreneur.indb 159 11/2/17 1:14 PM 11/2/17 1:14 PM 160 Financing Your Business 3. Conduct due diligence. In the case of IPOs, due diligence is the investigation of facts and statements of risk contained in the reg- istration statement; it aims to ensure that this material is accurate and that other relevant facts have not been omitted. Is the company using an unorthodox accounting convention? Is it involved in any current lawsuits? Has it been granted patents, or are patents pend- ing? Due diligence is the responsibility of those who prepare and sign the registration statement.

4. Print and distribute the prospectus. The preliminary prospectus (also called a red herring) is part of the registration statement. It contains information about the company and the intended use of the issue proceeds, and it is sent to prospective investors to generate interest in the deal.

5. Prepare and conduct a road show. At a series of meetings, usu- ally held in major cities around the country, potential investors can grill the CEO or CFO (or both) about the company and the intended offer ing of securities.

6. Agree on a ﬁ nal price and the number of shares to be sold. This step is one of the most important steps in the IPO process. What is a fractional share of ownership in a company actually worth? Im- portant as this question may be, the answer is based as much on art as on science. A price range will be indicated in the prospectus sent to investors—for example, $15 to $20 per share. As the big moment approaches, however, the underwriter will look at demand for the shares, the price that comparable companies managed to get in recent IPOs (if comparables can be found), and the projected earn- ings of the company itself. The underwriter will also suggest a price that will give investors in the newly issued shares a better-than- even chance of making money on their transactions—that is, a price slightly lower than the price at which the shares are likely to trade in the days immediately after the offering. If the issuing company does not like the price, it can put the brakes on the offering. H7303-Entrepreneur.indb 160 H7303-Entrepreneur.indb 160 11/2/17 1:14 PM 11/2/17 1:14 PM Going Public 161 7. Commence trading. After the price has been established and the ﬁ nal regulatory loose ends have been tied up, shares can begin trad- ing on the exchange chosen.

8. Close the purchase and sale of the shares. In this ﬁ nal act of the IPO process, stock certiﬁ cates are delivered to the shareholders, and the underwriter delivers the proceeds (less fees and expenses) to the issu ing company. The company now has its money.

This process generally takes four to ﬁ ve months. If all has gone well, the entrepreneurial ﬁ rm ends up with a substantial amount of cash in its war chest and is prepared to begin the second stage of its life—that of a publicly traded corporation. The underwriter will try to support that sec- ond stage by providing ongoing research to investors on the newly public company. This research keeps the company in the public eye and, if the news continues to be good, it supports the share price. Certainly there is much, much more to the IPO process than described here. For example, there are restrictions on company-generated publicity before, during, and immediately after the ﬁ ling period and on so-called lockup agreements, or the sale of shares by insiders. The rules regarding the issuing of securities in the United States are, indeed, many and ar- cane—and that is why professional help is essential. For a ﬁ rst-person overview of the IPO process—and the excitement it generates—see the box “IPO day.” The role of the investment bank Going public is a specialized activity, one that requires unique skills and capabilities that no entrepreneurial company has (or should have) on its payroll. Instead, you’ll get these skills and capabilities through an invest- ment bank. (See more on why you need an investment banker in the box “The need for an investment banker.”) An investment bank is not like the more familiar commercial bank. It is not in the business of taking deposits and making loans. Instead, it acts H7303-Entrepreneur.indb 161 H7303-Entrepreneur.indb 161 11/2/17 1:14 PM 11/2/17 1:14 PM 162 Financing Your Business IPO day By Annie Bourne, Managing Director of Ivy Road, LLC I had a front-row seat to one of the most successful IPOs of the dot-com boom. In July 1999, I left a law ﬁ rm for a business development role at a startup with a strange name—Akamai Technologies. On day one, be- cause we did not yet have a general counsel, the company told me—the only ex-lawyer then on staﬀ —to manage the IPO. Because of the phe- nomenal technology, timing, and team, the Akamai IPO became one of the most successful IPOs of that era. So what actually happens inside a company on IPO day? Here’s what happened in my experience (which, granted, was over a decade ago). Several of the company leaders reappear, having spent the prior two weeks ﬂ ying around Europe and the US on private jets, spinning the company’s prospects to potential investors. Before that, there’s a lot of government-regulated preparation. Bankers and lawyers write a docu- ment that describes the business and the risks of investing in it to po- tential investors. They build a ﬁ nancial model of existing and expected revenues. They ﬁ le it with regulators, wait for comments and respond to them. Then the company leaders start the roadshow, which hope- fully creates enough excitement about the company among large in- vestors that the bankers can line up buyers—if you’re lucky, stacks of buyers—for a chunk of the “book” of available shares. Then, in a seem- ingly unscientiﬁ c frenzy in a paneled room on Wall Street, the bankers decide what price to place on the opening shares, and when to start selling them. For the employees, the actual day of “going public” is very strange.

At Akamai, in the early afternoon, we left our desks and met in a con- ference room to watch. There was not much to see. A large TV monitor sat above eye level on a tall rack. Plates of cheese cubes and crackers covered a table. We squeezed in, shoulder to shoulder, heads tilted up to H7303-Entrepreneur.indb 162 H7303-Entrepreneur.indb 162 11/2/17 1:14 PM 11/2/17 1:14 PM Going Public 163 the screen. Most of our faces were unfamiliar to one another; the com- pany had hired a lot of top people leading up to the IPO with the lure of pre-IPO options.

The screen ﬂ ickered. Then green numbers appeared. We cheered!

AKAM stock was then available for purchase on the NASDAQ. Just like that. We watched the green numbers change—just simple rows of green numbers. Someone explained that the numbers represented the “bid” and the “ask”—what someone would pay for a share, and the price at which someone else would sell it. The bankers priced the shares at $26.

They opened for trading at $114.50, and buyers chased it higher and higher until it settled down and ﬁ nally closed at $145.19 at the end of the trading day. As those green numbers changed on the screen, we cheered more and ate cheese, while some colleagues had just become immeasurably wealthy—at least on paper. By law, vested employees were “locked up” and could not trade their vested shares until several months later. (Sev- eral months later, the boom would bust and much of that paper wealth would ﬂ utter away, but no one wanted to see that coming.) Akamai was so young, and the boom so frothy, that most employees had not yet vested any shares. Our cofounder [and chief technology oﬃ cer], Danny Lewin, had suddenly turned from a struggling graduate student to a staggeringly wealthy man. His share of the company was worth over a billion dollars at the end of the day. It would have turned anyone’s head. But at 29, somehow Danny knew that the IPO—this moment of triumph—could also destroy his company. This was because, ironically, the collective eﬀ orts of his employees had created value that had made many of them inde- pendently wealthy. They did not need to be there anymore, even if the company still needed them. That day, Danny did something remarkable. In the midst of the IPO celebration, Danny invited everyone to a conference room to discuss his (continued ) H7303-Entrepreneur.indb 163 H7303-Entrepreneur.indb 163 11/2/17 1:14 PM 11/2/17 1:14 PM 164 Financing Your Business as an agent and a deal maker for business entities seeking capital. In re- turn for a fee of 6 to 10 percent of the offering price, the investment banker does the following:

1. Helps the issuing corporation get its regulatory act together: Speciﬁ cally, it helps the corporation over the stringent regulatory hurdles that go hand in hand with issuing securities. These hurdles include the development of a prospectus. In its preliminary form, the prospectus provides full disclosure to potential investors about the company, its business, its ﬁ nances, and the way it intends to use the proceeds of its securities issuance. As mentioned above, the pre- liminary prospectus is called a red herring.

2. Sets the price of the securities being oﬀ ered: When shares are being offered to the public for the ﬁ rst time, no one knows for cer- tain how they should be priced. Those shares haven’t been traded back and forth by willing buyers and sellers, so there is no certainty as to the market-clearing price. The capital-seeking corporation naturally wants its shares priced as high as the market will bear; doing so maximizes the cash going into its coffers. But investors ex- pect a new issue to be priced at a bargain relative to seasoned secu- rities. The investment banker has expertise in this difﬁ cult pricing area and mediates between these disparate interests. grand vision of the company’s future. While green numbers still rose on the monitor, the party room emptied. The conference room ﬁ lled. Danny, another young redhead who wore faded jeans and white T-shirts, cov- ered whiteboards with his vision. He spun us all up on the immense and powerfully exciting challenges ahead. The same big idea that made in- vestors buy the company would make employees stay to build it.

Source: Annie Bourne, “To Be a Fly on the Wall at Facebook on IPO Day,” HBR.org, May 17, 2012. H7303-Entrepreneur.indb 164 H7303-Entrepreneur.indb 164 11/2/17 1:14 PM 11/2/17 1:14 PM Going Public 165 3. Arranges for the distribution of shares: The issuing corpora- tion may have the shares, but the investment banker has access to potential purchasers. By putting a syndicate of distributing broker- dealers together, the investment banker can “move the merchandise” into the portfolios of pension funds, mutual funds, and individual investors. The investment bank usually takes the shares off the hands of the issuing corporation at a given price, marks them up to some predetermined proﬁ table level, and uses its own distribution channels and those of its syndicate partners to sell them to the invest ing public. In this sense, the investment banker underwrites the risk of selling hundreds of thousands of shares.

To choose an investment banker, you’ ll probably have three to ﬁ ve can- didates make presentations to you and your leadership team. You should look for a good ﬁ t with your industry. They should also have the sales and distribution capabilities you need and should be able to provide good an- alyst coverage for you once you go public. You’ll also be interested in their take on the current market and what they think your valuation should be— and conﬁ rmation that they agree that you are ready to go public. The need for an investment banker Whatever route you take to secure outside capital, be it an IPO or an alternative, make sure to get the advice of an experienced investment banker. Commercial banks and securities broker-dealers have special departments that do this work. Their services are expensive, but they have the technical expertise and the investor contacts you need to make a favorable deal. For more information on this subject, see the sources listed in “Further Reading” at the end of this book. H7303-Entrepreneur.indb 165 H7303-Entrepreneur.indb 165 11/2/17 1:14 PM 11/2/17 1:14 PM 166 Financing Your Business Alternatives to an IPO An IPO can be just the thing a growing company needs to expand to its potential. But very few companies have the size or growth potential for this type of ﬁ nancing. Some enterprises are in industries so out of favor with the investing public that the deal would have few takers. Still other companies deliberately forgo IPOs to avoid the problems associated with going public. Are these companies cut off from substantial equity capital?

Are their current owners unable to harvest their investments? The answer is no. There are alternatives to an IPO: sale of a large block of equity via a private placement, and sale of the company itself. We’ll consider the ﬁ rst of these alternatives in this chapter and examine company sales in a later chapter. Private placement refers to the sale of company stock to one or a few private investors instead of to the public. In many cases, these private in- vestors are sophisticated ﬁ nancial institutions such as insurance compa- nies, pension funds, and endowment funds that seek a higher return than could be obtained from public investing. A key beneﬁ t of private place- ment is that these deals are exempt from SEC registration requirements (although some states do have requirements). Thus, the entrepreneurial ﬁ rm can obtain a sizable piece of capital without the time and expense of a public offering. Nor will its management and business results be subject to the public scrutiny that follows an IPO. Private placement ﬁ nancing can take several forms: senior or subordi- nated debt, asset-backed debt, and equity. Because these are private deals, the company and the investor may be able to work out arrangements that suit both parties. For example, if the company prefers debt but the inves- tor insists on an opportunity to share in the ﬁ rm’s upside potential, an investment banker might design a debt instrument with a below-market interest rate (good for the company) but with warrants attached (good for the investor). A warrant is a security that gives the holder the right to purchase com- mon shares of the warrant-issuing company at a stated price for a stated H7303-Entrepreneur.indb 166 H7303-Entrepreneur.indb 166 11/2/17 1:14 PM 11/2/17 1:14 PM Going Public 167 period. The stated price is generally set higher than the current valuation of the shares.

Summing up ■An IPO is a pipe dream for all but a few corporations.

■An IPO brings much-needed cash to a growing company and, for its owners, an opportunity to liquidate and diversify their wealth.

■The downside of an IPO is its expense, absorption of management time, dilution of ownership, ongoing public scrutiny, and pressure to produce short-term gains.

■Consider the right time to go public, weighing current market conditions as well as your interest in keeping control of the company.

■Don’t consider an IPO unless your corporation has these qualities: a CEO who knows how to communicate, a deal size of $10 million or more, a record of double-digit growth in revenues and earnings (or earnings clearly ready to follow), outstanding and diﬃ cult-to-copy products or services, quality employees, and a logical strategy for growth.

■From the perspective of a cash-hungry US corporation, there are eight steps to an IPO: selecting an underwriter, preparing and ﬁ ling a regis- tration statement with the SEC, conducting due diligence, distributing a preliminary prospectus (a red herring), mounting a road show by top man- agement, determining the share price and number of shares in the issue, beginning trading, and closing the purchase and sale of shares.

■An investment bank provides two important necessities: the technical knowledge for getting the deal through the registration process and the sales network needed to distribute the company’s shares to the investing public.

■A private placement is often a good alternative to an IPO. H7303-Entrepreneur.indb 167 H7303-Entrepreneur.indb 167 11/2/17 1:14 PM 11/2/17 1:14 PM H7303-Entrepreneur.indb 168 H7303-Entrepreneur.indb 168 11/2/17 1:14 PM 11/2/17 1:14 PM PART FOUR Scaling Up H7303-Entrepreneur.indb 169 H7303-Entrepreneur.indb 169 11/2/17 1:14 PM 11/2/17 1:14 PM H7303-Entrepreneur.indb 170 H7303-Entrepreneur.indb 170 11/2/17 1:14 PM 11/2/17 1:14 PM 10.

Sustaining Entrepreneurial Growth If your company has large growth potential and your goal (and that of your investors!) is to achieve that growth, you’ll work together toward increas- ing your revenue and market share and, ultimately, your proﬁ ts. You may even pursue a grander vision: to change how people work and live. Sometimes, scale can make or break a startup, especially if it is a plat- form business or a web-based marketplace. Reid Hoffman, cofounder of PayPal and LinkedIn, argues that in these types of business, fast scaling is necessary for a couple of reasons. First, it creates value for users. For exam- ple, LinkedIn offers a deep user base of professionals, eBay connects both buyers and sellers, and Amazon succeeds with its low margins and high volumes. Companies also need to scale quickly to reach customers faster than their competitors do, for ﬁ rst-mover advantage—the ability to con- nect with customers and secure their loyalty in a certain segment before H7303-Entrepreneur.indb 171 H7303-Entrepreneur.indb 171 11/2/17 1:14 PM 11/2/17 1:14 PM 172 Scaling Up anyone else does. Hoffman calls growth at the aggressive rate that these businesses require blitzscaling.Growth, however, is a mixed blessing—especially rapid growth. As you’ve seen earlier, infusions of external capital are usually required if the business is to keep pace with a growing demand for its product or service.

And every dollar of outside capital has a negative effect. Debt capital raises ﬁ xed expenses, making the enterprise more risky. Outside equity capital dilutes the founders’ ownership—and control. Finding more capital is only one of the challenges created by growth.

You’ll also run into larger challenges in marketing, strategy, human re- sources, and—perhaps most of all—the transition from entrepreneurial to professional management. In this chapter, we’ll address the changes your business needs to make as it grows, and in chapter 11, we’ll discuss the ac- companying changes in leadership and management.

The impact of growth Hewlett-Packard Corporation (HP) traces its origin to a small garage in Palo Alto, California. There in 1938, Bill Hewlett and David Packard de- veloped an audio oscillator. Walt Disney Studios ordered eight units to use in producing sound effects for one of its ﬁ lms, Fantasia , and the two young engineers formalized their partnership the next year. The enterprise listed two employees that year—Bill and Dave—and reported $5,369 in revenues. Within a year, HP had more than doubled its revenues, hired another employee, and moved into a larger rented workshop. The war years brought military orders for signal-generating equipment—so many orders that the company had to build a new facility and hire more people to handle all the work. By 1943, the height of the war years, HP had 111 people on its payroll and nearly $1 million in revenues. Founders Hewlett and Packard learned a thing or two about running a business during those early years and about managing their own transi- tions from technical whiz kids to leaders and managers. Packard’s wartime experience as an army ofﬁ cer no doubt helped. The two men learned rule number one: that management is about getting results through people. H7303-Entrepreneur.indb 172 H7303-Entrepreneur.indb 172 11/2/17 1:14 PM 11/2/17 1:14 PM Sustaining Entrepreneurial Growth 173 Their own skills were insufﬁ cient; Hewlett and Packard had to marshal the talents and energy of many employees. Innovations in electronics and a surging postwar economy created new challenges for the company founders. They had to identify new mar- ket opportunities in the peacetime economy and develop strategies for sat- isfying them. Equally important, Hewlett and Packard had to develop a style of management and a company culture that would attract talented people and encourage them to contribute to the fullest. That style and cul- ture, later dubbed the HP Way, evolved gradually during the late 1940s and early 1950s. By contemporary standards, the growth of HP from a two-man part- nership to a globe-spanning enterprise with almost ninety thousand em- ployees serving nearly a billion customers seems rather slow. Nineteen years crept by before the company reached the milestone of one thousand employees. How the company should grow and how big it should become were matters of intense internal debate in those days, according to the company’s own chroniclers. Even more remarkable, HP did not become a public company until 1957, nearly two decades after Bill and Dave went to work in their Palo Alto garage. That deliberate pace stands in sharp contrast to the record of more recent wunderkind startups. Amazon’s rev- enue was $5.1 million in 1996 and $1.64 billion three years later. Airbnb was founded in August 2008. By 2010, forty-seven thousand people stayed with Airbnb hosts in the summer alone, and by 2015, that number was 17 million. Uber, founded in 2009, has reportedly gone from $688 million in ride-share bookings in 2013 to a reported $10.84 billion two years later. Your venture may never achieve either this kind of explosive grow th or even the slow build to the scale of Hewlett-Packard. But simply breaking out of the startup phase and experiencing moderate growth will expose you to some of the same perilous transitions and challenges those compa- nies and their founders experienced. Expanded adoption and sales trigger requirements for grow th in all the activities that support it: customer ser- vice, marketing, transaction accounting, and after-sales service, as well as materials purchasing, inventory management, manufacturing, and logis- tics for physical product. Growing sales oblige you to study new channels of H7303-Entrepreneur.indb 173 H7303-Entrepreneur.indb 173 11/2/17 1:14 PM 11/2/17 1:14 PM 174 Scaling Up distribution, the feasibility of extending product lines, and possible entry into new markets. New customers create a demand for customer service and for strategies to retain their patronage.Growing sales must also be supported by growing employee head count —developers, security engineers, marketers, operations, sales, sales support, customer service, and so forth. You must have the human re- sources staff to recruit staff, comply with labor laws, and manage employee beneﬁ ts, all on a larger scale. And don’t forget about ﬁ nance. Without a knowledgeable CFO and accounting staff to keep payments, collections, and spending on an even keel, the enterprise could easily capsize and sink.

More than a few promising ventures have failed because they did not man- age their way through their initial success. If you’ve broken out of the startup phase and are experiencing revenue growth, ask yourself three questions:

• Is our strategy sustainable?

• Do we have unique advantages that would let us expand into other markets?

• Is scaling up the business a practical possibility?

Ideally, you will have given these questions much thought in planning your business. Even so, you need to revisit them and recalibrate where nec- essary. Let’s consider each issue in some detail.

Growth strategy By deﬁ nition, strategy is what differentiates a business in a way that con- fers a competitive advantage. Robust revenue grow th is evidence that your strategy is working. The question is, How much longer will it continue working? Perhaps your strategy is based on a new and superior product or technology or on your ability to deliver an ordinary product at a lower price or in a manner that is extremely convenient for customers. But what hap- pens if your competitors improve their offerings, the technology matures, new technology arises, or the context changes in some other way? H7303-Entrepreneur.indb 174 H7303-Entrepreneur.indb 174 11/2/17 1:14 PM 11/2/17 1:14 PM Sustaining Entrepreneurial Growth 175 Few strategies are sustainable over the long term. Eventually, some change will undermine the competitive advantage: new regulation, de- regulation, the introduction of a new and superior technology, or a new process for making a product faster, cheaper, or better. In other cases, an entrepreneurial ﬁ rm (such as yours) creates a new market; if that new mar- ket is proﬁ table and expanding, other entrepreneurs will recognize its po- tential and enter with products or services of their own. The market for home video is a good example. Blockbuster, founded in 1985, was by 1993 the market leader in home movie and game rentals, with its brick-and-mortar stores almost ubiquitous in towns across America.

But when Netﬂ ix introduced its mail-service video program in 1999, with no late fees and a much greater variety of videos available, it began mak- ing incursions into Blockbuster’s business. Additional competition from Redbox and on-demand cable channels further challenged the brick-and- mortar behemoth. Despite several attempts at its own online business, Blockbuster began closing stores in 2006 and ceased operations in 2013. Could this happen to your business?

To sustain growth, keep looking several steps ahead. Recognize pat- terns in your industry to anticipate solutions offered by your competitors.

Find ways to bar the door to new competitors. Netﬂ ix did this by using its DVD business as a way to introduce customers to the new technology of streaming video. People who were already Netﬂ ix customers found it easy to switch their video-watching habits from DVDs to movies streamed di- rectly and immediately to devices in their homes. By then building its own original-content div ision, Netﬂ ix controlled both the content and a distri- bution mechanism to customers. The strategy, which became a virtuous circle that competitors had a hard time breaking into, has placed Netﬂ ix as a leader in its industry. It’s unlikely that Netﬂ ix’s strategy would be appropriate for your busi- ness, but there are other ways to be the vendor of choice or to discourage rivals from entering your market. Here are a few:

• Exploit the learning curve. If you are the ﬁ rst in the market, continual improvement in product design and manufacturing H7303-Entrepreneur.indb 175 H7303-Entrepreneur.indb 175 11/2/17 1:14 PM 11/2/17 1:14 PM 176 Scaling Up efﬁ ciency will allow you to offer your item for less and yet main- tain the same proﬁ tability. Late-to-market competitors that fail to catch you on the learning curve will be doomed to slim proﬁ ts or none at all.

• Don’t price for maximum proﬁ ts. Competitors are drawn to markets with high proﬁ t margins. If you are ﬁ rst in your market, you can make the market unappealing to rivals if you and your investors are willing to price low and accept a modest proﬁ t mar- gin. Faced with modest proﬁ ts, would-be competitors are likely to stay away.

• Continually refresh your oﬀ er to customers. Think of all the ways you can make your product more appealing: by adding new features or color choices, lowering the price, making it more con- venient to purchase, eliminating quality problems, or providing amazing customer service. And think more broadly: how can you reinvent your product to solve an as-yet unmet customer need?

• Be constantly vigilant about competition. As you grow, who is going to notice you and try to stop you? How can you change course or reﬁ ne your strategy to avoid or beat a competitor’s challenge?

Such initiatives can create barriers to competition or make you the vendor of choice in a crowded ﬁ eld. Together, they will help you sustain growth. Expanding into new markets Does your venture have unique advantages that would help you move suc- cessfully into other markets? For example, there may be geographic re- gions where you currently have no distribution. Assuming that customer needs in those unserved regions are the same as, or similar to, those you are currently satisfying, geographic expansion is the answer—either through your own sales and marketing efforts or indirectly through distributors or a sales representation arrangement. H7303-Entrepreneur.indb 176 H7303-Entrepreneur.indb 176 11/2/17 1:14 PM 11/2/17 1:14 PM Sustaining Entrepreneurial Growth 177 Other untapped markets may be found within your current geographic range. Here a few ideas for doing so:

• Find new uses for the same product. A classic example: almost every household has a small box of baking soda (sodium bicarbonate) in the kitchen. Most families will not use more than one box per year for cooking. One of the leading suppliers aimed to increase other kinds of consumption of the product. Its advertising campaign encouraged people to put an open box of its baking soda in the refrigerator to absorb food odors. And, of course, it recommended changing that box every month. Mixing baking soda in the cat’s lit- ter box was yet another sales-generating idea. This campaign greatly increased sales to existing customers and created many new ones.

• Find ways to alter or customize your product to the needs of other niches. For example, the Swiss manufacturer of Swatch watches learned to develop dozens of unique watches—for men, women, teenagers, sports fans, and other groups—using the very same inter nal timepiece elements. The only thing that changed was the exterior case design. But that single change enabled the watch- maker to exploit different market niches at very low cost.

What plan does your enterprise have for recharging the growth en- gine? A steady stream of new products can help, but new-product devel- opment is risky and expensive. As these examples indicate, sustained sales growth does not always require invention. Scaling up your organization Sales growth challenges the entrepreneurial ﬁ rm’s capacity to keep pace.

A service venture that bases its production on employee output must keep hiring qualiﬁ e d p e ople i f it hop e s t o g r ow. C on sider a m a n a g ement c on s u lt- ing ﬁ rm. Its production is handled through professional employees. Thus, to fuel its growth engine, the ﬁ rm must hire individuals who can sell and deliver consulting services. Only people with unique skills and experience H7303-Entrepreneur.indb 177 H7303-Entrepreneur.indb 177 11/2/17 1:14 PM 11/2/17 1:14 PM 178 Scaling Up are capable of providing these services, and some training may also be re- quired. But capable personnel may be in short supply and expensive. The management team would have to ask itself, “Can we scale up our human assets fast enough to satisfy demand and our own expectations of growth?” The same question applies to other service ﬁ rms.

Product-based businesses must also scale up to meet the demands of growth. For these companies, scaling up ordinarily involves substantial commitments of capital made well in advance of actual sales. For example, a manufacturer must usually plan and begin construction of production facilities a year or more before the ﬁ rst widget comes off the line. Doing so requires both capital and a strong conviction that customer demand will actually be there a year or more in the future. LinkedIn’s Reid Hoffman describes how this kind of rapid growth places demands on the kinds of guidelines businesses typically maintain:

In hiring, for instance, you may need to get as many warm bodies through the door as possible, as quickly as you can—while hiring quality employees and maintaining company culture. How do you do that? Different companies use different hacks. As part of blitz- scaling at Uber, managers would ask a newly hired engineer, “Who are the three best engineers you’ve worked with in your previous job?” And then we’d send those engineers offer letters. No interview.

No reference checking. Just an offer letter. They’ve had to scale their engineering fast, and that’s a key technique that they’ve deployed.

Th i s k i nd of cre at ive t h i n k i ng—a nd r i sk t a k i ng—a l lowed Uber t o g row more rapidly than if they had stuck to predetermined processes. For manufacturing ﬁ rms, one antidote—at least in the short run—is to outsource (for caveats about this approach, see the box “Tips on out- sourcing”). There are usually plenty of competent manufacturers willing to sell unused capacity. This is exactly what Jim Koch, founder of Bos- ton Beer Company, did when he began his venture to brew and distrib- ute Samuel Adams Boston Lager and its various specialty beers. Koch, a sixth-generation brewer, left his management consulting job to start the H7303-Entrepreneur.indb 178 H7303-Entrepreneur.indb 178 11/2/17 1:14 PM 11/2/17 1:14 PM Sustaining Entrepreneurial Growth 179 company. And like most smart entrepreneurs, he started small. He set up an R&D facility inside an abandoned Boston brewery, where he developed his initial recipes. The actual brewing and bottling—capital-intensive ac- tivities—were done on a contract basis under the supervision of Koch’s brewmaster at a high-quality Pennsylvania brewery. Thus, the entrepre- neur maintained control of the features that made his product distinctive; the contract brewery contributed what Koch lacked and scaled his output to customer demand. As Boston Beer Company’s sales grew and distribu- tion expanded around the United States, the company employed similar brewery outsourcing arrangements to scale up quickly and without major capital outlays. Tips on outsourcing Outsourcing can help you scale up rapidly without creating ﬁ xed as- sets that you cannot aﬀ ord—or assets that would drag you down if de- mand were to falter. And it frees up managerial time and attention for the things that really diﬀ erentiate your company. But observe these two cautions in outsourcing activities to others:

• Avoid outsourcing any activities that connect you directly with customers—such as sales, customer service, market research, and product or service development. These interfaces pro- vide communication links between you and your constituency, enhanc ing your ability to learn about them and their ability to learn about you. If you outsource these links, your customers will become your outsourcing partner’s customers.

• Avoid depending too much on any single outsource partner. Think what would happen if a manufacturing, assembly, or distribution partner were to fail or otherwise stop doing business with you.

Hedge your bets by diversifying your outsource relationships. H7303-Entrepreneur.indb 179 H7303-Entrepreneur.indb 179 11/2/17 1:14 PM 11/2/17 1:14 PM 180 Scaling Up As your business scales up, it also needs to change. You may need to modify your strategy, reshape your offering, shift your structure, or recon- sider how you hire. Summing up ■Growth forces companies through transitions.

■Continued growth is usually a function of a sustainable strategy, the ability to expand into other markets, and mechanisms for scaling up the volume of output.

■Companies have several mechanisms for sustaining growth. They include (1) exploiting the learning curve to maintain a cost advantage, (2) not pricing for maximum proﬁ t (high proﬁ ts attract competitors), and (3) con- tinually refreshing the oﬀ er to customers.

■To scale up, businesses often have to change their guidelines around pro- cesses like hiring to make themselves more nimble.

■Companies can often scale up to meet rising demand by outsourcing peripheral tasks to suppliers. However, outsourcing core tasks—particu- larly those that put the outsource partner in direct contact with custom- ers—can have very bad consequences. H7303-Entrepreneur.indb 180 H7303-Entrepreneur.indb 180 11/2/17 1:14 PM 11/2/17 1:14 PM 11.

Leadership for a Growing Business Although sales may seem to be the greatest growth challenge for a grow- ing venture, organizational issues often eclipse it. You and your startup team must periodically reinvent your organization to cope with changing circumstances. As Amar Bhidé of the Fletcher School at Tufts University puts it, “To attain sustainability, the capabilities of the ﬁ rm (as opposed to those of the entrepreneur) have to be somehow broadened and deepened.

More qualiﬁ ed personnel have to be added, the specialization of functions increased, decision making decentralized, systems to cope with a larger and more complex organization instituted, and the employees oriented towards a common long-term purpose.” To accomplish all these worthy goals, you and the other founders must usually reinvent yourselves; that is, you must change your mode of working from doing things yourselves to doing things through other people. Many ﬁ nd this reinvention difﬁ cult.

They fail to change, becoming liabilities to the very companies that they founded. H7303-Entrepreneur.indb 181 H7303-Entrepreneur.indb 181 11/2/17 1:14 PM 11/2/17 1:14 PM 182 Scaling Up You and your core team contribute important assets to the company: a common vision, technical skills, management skills, and personal energy and time. Growth puts a strain on each of these contributions:

• Your vision must be instilled in newly hired employees.

• The technical skills that made your startup successful become relatively less important as the need for operational and manage- ment skills increases.

• Your founding team’s management skills may not be up to the challenge of a larger organization.

• Your personal energy and time are ﬁ nite, but the need for energy and time to direct and control the expanding enterprise keeps growing. The right leadership approach for your size To remain relevant and effective, you and the rest of the leadership team must ﬁ nd new ways to operate. Har vard Business School professor Mi- chael J. Roberts has described the four possible approaches to leading a startup faced with rapid growth:

• Managing content • Managing behaviors • Managing results • Managing context Roberts describes each of these approaches in more detail. Let’s exam- ine them as well.

Managing content The most direct approach to getting things done is to do them yourself or to directly supervise those who do. Whether it’s hiring a new employee, H7303-Entrepreneur.indb 182 H7303-Entrepreneur.indb 182 11/2/17 1:14 PM 11/2/17 1:14 PM Leadership for a Growing Business 183 working out the design of a new product, or moving goods through produc- tion and into the stockroom, the content manager is intimately involved.

In a startup organization, the CEO and leadership team often follow this approach. And why not? The scope of activity is small, and employees are few.

Managing content gives you substantial control. And control appeals to many entrepreneurs, who are often motivated to start their own compa- nies out of an innate need or desire to control their own work and future.

But as operations expand, the entrepreneur’s time and energy cannot keep pace. Also, his or her ability to make good decisions may falter with the arrival of new challenges that require special skills or experience. Failing to recognize when managing content is no longer appropriate can cause the business to fail.

Managing behaviors In this approach, according to Roberts, you specify how people should behave; you identify the behaviors that lead to success and codify them through policies, rules, and procedures that employees are told to follow.

Unlike the content-oriented manager, the behavior-mode founder of, say, a medical diagnostic laboratory doesn’t supervise the day-to-day work of test-lab workers. Instead, the founder trains them to run speciﬁ c tests and then audits their compliance with that training. This approach makes better use of your time and effort, enabling you to maintain control over a growing enterprise. Instead of trying to man- age everything, you rely on policies, rules, procedures, job design, and behavior-auditing systems to do the heav y lifting. This approach is most useful when employees are inexperienced or need clear direction. For example, the manager of a newly trained group of salespeople might tell them, “I want each of you to talk with twenty prospective clients every day. Do that, and you should get one new account per day, or ﬁ ve every week. After six months, you’ll have a solid base of commission business.” If employees agree to this work strategy, the man- ager can then use his or her time to monitor compliance with the twenty- contact rule, helping where needed. H7303-Entrepreneur.indb 183 H7303-Entrepreneur.indb 183 11/2/17 1:14 PM 11/2/17 1:14 PM 184 Scaling Up Managing results Unfortunately, the manage-behavior approach assumes that you’ll get the results you want if people behave in the manner you’ve prescribed. This doesn’t always happen. In the salesperson example just given, maybe talk- ing to the required number of prospects doesn’t actually yield a new ac- count every day.Worse, the approach assumes that your prescription is the only way to reach that goal of ﬁ ve accounts per week. But that’s not always the case. In many scientiﬁ c and engineering endeavors, for example, employees must solve complex problems for which there are no clear guidelines. In these cases, leaders must look to their talented and creative employees to ﬁ nd optimal solutions. A leader using a results approach says, for example, “We need to desig n a milita r y vehicle that is f uel- ef ﬁ cient (twenty-ﬁ ve miles per gallon on paved roads), that is capable of driving over rough terrain, and that can protect the driver and ﬁ ve passengers from small-arms ﬁ re.” The leader tells the employees what the result should look like and gives them the responsibility for producing it. Returning to our salesperson example, you might simply tell each employee that the annual goal is to produce a minimum of 150,000 euros in commission revenue. Results-focused management saves time for time-strapped entrepre- neurs. Instead of specifying what people in different jobs should do and how to do it, they can concentrate on providing the resources, the training, and the motivation that people need to produce results.

Managing context Leaders who take a more context-based approach also focus on results, but they seek it more broadly by shaping the culture, values, and structure of the organization. Generally speaking, they aim to create an environment that will naturally attract and retain highly competent employees and allow them to do their best work. According to Roberts, these managers se- lect employees, develop them, and rely on general communication to shape the context of the work. Upper management spends little or no time telling H7303-Entrepreneur.indb 184 H7303-Entrepreneur.indb 184 11/2/17 1:14 PM 11/2/17 1:14 PM Leadership for a Growing Business 185 people what to do or how to do it. In our salesperson example, a leader might give the sales team freedom not only to determine the best way to win new accounts but also to set their own goals. The salespeople might consequently create goals like w inning back lapsed accounts or measuring the proﬁ tability of certain kinds of accounts to make better decisions about which leads to pursue in the long term.

Is there a best way to manage a startup? Certainly not. But there may be a best mode for a particular company at a particular point in its develop- ment. For example, McDonald’s owes much of its success to its highly con- trolled, behavior-mode style of management, which relies on procedures and job design to prepare and serve its products with high efﬁ ciency. It would never tell its crews, “Figure out the best way to handle all those cus- tomers who are lined up for our food.” It has spent years developing an efﬁ cient operational blueprint. Yet the rigid, by-the-book rules that work for McDonald’s would be disastrous for a creative design company such as IDEO. So be aler t to your current needs, and understand how they are chang- ing. As Roberts warns, the transitions between these approaches need extra attention; as the volume and scope of work grows, the manager has le s s t i me for h a nd s - on i nvolvement . W h i le you ng , sm a l l , si mple ent er pr i se s tend to depend on a content management style, with leadership closer to the front lines, larger and larger organizations call for the other leadership styles in turn. Which management method are you using today? Is it appropriate for your current state of development and growth? Table 11-1 is Roberts’s assessment of when the different approaches are most appropriate, along with the assumptions, behaviors, and tools associated with each. Although the four leadership approaches discussed in this section may help you think about how best to manage in different circumstances, no law of nature dictates that an executive can use only one mode at any given time. You may ﬁ nd reasons to use more than one mode, depending on the H7303-Entrepreneur.indb 185 H7303-Entrepreneur.indb 185 11/2/17 1:14 PM 11/2/17 1:14 PM 186 Scaling Up TABLE 11-1 Four leadership approaches Leader’s focus Content Behavior Results Context SituationYoung, small, sim- ple enterprise Somewhat larger, more involved enterpriseLarge, complex organization Very large, very complex, mature organization Driving assumptions Insuﬃ cient knowl- edge, experience to plan Subordinates not capable of inde- pendent action or decisions Too little time to do everything Subordinates can act independently but in accordance with managerial prescriptionToo little time Subordinates can achieve better out- comes with their own means Too little time and knowledge Right people in the right envi- ronment with the right mission will succeed Behavior On the front lines Barking orders Pitching in to help out Developing process and procedure Observing Attending meet- ings, reviews Studying plans, papers, reports Writing memos Lots of time on key hires and promotion To n e -s e t t in g events Key skills, tools Action Decisions Policies Procedures Behavior auditPlans Budgets Organizing struc- ture and systems Communication Leadership by example Source:

Michael J. Roberts, “Managing Transitions in the Growing Enterprise,” in The Entrepreneurial Venture, 2nd ed., eds William A. Sahlman, Howard H. Stevenson, Michael J. Roberts, and Amar Bhidé (Boston: Harvard Business School Press, 1999), 390.

circumstances. Perhaps a hands-on approach to helping a newly appointed manager succeed is compatible with a results-oriented mode of dealing with the overall operation.

Is it time to change the guard?

Many entrepreneurs have demonstrated a capacity not only to launch a successful venture but also to actively guide it successfully through years of growth. Examples include Larry Page and Sergey Brin at Google, Bill Gates at Microsoft, Herb Kelleher at Southwest Airlines, Scott Cook at Intuit, and Richard Branson at Virgin Group. Each leader successfully H7303-Entrepreneur.indb 186 H7303-Entrepreneur.indb 186 11/2/17 1:14 PM 11/2/17 1:14 PM Leadership for a Growing Business 187 adapted his management mode to the needs of the business as it grew and changed. Not all entrepreneurs have this adaptive capacity; they either cannot change the behaviors that served them well in a small, entrepre- neurial setting—and habits of behavior are very difﬁ cult to change—or they actively resist changes that would dilute their control. In either case, the inability of the founder-leader to adapt as the enter prise becomes larger and more complex can have these damaging consequences:

• Employee initiative is smothered by the founder’s insistence on controlling all activities and making all important decisions. The best employees eventually leave in frustration.

• The organization misses opportunities because it can operate only at the pace of the overworked founder.

• The scope of the enterprise is limited to the knowledge and vision of the founder.

Getting help Reﬂ ect on your own management capabilities and your ability and willing- ness to change as your business expands. Is your business at a transition point, where your style of leading and management must change? Can you adapt? Are you willing to adapt? If you are willing to adapt but have difﬁ culty in doing so, ﬁ nd peo- ple who can and will give you objective criticism on your leadership style.

You’ll want people who are not afraid to tell you if your grip on the business is too tight (or too loose) and where you need help. They can also tell you when it’s time for you to go—that is, when it’s time to bring in professional management. Feedback of this type will help you adjust to the demands of the business and will support the collaboration that every enterprise needs to succeed. Those whom you ask for this kind of feedback could include other members of the management team and members of your board. Other practical possibilities include the following parties: H7303-Entrepreneur.indb 187 H7303-Entrepreneur.indb 187 11/2/17 1:14 PM 11/2/17 1:14 PM 188 Scaling Up Your f under s Entrepreneurs Evan Baehr and Evan Loomis write, “If you want advice for your startup, ask for money. If you want money, ask for advice. To suc- ceed, you will need both.” Many of the sources of funding discussed ear- lier in this book come with experienced entrepreneurial professionals who can give you guidance. For example, serial entrepreneur-turned-venture- capitalist Marc Andreessen believes that the skills that make a good CEO can be taught (whereas those that make a good innovator are more innate), so he sees part of his VC ﬁ rm’s role as specializing in that training. But the author of The Gig Economy , Diane Mulcahy, warns that VCs differ widely on how much they actually coach their CEOs. As you’re looking into fund- ing, get the names of the CEOs of other companies that the VC is funding.

Ask these executives how effective the VC ﬁ rm’s mentoring is.

Talk with the CEOs of the VC ﬁ rm’s other portfolio companies. Ask if the VC partner is accessible, how much they add to boardroom discussion, and whether the CEO has received constructive help in dealing with com- pany problems.

An advisory board As your business scales, an advisory board can not only act as a sound- ing board for new ideas, but also provide skills, mentorship, and a broader network. But it can be hard to determine whom to invite onto your board if you don’t know yet what kind of expertise you are missing. See the box “How to build a board” for more on how to overcome these challenges and get your board up and running.

An executive coach Executive coaches provide a one-on-one, customized approach to altering behavior, w ith the goal of improving on-the-job performance. In general, these professionals follow one of two approaches. The traditional approach, which we will call diagnosis and development , has strong roots in psychol- ogy and is deeper in its method, but it takes longer to deliver. The other, called the prescriptive approach , has more in common with the everyday H7303-Entrepreneur.indb 188 H7303-Entrepreneur.indb 188 11/2/17 1:14 PM 11/2/17 1:14 PM Leadership for a Growing Business 189 coaching that managers give to their subordinates. It is faster and more direct. Each approach has its advantages. Executive coaching is expensive, but it may be worth it to you and your company.

Stepping aside If you cannot or will not adapt to the changing requirements of your com- pany, it may be time to change your role or step aside. There is certainly no shame in either of these options. eBay’s Pierre Omidyar, for example, conﬁ ned himself to the chairman’s job, handing the management of the company over to Meg Whitman as CEO; in fact, Omidyar had brought on a VC ﬁ rm in part to better recruit management expertise to the company.

Some people are simply not suited to be leaders of large organizations. Ei- ther they lack managerial and interpersonal skills, or the job of business leadership is incompatible with their temperaments or deep-seated life goals. Consider this ﬁ ctional example:

Esther is a molecular biologist. She has spent her professional life in university settings, both teaching and conducting funded research. In 2018, she developed a molecule that had potential ther- apeutic value for use in chickens and turkeys. Under the terms of her employment, she was free to exploit the commercial possibili- ties of her discovery in return for a 25 percent share claimed by her university. Thanks to her reputation, Esther received seed ﬁ nanc- ing from both the university and a VC ﬁ rm.

Esther was content in her role as CEO of the business in the early-development stage. The bulk of her time continued to be spent in the lab, where she felt most at home. But as her discovery entered the testing phase and the company hired a product man- ager and an administrative assistant, she began to feel out of her element. Approval and commercialization of the product made her life less fulﬁ lling. She found that she was wearing her executive hat much more and her lab coat much less. Nor did she like dealing with the VCs who now owned part of her company and the MBAs they virtually forced her to hire. One night, she told her husband, H7303-Entrepreneur.indb 189 H7303-Entrepreneur.indb 189 11/2/17 1:14 PM 11/2/17 1:14 PM 190 Scaling Up How to build a board Look outside your existing network of contacts. As you sit down to think about whom to invite onto your advisory board, remember ﬁ rst that this should not be a group of your friends and fans. You’re looking to drive new business opportunities and new ways of thinking with diverse experience, expertise, viewpoints, and skill sets. Work to ﬁ nd people outside your inner circle— people who have built successful businesses and can pass that knowledge on to you. Think about who would be a constructively critical audience and who can provide access to other valuable contacts, from potential customers, suppliers, and strategic partners to ﬁ nanciers, publicists, and other professional service vendors. Recruit a well-known community member or an industry in- ﬂ uencer as your ﬁ rst board member. There is a reason that ﬁ lm producers begin their projects by lining up the most bankable talent they can. The talent’s involvement helps attract others who want to work with the celebrity or who simply see a star’s commitment as reassurance that the project will take oﬀ . In the same way, entrepreneurs should work ﬁ rst to recruit the people who will attract others and who will give an advisory board strong credibility from the start. Invest the time in developing relationships with your board members. Since most members are not compensated, their re- ward is the satisfaction of sharing their knowledge and experience and helping you succeed. So make them feel appreciated! (Mean- while, if a prospective board member does insist on being com- pensated, determine how uniquely valuable they are. If there’s a possibility of a long-term business relationship, you might want to oﬀ er that person some kind of remuneration.) H7303-Entrepreneur.indb 190 H7303-Entrepreneur.indb 190 11/2/17 1:14 PM 11/2/17 1:14 PM Leadership for a Growing Business 191 Establish goals and expectations for the board up front, including how often it meets and where. Usually, in-person meetings once every three to six months will suﬃ ce, but you may want to reserve the right to consult with individual members on an ad hoc basis if a particular issue comes up. When the board does meet, make sure you have an agenda with speciﬁ c goals.

Your board members are busy professionals, so don’t waste their time. Perform a yearly assessment of how the board is working. If you can aﬀ ord it, invite them to an oﬀ -site at a comfortable locale at your expense to have them discuss the board’s progress. Have a framework for changing the board members. Because you are a high-growth entrepreneur, your business will evolve, and you will probably need advisers who bring diﬀ erent skills to the table at diﬀ erent phases of growth. Most members will not have the time to serve on your board for more than two or three years, anyway. And others may not be as helpful as you had hoped. So, make it clear up front that they serve as needed and spell out term limits. Be clear on the role of your advisory board. Finally, if you’re thinking of setting up an advisory board, be very clear on what it is and what it’s not. The board is not a formal board of directors, which has well- deﬁ ned duties, including a ﬁ duciary responsibil- ity. An advisory board holds no legal or ﬁ nancial responsibility for the decisions you make. Instead, it is a group of volunteers with knowledge and skills that you, the business owner, lack, and whose purpose is to help you make your company a success. An advisory board can assist you, challenge you, guide you, and open your eyes to new opportunities. Source: Adapted from Kerrie MacPherson, “Who Advises the Entrepreneur?” HBR.org, October 22, 2016. H7303-Entrepreneur.indb 191 H7303-Entrepreneur.indb 191 11/2/17 1:14 PM 11/2/17 1:14 PM 192 Scaling Up “Now that we’ve demonstrated the therapeutic value of ChickenFix, every thing seems anticlimactic.” Clearly, Esther’s heart isn’t in her executive role. Her life is dedicated to science and discovery and not to getting regulatory approval, working out manufacturing and distribution arrangements, and building a larger enterprise. In Esther’s situation and that of many others, the best thing a business can do is to bring in professional management, with the founder staying on as chair of the board (the box “Do you need professional management?” can help you decide whether this step is appropriate). This solution also works when the founders are simply incapable of handling the kind of work en- t a i le d i n bu si ne s s bu i ld i ng: negot i at i ng w it h suppl ier s , sa le s , se t t i ng up pr o - cedures and control systems, dealing with people problems, scrambling for money, and delegating tasks. Unfor tunately, many businesses do not recog- nize the need for professional management soon enough to avoid a crisis. According to transition experts Eric Flamholtz and Yvonne Randle, founder-entrepreneurs often ﬁ nd it very difﬁ cult to let go. Some try to Do you need professional management? Does this scenario sound familiar? If so, you should consider profes- sional management for your business.

• Every decision must be made at the top.

• Policies for handling routine functions are almost nonexistent.

• The ﬁ rm’s human resources are not being developed.

• You make decisions, but no one follows through with action.

• Accounting functions are haphazard and amateurish.

• You’re having trouble recruiting competent people.

• People are spending a lot of their time putting out ﬁ res. H7303-Entrepreneur.indb 192 H7303-Entrepreneur.indb 192 11/2/17 1:14 PM 11/2/17 1:14 PM Leadership for a Growing Business 193 change their behavior as a way of avoiding this step back, but they often fail. Others, the authors write, “merely give the illusion of turning the or- ganization over to professional managers.” Flamholtz and Randle cite the case of one founder who hired two experienced managers, made a big deal about how he was turning over the reins, but then continued to control everything himself.

As Flamholtz and Randle explain in Growing Pains, their insightful book on the challenges of entrepreneurial growth, “developing certain sys- tems and processes are essential if a ﬁ rm is to continue to grow success- fully and proﬁ tably during its life cycle.” Professional managers know how to develop those systems and processes, and your company will need them at some point if it continues to grow. From the perspective of your ﬁ rm today, how does professional man- agement look? Are you at the point at which a lack of systems and pro- cesses is holding the ﬁ rm back? Are you personally up to the challenge of building the business, or would the company be better off if you stepped aside in favor of experienced managers?

Summing up ■Growth challenges the founding management team, whose members may lack the skills, experience, or temperament for leading a larger, more com- plex organization.

■The work of Michael Roberts describes four modes of management: real- time management of content, management of behavior, management of results, and management of context. The founder and management team must recognize which mode is appropriate under which circumstances and must know when to change from one approach to another.

■A few entrepreneurs have successfully adapted with the growth of their companies. Others must either change themselves (often a diﬃ cult pros- pect), change their roles by bringing in professional management, or cash in their equity and move on to new challenges. H7303-Entrepreneur.indb 193 H7303-Entrepreneur.indb 193 11/2/17 1:14 PM 11/2/17 1:14 PM H7303-Entrepreneur.indb 194 H7303-Entrepreneur.indb 194 11/2/17 1:14 PM 11/2/17 1:14 PM 12.

Keeping the Entrepreneurial Spirit Alive People associate entrepreneurial ventures with innovation. And they are usually right. A successful entrepreneur brings something new to the mar- ketplace—a unique product or service that differentiates the company, gives it a competitive advantage, and even perhaps changes the world in some important way. Entrepreneurial innovation may take the form of a technical advance, such as a thin-screen computer monitor with much higher performance, or a welcome new ser vice, such as smartphone-based taxi hailing. The innovation may also be something that customers never see, such as a breakthrough manufacturing process that slashes time and cost from the manufacturing process. Henry Ford’s assembly line accom- plished this in the twentieth century; process innovations that enable manufacturers to produce smaller and more complex semiconductor chips at lower cost are a modern equivalent. H7303-Entrepreneur.indb 195 H7303-Entrepreneur.indb 195 11/2/17 1:14 PM 11/2/17 1:14 PM 196 Scaling Up Newness that customers view favorably is usually the entrepreneur’s wedge for ﬁ tting into a proﬁ table market niche. It is difﬁ cult to think of successful entrepreneurial ﬁ rms that aren’t good at innovating.

Established companies, in contrast, are often viewed as slow in identi- fying and exploiting opportunities and as too rigid to innovate. That per- ception contradicts evidence of innovation in some established companies.

Both Honda and Toyota introduced the hybrid automobile to the mar- ket—perhaps the single greatest innovation in automotive technolog y in the previous half century. This feat was not merely technical but matched a real need for substantial emissions reductions and fuel conservation.

Corning, a 160-year-old ﬁ rm, has produced innovation decade after de- cade, most recently with thin, lightweight, and exceptionally durable glass for smartphones and other electronics. Similarly, 3M continues to uphold its decades-long reputation as a serial innovator. But for every Honda, Toyota, Corning, and 3M, there are dozens of large ﬁ rms for which innovation is a forgotten art. When they need innova- tion, they buy it through acquisition or licensing agreements—and usually from entrepreneurial companies. Business founders risk losing the entrepreneurial spirit and the ability to innovate as their startup companies grow. This chapter takes a hard look at why many small ﬁ rms lose their entrepreneurial spark as they suc- ceed. It offers some practical remedies for offsetting this risk. The challenges Why are large, established ﬁ rms less adept at innovation than entrepre- neurial ﬁ rms are? There are three plausible answers: size, the desire to serve existing customers, and complacency. All three reasons are challenges that the entrepreneurial enterprise must confront and defeat as it grows.

The size problem Size requires specialization of functions, creates communication and coor- dination problems between functions, and requires management systems —review boards and approval requirements—that often frustrate creative H7303-Entrepreneur.indb 196 H7303-Entrepreneur.indb 196 11/2/17 1:14 PM 11/2/17 1:14 PM Keeping the Entrepreneurial Spirit Alive 197 people and impede the pace of idea development. The problems that the founding team solved informally over coffee now require formal meetings involving many people with divergent views. The more people who are in- volved, the longer it takes to agree on the simplest things. And agreements are more likely to be compromises than optimal solutions.

The existing-customers problem Businesses understand the importance of customers and the importance of serving and retaining them; customer-focused has become almost a buzz- word today. When an enterprise serves its existing customers diligently, it faces two consequences that can impede innovation:

• Existing customers often discourage substantial innovation. For example, a major technical advance in computing can jeopardize the investments customers have made in existing hardware and systems. Consequently, these customers often urge their vendors to continue supplying them with parts and incremental upgrades—in effect, to stay in their old businesses. Some call this phenomenon the “tyranny of served markets.” Companies that slavishly give customers what they want concentrate on incremental innovations to existing products, leaving the invention of truly breakthrough products to their rivals. Ironically, if you keep giving your custom- ers what they want, they will eventually abandon you and switch to more innovative rivals.

• Management shifts its focus to operations. The job of serving customers proﬁ tably requires operational excellence. As the busi- ness grows, the leadership team’s attention is increasingly ab- sorbed by people issues, marketing, ﬁ nance, operations, customer service, and so forth. Innovation can easily slip off the radar. Complacency Success begets complacency and self-satisfaction. It tricks people into believing that if they simply continue doing what they are doing, all will be well. Author and scholar Richard Pascale described this phenomenon H7303-Entrepreneur.indb 197 H7303-Entrepreneur.indb 197 11/2/17 1:14 PM 11/2/17 1:14 PM 198 Scaling Up many years ago as the paradox of success. Success, in his view, plants the seeds of eventual failure.When faced with a new competing technology, for example, many suc- cessful companies have the impulse to invest still further in the technology that made them successful in the ﬁ rst place. This impulse applied, for ex- ample, when steamships challenged makers of sailing ships, when Edison’s electric lighting systems challenged the gas illumination companies in the late 1800s, and when jet engines challenged piston-driven aircraft engines in the late 1940s. The established companies threatened by these innova- tions continued to invest in and marginally improve their mature technolo- gies even as the new ones were becoming better and cheaper by the month. When you launch a new company, your organization is initially un- troubled by the problems of size, the tyranny of served markets, and com- placency. Success and growth, however, have a way of undermining that advantage. As your organizational infrastructure expands to support growing customer and user bases, your innovative spirit can be gradually dissipated. The challenge to the founding team, then, is to keep the inno- vative spirit alive as the organization matures. Fortunately, success and growth are not incompatible with the entre- preneurial spirit, as we saw with Toyota, Corning, and other established companies that continue to innovate. But what can the leadership do to ensure the continued vitality of that spirit? This section contains some practical advice for staying aggressive, innovative, and responsive to mar- ket conditions.

Preserve an innovation-friendly culture The impact of organizational culture on creativity and idea generation is well understood. In the absence of a supportive culture, creativity and in- novation will not germinate and grow. Authors Michael Tushman and Charles O’Reilly explain that in the cul- ture at IBM before CEO Lou Gerstner took over, innovation fell on infertile soil. The culture was, in their words, “characterized by an inward focus, ex- tensive procedures for resolving issues through consensus and ‘push back,’ H7303-Entrepreneur.indb 198 H7303-Entrepreneur.indb 198 11/2/17 1:14 PM 11/2/17 1:14 PM Keeping the Entrepreneurial Spirit Alive 199 arrogance bred by previous success, and a sense of entitlement on the part of some employees that guaranteed jobs without a quid pro quo.” If your company’s culture is taking on these characteristics, then creativity and innovation are unlikely to ﬂ ourish. Worse, the most innovative people will become discouraged and dispirited, and they will begin looking for other opportunities. These questions will help you determine whether your company is los- ing its creative edge:

• Is our current success making us self-satisﬁ ed and complacent?

• Are we inwardly focused?

• Do we punish risk takers who fail?

• Are creative people and new ideas unwelcome or unappreciated in this company?

• Do we fail to reward acts of creativity?

• Do we handle new ideas too bureaucratically?

• Are hierarchy and its symbols creeping into our culture?

If you answered yes to any of these questions, your organizational cul- ture needs a serious evaluation and an adjustment. Three places to look are your physical environment, risk taking and learning, and incentives and rewards.

Enrich the physical environment A work space that invites face-to-face interactions and chance encounters, especially one ﬁlled with many types of creative stimuli, can encourage peo- ple to make new connections and to think more broadly about problem solv- ing and ﬁnding new opportunities. Casual conversations and spontaneous meetings can spark innovative ideas in unexpected ways. Part of the power of these interactions—which often occur around coffee machines or water coolers and in other public areas such as copy rooms or kitchens—may come from their spontaneity. Note where people already gather informally, and H7303-Entrepreneur.indb 199 H7303-Entrepreneur.indb 199 11/2/17 1:14 PM 11/2/17 1:14 PM 200 Scaling Up make these areas more inviting places to linger. Add comfortable chairs that encourage people to sit and converse. One company designed stair- cases wide enough for people to stop and chat. Another placed beanbag chairs in conference rooms to create a more casual atmosphere. Bring in snacks every week or two, and invite your team to take a break just to talk.Place tools for creativity and communication in unexpected spots.

Some organizations leave whiteboards, markers, and ﬂip charts in infor- mal meeting spaces—in the kitchen, for example. These tools inspire peo- ple to capture and sketch out ideas during a spontaneous discussion. Other companies distribute crayons and white paper on conference room tables to encourage doodling and making diagrams, enabling a mode of thought that’s different from the usual verbal discussion. Find opportunities for play using games and other stress relievers. Play serves a serious function: when employees are clattering a ball around a foosball table, they may also be subconsciously unwinding a sticky work problem. Giving the conscious mind a break from the problem at hand al- lows a person to later return to work refreshed—perhaps with a new ap- proach or a unique solution. Keep in mind, though, that like your diverse team, your organization has many different ways of working and thinking. Beyond these open, col- laborative spaces, create areas for quiet work and reﬂection: a company library where silence is expected or meeting rooms where doors can shut out distractions.

Encourage risk and learning In addition to considering your company’s physical environment, look at its psychological setting. Creative problem solving and inventive think- ing w ill ﬂourish only in an organization that welcomes them. Innovation should be viewed as a normal part of business. Encourage individuals within your company to take risks. Innovative progress and risk are inseparable. One new idea could easily fail, but an- other could have great beneﬁts. An organization that recognizes this dy- namic must communicate that reasonable risks aren’t only acceptable, but are necessary to keep the company moving forward. H7303-Entrepreneur.indb 200 H7303-Entrepreneur.indb 200 11/2/17 1:14 PM 11/2/17 1:14 PM Keeping the Entrepreneurial Spirit Alive 201 Encourage knowledge sharing across the organization. Tightly con- trolling information limits the opportunity for people’s knowledge to com- bine and intersect in ways that can spur innovation and creative thinking.

Make opportunities for your employees to share information and bring new ideas to the fore. Encourage communities of interest, groups of peo- ple across the organization with similar passions, to exchange ideas. Urge employees to gain insight from external sources by attending professional meetings and conferences, visiting customers, and meeting experts. The more knowledge that’s exchanged and brought into your organization, the more likely it is to be used in creative ways. Establish a reward system Inspire idea cha mpions. Net work w ith inﬂuentia l people w ithin your orga- nization, and make sure they see especially creative efforts. Attention from organizational leadership signals to an individual, a team, and the rest of the company that a project is important. And that attention can be a pow- erful motivator for continued creative work. Executives who stand behind good ideas can provide not only moral support but also protection and re- sources to new endeavors. Such support—and the rewards that come with it—can further motivate employees to bring their creative ideas to life. Most people naturally associate the word reward with money or bo- nuses. Such extrinsic rewards—which include additional pay, a vacation, or even special recog nition—appeal to a person’s desire to attain a goal that is distinct from the work itself. But these external awards aren’t the only way to motivate your employees to continue their inventive efforts. Intrinsic re- wards can appeal to a person’s desire for self-actualization or challenge, to a deep interest and involvement in the work, or to an individual’s curiosity or sense of enjoyment. Four types of intrinsic and extrinsic rewards can support and encour- age your employees to continue their inventive efforts:

1. Recognition: A sense of making progress is a powerful motivator.

Publicly acknowledge an individual or a group with an announce- ment or award. For example, ask a high-level executive to share his H7303-Entrepreneur.indb 201 H7303-Entrepreneur.indb 201 11/2/17 1:14 PM 11/2/17 1:14 PM 202 Scaling Up or her appreciation for what a team is doing. Or publicly recognize people who have worked outside their preferred style or function.

2. Control: Involve an individual or a group in a decision that affects them. Grant them the autonomy to solve problems on their own. For example, after a successful customer engagement event, invite your team members to choose a new marketing opportunity to think about next. Or give them increasingly challenging projects to tackle that pique their interests.

3. Celebration: Applaud a successful venture by throwing a small party. Toast a new product’s launch, or take your employees out to dinner after successfully launching a redesigned website.

4. Rejuvenation: Offer time off or time away from a given task. Give team members extra vacation days for breaking your company’s core cereal brand into a new international market. Or send individuals to industry conferences so that they can develop their skills, build rela- tionships, and come back to work renewed and energized.

You can stimulate and sustain your team’s creative energy—and help people make progress every day—with a thoughtfully constructed sys- tem of rewards and support in an atmosphere of openness. A culture that builds creative momentum can help you lead your team to generate and implement new solutions to the tough challenges you face. Establish vision and strategic direction If innovative people lose sight of where the company should be heading, they are likely to generate and pursue ideas that don’t ﬁ t, that eat up re- sources, and that eventually will be rejected before commercialization. A loss of vision thus costs money and dissipates the energy of idea generators. As a company grows, keep it focused on its mission. PayPal and LinkedIn founder Reid Hoffman expands on this idea: “Almost every blitzscaling org that I have seen up close has a lot of internal unhappiness.

Fuzziness about roles and responsibilities, unhappiness about the lack of a H7303-Entrepreneur.indb 202 H7303-Entrepreneur.indb 202 11/2/17 1:14 PM 11/2/17 1:14 PM Keeping the Entrepreneurial Spirit Alive 203 clearly deﬁ ned sandbox to operate in. ‘Oh my God, it’s chaos, this place is a mess.’ The thing that keeps these companies together—whether it’s PayPal, Google, eBay, Facebook, LinkedIn, or Twitter—is the sense of excitement about what’s happening and the vision of a great future.” This vision can help the innovative team focus. Because both creative energy and money are scarce commodities, it makes sense to encourage your team to generate ideas within the boundaries deﬁ ned by your com- pany strategy. For example, if your e-commerce site focuses on active women’s professional apparel, encourage ideas that fall within the bound- aries of “better connections with our customers” and “fast and accurate order fulﬁ llment.” Within those strategy-related boundaries, new ideas for improving customer intelligence, order processing, and logistics should be welcomed. If you set the boundaries right, your company’s creative en- ergies will naturally focus themselves in areas with the greatest payoff potential. And don’t forget your competitors: always be thinking about who is going to be coming after your space and how. Cannibalize yourself before someone else can do it. For example, to avoid cannibalizing its highly suc- cessful line of iPods, Apple could have held off on introducing the iPhone or avoided including iPod features in its new product. And certainly, the es- tablished iPod line lost revenue once the iPhone was introduced. But Apple as a whole beneﬁ ted.

Be personally involved with innovation As your company grows, operational issues will begin to eat up your time.

This is natural. But don’t allow operational humdrum to detach you from the innovation on which your future depends. Some of the best and most successful executives have been happiest and most effective when they were in the R&D lab rubbing elbows with bench scientists and technicians.

Leaders cannot make good decisions about R&D if they operate in a vac- uum or think of innovation as a mysterious force. They must understand the technical issues facing their organizations and the portfolio of ideas and projects that are in the pipeline at any given time. H7303-Entrepreneur.indb 203 H7303-Entrepreneur.indb 203 11/2/17 1:15 PM 11/2/17 1:15 PM 204 Scaling Up So stay very close to sources of innovation within your company as it grows. Visit the research people regularly. Have lunch with project teams.

Get to know key people one-on-one. Understand the technical hurdles that stand between appealing ideas and their commercialization. Staying close to innovative activities has several beneﬁ ts:

• It sends a powerful signal to employees that innovation matters.

• It provides entrepreneurial leaders with opportunities to articulate the strategic direction of the enterprise and the boundaries within which innovation should be pursued.

• It keeps you up-to-date on technological advances, customer trends, and market trends. Continually improve the idea-to- commercialization process Chances are that the innovative idea that spawned your company was con- ceived and developed informally. You didn’t have approval committees and proposal documentation and approval processes to deal with. The growth that follows success, however, makes such processes both necessary and useful. Indeed, companies that continue to innovate and grow have a pro- cess for generating ideas, experimenting with them, evaluating promis- ing ideas, and recognizing which have commercial potential, followed by development and commercialization. You will need such a process, too; other wise, your innovative efforts will be ad hoc, arbitrary, and a waste of resources. A good innovation process does the following:

• Generates a sufﬁ cient number of good ideas • Is free of the bottlenecks that impede development and frustrate innovators • Is free of politics • Encourages calculated risk taking H7303-Entrepreneur.indb 204 H7303-Entrepreneur.indb 204 11/2/17 1:15 PM 11/2/17 1:15 PM Keeping the Entrepreneurial Spirit Alive 205 • Is not arbitrary • Creates cheap failures • Channels resources to the worthiest projects • Involves people who understand the company’s capabilities, its strategy, and its customers Like the shaping of organizational culture, developing and improving the innovation process is a job for founders and the leadership team. And it’s one of the most important jobs they will ever handle. Apply portfolio thinking Many entrepreneurial ﬁ rms, particularly in the tech space, are launched w ith only one or two products in process. That makes organizational life simple: all resources, brainstorming, and marketing can be concentrated on those one or two things. As these companies succeed and grow, however, they may have dozens of funded projects in play at any given time. Some may be low-risk, short-term projects that aim to incrementally improve an existing product. Others may represent radically new concepts that aim to create new markets. Still others may fall between these two extremes. Because incremental and radical projects entail substantial differ- ences in risk levels, time frames, and potential payoffs, it’s helpful to think of them in terms of a portfolio. Portfolio thinking helps you see a set of ongoing projects in terms of risk-versus-return characteristics. And when you understand those characteristics, you can shape and manage the port- folio to achieve the right balance of risk and potential return. As a ﬁ rst step toward portfolio thinking, create a visual map of your ongoing projects like the one in ﬁ gure 12-1. Here, the horizontal axis indi- cates the maturity or newness of market or technology factors. The ver- tical axis indicates rising levels of technical challenge, uncertainty, and economic opportunity. Each circle in the matrix represents a project, and the size of each circle indicates the magnitude of the resources currently dedicated to it. H7303-Entrepreneur.indb 205 H7303-Entrepreneur.indb 205 11/2/17 1:15 PM 11/2/17 1:15 PM 206 Scaling Up In the map shown here, the biggest projects are cautious. They have mature technical and market characteristics. As a result, these projects are among the least technically challenging and involve the least risk and potential opportunity for the company. In contrast, the small projects in the upper-right quadrant involve higher technical risk and address new markets, but they also hold the prospect for greater economic opportunity for the company. Try constructing a similar map for your company. When you’ve mapped out your current projects, what does it tell you? If most projects and re- sources are located in the lower-left quadrant, your company is being very risk-averse and may be doing too little to address future opportunities, new technologies, and new markets. On the other hand, if most projects Mature New Market characteristics High Low Technical challenge, uncertainty, and opportunity FIGURE 12-1 Innovation portfolio H7303-Entrepreneur.indb 206 H7303-Entrepreneur.indb 206 11/2/17 1:15 PM 11/2/17 1:15 PM Keeping the Entrepreneurial Spirit Alive 207 and resources are in the upper-right quadrant, your ﬁ rm is being very ag- gressive, perhaps dangerously so. What would constitute a suitable risk-to-reward balance for your com- pany? As the entrepreneurial leader, can you articulate that balance to your employees and investors? As you consider your choices, consult the box “Tips for making good innovation decisions.” H7303-Entrepreneur.indb 207 H7303-Entrepreneur.indb 207 11/2/17 1:15 PM 11/2/17 1:15 PM 208 Scaling Up Hire people who have entrepreneurial attitudes The most important decisions an entrepreneur makes as the company grows involve hiring. Growth creates a need for new employees, but what types of people are most likely to be successful innovators?Look for people who think beyond their own roles and who look to the organization and beyond. They should understand the patterns of your industry, internalize your strategy, and connect this insight with their own work. People who are narrowly interested in applying their technical skills will rarely produce the practical innovations you need. New hires in general should have the following qualities:

• Be comfortable with change.

• View unmet needs as opportunities.

• Adopt appropriate time horizons.

• Be comfortable with failure.

• Have an experimental mindset.

• Enjoy collaborative work.

• Think and act like entrepreneurs.

Some observers say that those with a liberal arts background can be a particularly good ﬁ t for innovative roles. People with such backgrounds are used to dealing with big ideas, complexity, ambiguity, writing, and communications. People being hired as supervisors or managers should be comfortable with the idea of participative management. Anything else will lead to the kind of hierarchical, bureaucratic environment that kills the entrepre- neurial spirit. H7303-Entrepreneur.indb 208 H7303-Entrepreneur.indb 208 11/2/17 1:15 PM 11/2/17 1:15 PM Keeping the Entrepreneurial Spirit Alive 209 Create an ambidextrous organization Leaders of fast-growing entrepreneurial companies quickly ﬁ nd them- selves being tugged in two directions. On the one hand, you need to focus on the innovations required to sustain growth. On the other, you must run an operationally effective organization. How can you possibly do both? The source of the challenge is not hard to understand. Success in the current business is usually driven by certainty, efﬁ ciency, and cost control.

The future business, conversely, depends on an innovation process that is uncertain, inefﬁ cient, and costly. Few executives can operate successfully in these two different worlds. Most become absorbed with one world, to the detriment of the other. In most cases, the immediate problems of the business dominate their time and attention, leaving the future business to be treated as a stepchild. Tushman and O’Reilly suggest that leaders create “ambidextrous” or- ganizations—that is, organizations that can “get today’s work done more effectively and anticipate tomorrow’s discontinuities.” These are seemingly contradictory capabilities, but ambidextrous enterprises can excel in the present even as they create the future. How to do this? Innovation experts from Clayton Christensen to Vijay Govindarajan suggest creating separate areas of your organization to fos- ter discontinuous innovation. As Govindarajan explains, you should not distract those doing today’s work at high performance levels with the work of innovation. And similarly, according to Christensen, those working on innovation need to have different goals, values, and processes from those of the core business.

Summing up ■Growth challenges the entrepreneurial spirit. Size creates specialization of functions, communication problems, and control systems that frustrate creativity and idea development. H7303-Entrepreneur.indb 209 H7303-Entrepreneur.indb 209 11/2/17 1:15 PM 11/2/17 1:15 PM 210 Scaling Up ■Once a company has customers, the tyranny of served markets can block a company’s capacity to innovate.

■The success that accompanies growth often leads to complacency, which is antithetical to the entrepreneurial spirit.

■Establish the strategic direction within which innovation should take place.

■Entrepreneurial leaders can keep the spirit alive if they (1) preserve an innovation-friendly culture, (2) establish a strategic direction, (3) remain personally involved with innovation, (4) continually improve the idea- to-commercialization process, (5) apply portfolio thinking to their innova- tive eﬀ orts, (6) hire people with entrepreneurial attitudes, and (7) create an ambidextrous organization that is eﬀ ective at both getting today’s work done (operations) and anticipating the future. H7303-Entrepreneur.indb 210 H7303-Entrepreneur.indb 210 11/2/17 1:15 PM 11/2/17 1:15 PM PART FIVE Looking to the Future H7303-Entrepreneur.indb 211 H7303-Entrepreneur.indb 211 11/2/17 1:15 PM 11/2/17 1:15 PM H7303-Entrepreneur.indb 212 H7303-Entrepreneur.indb 212 11/2/17 1:15 PM 11/2/17 1:15 PM 13.

Harvest Time Some entrepreneurs pass on their businesses to family members. The ma- jority, however, eventually look for an opportunity to harvest the mone- tary value they have created—value that is locked up in the enterprise. This chapter examines the motivations that lead to an exit, the primary mech- anisms for using an exit to harvest the company’s value, and the methods used to determine the right value for the business.

Why entrepreneurs cash out There are probably as many reasons for harvesting an investment as there are entrepreneurs. Retirement is one reason. An offer “too good to refuse” is yet another. Most investment harvesting, however, tends to be motivated by one or another of the following reasons:• A need to diversify wealth: Successful entrepreneurs can easily get into a position in which most of their wealth is dangerously concentrated in one basket. Their net worth could easily be wiped out by a change in technology, the emergence of powerful H7303-Entrepreneur.indb 213 H7303-Entrepreneur.indb 213 11/2/17 1:15 PM 11/2/17 1:15 PM 214 Looking to the Future competitors, or some other business setback. Harvesting gives the entrepreneur an opportunity to diversify personal wealth.

• The business has reached the end of its line: Some successful entre preneurs sense where the wind is blowing, and sometimes they sense an ill wind. More speciﬁ cally, they realize that their business has gone about as far as it can go, at least under their leadership. They recognize that continued growth would require a new level of investment that they are not interested in making.

In other cases, they can feel the competitive environment turning against them, as when the owner of several hardware stores ﬁ nds that the business must now go head-to-head with a national chain having enormous buy ing power.

• The owner’s urge to begin anew: Some entrepreneurs are moti- vated by the challenge of creating something out of almost nothing.

They love the early phase of business building. But when opera- tional concerns begin to absorb most of their time, they are happy to move on. Harvesting mechanisms When you have decided to cash out, the next step is to determine which harvesting method is most timely and appropriate. This section examines the most common harvesting methods as well as their advantages and shortcomings. (See the box “Shearing versus selling” if you are interested in something less than full harvesting, that is, if you only want to liquefy some of your capital.) Initial public oﬀ ering We described the role of the IPO in harvesting entrepreneurial investments in chapter 9. When a public market for a ﬁ rm’s shares has been established, its founders as well as its private investors can, within certain regulatory restrictions, sell some or all of their shares. Those restrictions, however, H7303-Entrepreneur.indb 214 H7303-Entrepreneur.indb 214 11/2/17 1:15 PM 11/2/17 1:15 PM Harvest Time 215 may hold up share sales by insiders for some period and may put a cap on the number of shares that the holder of restricted shares can sell in any one-month period (SEC Rule 144). (For information on SEC Rule 144, see appendix D.) The investment banker underwriting the deal will also require key pre-IPO shareholders to sign a lockup agreement barring them from sell- ing their shares during a speciﬁ c period after the company goes public.

This lockup, which may last up to six months, ensures that insiders will not dump their shares onto the market, causing losses for the public investors who stepped forward to buy shares of the IPO. Few ﬁ rms ever qualify for an IPO in any case; they are either too small or too limited in their potential, or they are in a moribund industry that doesn’t attract investor interest. Even those that qualify have plenty of rea- sons to avoid the harvesting IPO route: deal-making costs, public scru- tiny of the ﬁ rm’s operations, reporting requirements, and so forth. These reasons may not trouble private investors (e.g., venture capitalists); their primary interest is often to quickly cash out, lock in a high rate of return, and move on to the next opportunity. Perhaps the best case for harvesting via an IPO is the higher price that is often obtained through this means than through others. This is particu- larly true when investor appetite for new shares is high.

Mergers and acquisitions Many more harvests are accomplished through mergers and acquisitions than through IPOs. Each year, thousands of companies join with others in some form of strategic merger. Perhaps as many are snapped up by other companies that seek to capture their patents, product lines, or manufac- turing capabilities or something else. Because the typical entrepreneur has no experience with the complex transactions of mergers and acquisitions, you should enlist experienced legal and ﬁ nancial advisers to help with any proposed deal. The trans- actions are particularly complicated when neither of the participants is a public company whose share value can be determined from actual public trading. In these cases, valuations must be conducted. H7303-Entrepreneur.indb 215 H7303-Entrepreneur.indb 215 11/2/17 1:15 PM 11/2/17 1:15 PM 216 Looking to the Future In general, give careful attention to the following three issues as you approach a merger or acquisition deal:

• How the deal is valued: Different valuation methods produce dif- ferent results.

• How payment will be structured: Payment may be in the form of cash, some mix of cash and the stock of the acquiring company, or debt. In a merger, the entrepreneur may end up with the stock of a newly formed company. Cash is the ideal form of payment because all other forms tie up the entrepreneur’s capital in the other com- pany for some period. But not all stock-in-payment deals are bad.

For example, Sabeer Bhatia received 2.7 million shares of Micro- soft when he sold his company, Hotmail, to the software giant. The shares of other acquiring companies may be less solid.

• The relationship between the selling entrepreneur and the merged or acquired company: Many deals provide for some period of managerial involvement by the seller. The seller may even welcome this arrangement. Approach these arrangements with care, however, because the acquirer is unlikely to give you the free hand you enjoyed in running the business that was once yours. Employee stock ownership plan An employee stock ownership plan (ESOP) is another harvesting option for a company that lacks a public market for its shares. An ESOP is a formal plan under which corporate shares are acquired by the plan on behalf of employees, for whom it is a tax-qualiﬁ ed retirement plan. In effect, the ESOP acts as a market for the owner’s shares, purchasing those shares gradually over a period of years. Consider this hypothetical example:

Macmillan Metal Works was a closely held corporation with eighty full-time employees. Howard Macmillan, the founder, owned all the shares. Most of his family’s wealth was tied up in the company, and Howard had few means of getting it out other than selling the H7303-Entrepreneur.indb 216 H7303-Entrepreneur.indb 216 11/2/17 1:15 PM 11/2/17 1:15 PM Harvest Time 217 enterprise. Howard learned from his attorney that an ESOP could meet several of his goals at once: provide a retirement plan for his employees, give employees an ownership interest in the business, and allow him to gradually cash out his shares.

The attorney set up a plan, and Howard hired a business ap- praiser to develop a valuation for company shares. Using this valuation, he sold two thousand shares that year to the plan.

Qualiﬁ ed employees were then committed to purchasing speciﬁ ed numbers of shares each year, with Macmillan Metal Works con- tributing part of the purchase price. The sales proceeds, of course, went to Howard Macmillan, who used the cash to diversify his invest ment assets.

The ESOP harvest approach has disadvantages. Company shares must be valued through an independent business appraisal every year, a process that can be costly for a small company. What’s more, the employee mem- bers of the plan will one day own a majority of the shares, something that you as the founder may not like. Another disadvantage involves the employees themselves. ESOPs are not always a good thing for them. Tying up part or all of their retirement funds in the shares of a single company (their employer) puts them in a doubly nondiversiﬁ ed position. A serious setback for the company could resu lt in bot h a loss of employ ment a nd a loss of ret irement f und va lue. The huge personal losses suffered by employees of Enron Corporation in the early 2000s exemplify what can happen when employees have both their net worth and their current income tied up in a single enterprise. Selling to management Senior managers represent another potential set of buyers if you are seek- ing to harvest your investment. These senior managers understand the company and the industry. They know the cash-generating potential of the business as well as anyone. So it is not surprising when an employee group offers to buy the company from the founding owner. These cases are often referred to as management buyouts. H7303-Entrepreneur.indb 217 H7303-Entrepreneur.indb 217 11/2/17 1:15 PM 11/2/17 1:15 PM 218 Looking to the Future In many cases, the buyer group can use the assets of the company as collateral for loans they need to ﬁ nance the purchase. After the pur- chase is made, the buyers ﬁ nd themselves with a very high debt-to-equity ratio—sometimes 10:1—and staggeringly large interest payments. Typi- cally, management responds by selling the ﬁ rm’s operating units that are either underperforming or that don’t ﬁ t management’s new strategy. Man- agers also sell the corporate aircraft and nonessential property to pay down large chunks of the debt immediately. At the same time, the new owners increase the amount of free cash by reducing employee head counts, cut- ting expenses, and reducing inventories. This type of transaction is called a leveraged buyout, an approach that was practiced widely during the 1980s, often by outside “raiders” who rec- ognized that the separate parts of a company could be sold for much more than the company’s total market value. Most of the leveraged-buyout deals of the 1980s relied on substantial outside debt capital in the form of high-yield, or junk, bonds, an approach that is seldom available to today’s buyer groups. Consequently, the selling owner today may have to act as lender, taking a collateral-backed note in payment for his or her share of the company. The owner’s harvest in these cases is spread out over many years of principal and interest payments by the buying group. Although they get much less press these days, leveraged buyouts still accounted for $70.5 billion in US company sales transactions in 2016. In general, the best candidates for these buyouts are companies with high levels of predictable free cash ﬂ ow, few requirements for capital spending, little debt, and substantial nonessential assets. Selling to a new owner While selling your business to current management ensures that the com- pany will remain in the hands of those experienced in running it, another option is to sell your business to a completely new owner. Business bro- kers who specialize in businesses of your size can help connect you with qualiﬁ ed buyers—typically these brokers work with businesses valued up to $20 million. They work on a commission that you’ ll pay mostly when the H7303-Entrepreneur.indb 218 H7303-Entrepreneur.indb 218 11/2/17 1:15 PM 11/2/17 1:15 PM Harvest Time 219 deal is ﬁ nalized. Most brokers are members of professional groups that you can approach for broker listings, for example, the International Business Brokers Association, the Association for Corporate Growth, the Alliance of Merger & Acquisition Advisors, or the Association of Professional Merger and Acquisitions Advisors. When you sell, you will need to decide (and negotiate with your buyer) whether you are selling the company’s assets or its stock. Selling the assets Shearing versus selling Selling is a way for you to get a substantial amount of capital out of your company, particularly when you want to walk away and do something else with your life. For many owners, however, walking away isn’t the issue; nor is receiving all their capital at once a primary goal. Some own- ers are content to periodically withdraw some of their capital to improve their living standards, to gain retirement income, or to diversify. If this is your goal, you could pocket whatever cash ﬂ ow is not needed to main- tain or expand your business. Successful ventures generate more cash ﬂ ow than the amount they need to maintain a steady state condition. Growth-oriented owners re- invest that excess cash in the business: to expand the sales force, to acquire or develop new product lines, to open new retail locations, and so forth. But if you want to liquefy some of your capital, you can pocket this excess cash instead of reinvesting it. This “shearing” of company cash ﬂ ow will limit your company’s ability to ﬁ nance continued growth through internally generated cash. But for some owners, growth may no longer matter; their companies may be as large as they can comfortably handle. And if you do want continued growth, you may be able to sub- stitute debt capital for internally generated cash ﬂ ow. In that case, you will get part of your equity capital, and your business will experience a change in its debt-to-equity ratios. H7303-Entrepreneur.indb 219 H7303-Entrepreneur.indb 219 11/2/17 1:15 PM 11/2/17 1:15 PM 220 Looking to the Future means that the buyer is getting just the physical elements of the business:

its employees, its buildings, its equipment, and intangibles like trademarks and goodwill. Things like liability, however, stay with you: if an employee you hired ﬁ les a lawsuit, you may be liable. Selling the stock may therefore be more beneﬁ cial to you; it means that the company itself shifts to the new owner’s responsibility. Timing matters No matter which method of harvesting you use, you need to select the proper time. The only exception to the strategies mentioned here is the ESOP, which features the sale of stock over many years, in both good times and bad. What applies to the IPO market applies also to other forms of harvest- ing: the mood of investors—and business buyers—swings like a pendulum between optimism and fear. Buyers who are giddy with optimism will pay much more for a business than they will during periods of fear. Be alert to the mood of investors in timing the sale of shares or of the entire business.

What’s it worth?

With the exception of the shearing method, valuation is at the heart of each harvesting mechanism described in this chapter. Valuation attempts to answer a fundamental question: “What is this company really worth?” If you cannot answer that question, you will be in a poor position to negotiate a deal.

Values for an IPO The share value in an IPO is generally a function of what the marketplace of investors will accept and what the future of the company appears to hold. Thus, the deal’s underwriter will look at the mood of investors, the price of comparable public corporate shares relative to earnings, the com- pany’s current and anticipated ﬁ nancial performance, proprietary tech- nology, and growth potential. In light of this less-than-scientiﬁ c process, the underwriter will suggest an issuing price per share, one that is slightly H7303-Entrepreneur.indb 220 H7303-Entrepreneur.indb 220 11/2/17 1:15 PM 11/2/17 1:15 PM Harvest Time 221 discounted to the anticipated trading level of the shares. That discount is meant to put initial investors in a proﬁ table position when trading begins.

More-rigorous valuation methods Other harvesting mechanisms rely on more rigorous methods of evaluat- ing the worth of the company. Although appendix C explains these meth- ods and their strengths and weaknesses in some detail, we’ll summarize them here as well. The two most reliable valuation approaches are the earnings-based method and the discounted cash-ﬂ ow method (see the box “Working with a business appraiser” for recommendations about who should conduct a valuation of your business).

Earnings-based valuation The earnings-based method multiplies one or another earnings ﬁ gure from the income statement by some number. For example, a valuation spe- cialist might ﬁ nd that similar companies in the same industry are selling at roughly ﬁ ve times their earnings before interest and taxes (EBIT).

A more exacting approach adds back any depreciation or amortiza- tion charges that reduced income statement earnings, because those are noncash expenses. This more exacting ﬁ gure is called EBITDA (earnings before interest and taxes plus depreciation and amortization). The idea in both cases is to attach the multiple to the cash ﬂ ows actu- ally available to the owner. Thus, if EBIT for an entrepreneurial ﬁ rm were $2 million and if similar companies in the industry were selling for ﬁ ve times that multiple, the value of the ﬁ rm would be $10 million.

The multiple used in these valuations shouldn’t appear from outer spa ce. R at her, it shou ld cor respond w it h what ot her invest ors have pa id re - cently for the EBIT of comparable companies that were on the sales block.

So be very careful about the multiple you use, because it can make a huge difference in the estimated value of your company. You should also un- derstand that multiples, as with price-earnings ratios for company stock, ﬂ oat up and down with the moods and expectations of investors. When an industry is out of favor and when investors are pessimistic about future prospects, its multiple will slide downward. The opposite happens when an H7303-Entrepreneur.indb 221 H7303-Entrepreneur.indb 221 11/2/17 1:15 PM 11/2/17 1:15 PM 222 Looking to the Future industry is in favor or when prospects for earnings growth are favorable.

The lesson to the selling entrepreneur is to sell when investors are giddy with optimism.

Discounted cash-ﬂ ow (DCF) valuation The key drawback of this multiple-of-earnings method is that it is not forward-looking. It bases value on current earnings, not on future ones.

Thus, a ﬁ rm with rapidly growing earnings would probably be short- changed by this type of valuation. The remedy is to consider the ﬁ rm’s value in terms of its stream of fu- ture cash ﬂ ows. It is that stream of f uture earnings, af ter all, that investors are buying. As described by Tom Copeland, Tim Koller, and Jack Murrin, authors of what many consider the bible of valuation, “The DCF approach captures all the elements that affect the value of the company in a compre- hensive yet straightforward manner.” The DCF valuation method requires a forecast of cash ﬂ ows extending several years into the future and the application of time-value-of-money calculations. It discounts those cash ﬂ ows to their present value. Profes- sional help is usually needed to implement these requirements. Working with a business appraiser Business valuation isn’t likely to be the entrepreneur’s area of exper- tise. Nor is it an issue that matters more than once or a few times dur- ing a business career. Nevertheless, valuation’s impact on the outcome of harvesting is huge. Consequently, the entrepreneur should learn as much as possible about this technical ﬁ eld—or at least enough to work with a professional business appraiser and make intelligent decisions. H7303-Entrepreneur.indb 222 H7303-Entrepreneur.indb 222 11/2/17 1:15 PM 11/2/17 1:15 PM Harvest Time 223 Summing up ■Entrepreneurs seek to harvest their investments for several reasons. Key among them are to diversify their wealth, to take the business to a higher level, or to try something new.

■Although it is available to very few enterprises, an IPO can give the entre- preneurial team liquidity over time.

■For most companies, selling the company through an acquisition is a more likely harvesting mechanism than is an IPO. In an acquisition, the entrepre- neurs should pay close attention to how the deal is valued, how payment will be structured (cash, stock, debt), and how any ongoing relationship with the acquiring entity or merger partner will be deﬁ ned.

■An ESOP is a tax-qualiﬁ ed retirement plan that purchases owner shares over a period of years. In eﬀ ect, the owner sells to the employees.

■In many cases, the members of a business’s management group will join together to buy out the founder-owner. They can do so through a leveraged buyout or through a debt arrangement with the seller.

■One popular approach to business valuation multiplies earnings before interest and taxes (EBIT) times a number called a multiple. The multiple should correspond with what other investors have paid recently for the EBIT of comparable companies.

■The discounted cash-ﬂ ow (DCF) approach to valuation provides a better measure of company value because it is future oriented. H7303-Entrepreneur.indb 223 H7303-Entrepreneur.indb 223 11/2/17 1:15 PM 11/2/17 1:15 PM H7303-Entrepreneur.indb 224 H7303-Entrepreneur.indb 224 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix A Understanding Financial Statements What does your company own, and what does it owe to others? What are its sources of revenue, and how has it spent its money? How much proﬁ t has it made? What is the state of your company’s ﬁ nancial health? This appendix helps you answer those questions by explaining the three essen- tial ﬁ nancial statements: the balance sheet, the income statement, and the cash-ﬂ ow statement. The appendix also helps you understand some of the managerial issues implicit in these statements and broadens your ﬁ nancial know-how through a discussion of two important concepts: ﬁ nancial le- verage and the ﬁ nancial structure of the ﬁ rm.

If you have a business degree or senior management experience, you may already know as much as you need to know about these topics. But many entrepreneurs have neither. For example, Ken Olsen, the legendary founder of Digital Equipment Corporation in the late 1950s, knew all about electrical engineering and programming, and he had terriﬁ c ideas for H7303-Entrepreneur.indb 225 H7303-Entrepreneur.indb 225 11/2/17 1:15 PM 11/2/17 1:15 PM 226 HBR’s Entrepreneur’s Handbook building a new generation of computers. But he knew next to nothing about ﬁ nancial statements, which the venture capitalists (VCs) wanted him to in- clude in his business plan. According to entrepreneurial lore, Olsen went to the public library, borrowed a copy of Paul Samuelson’s famous economics textbook, found an example of a balance sheet and income statement, and used them as models for his projected ﬁ gures. The VCs were impressed and gave him the money he needed to develop his business. If you’re already knowledgeable about ﬁ nancial statements, you can skip this appendix. But the ability to read and interpret ﬁ nancial state- ments is essential for the enterprising businessperson. So if you’re more like Olsen, this appendix gives you an introduction to the fundamentals.

For more details, we recommend the HBR Guide to Finance Basics for Managers .

Why ﬁ nancial statements?

Financial statements are the essential documents of business. Managers use them to assess performance and identify areas that require their in- tervention. Shareholders use them to keep tabs on how well their capital is being managed. Outside investors use them to identify opportunities. And lenders and suppliers routinely examine ﬁ nancial statements to determine the creditworthiness of the companies with which they deal. Publicly traded companies are required by the Securities and Ex- change Commission (SEC) to produce ﬁ nancial statements and make them available to everyone as part of the full-disclosure requirement the SEC places on publicly owned and traded companies. Companies not publicly traded are under no such requirement, but their private owners and bank- ers expect ﬁ nancial statements nevertheless.

Financial statements—the balance sheet, the income statement, and the cash-ﬂ ow statement—follow the same general format from company to company. And even though speciﬁ c line items may vary with the nature of a company’s business, the statements are usually similar enough to allow you to compare one business’s performance against another’s. H7303-Entrepreneur.indb 226 H7303-Entrepreneur.indb 226 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix A: Understanding Financial Statements 227 The balance sheet Many people go to a doctor once a year to get a checkup—a snapshot of their physical well-being at a particular time. Similarly, companies prepare balance sheets as a way of summarizing their ﬁ nancial positions at one point in time, usually at the end of the month, the quarter, or the ﬁ scal year.

In effect, the balance sheet describes the assets controlled by the busi- ness and shows how those assets are ﬁ nanced—with the funds of creditors (liabilities), with the capital of the owners, or with both. A balance sheet reﬂ ects the following basic accounting equation: Assets = Liabilities + Owners’ Equity Assets in this equation are what a company invests in so that it can conduct business. Examples include cash and ﬁ nancial instruments, in- ventories of raw materials and ﬁ nished goods, land, buildings, and equip- ment. Assets also include money owed to the company by customers and others—an asset category referred to as accounts receivable. Now look at the other side of the equation, starting with liabilities.

To acquire its necessary assets, a company often borrows money or prom- ises to pay suppliers for various goods and services. Moneys owed to credi- tors are called liabilities. For example, a company that makes smartphone cases may acquire $1 million worth of plastic for molding from a supplier, with payment due in thirty days. In doing so, the company increases its inventory assets by $1 million and increases its liabilities—in the form of accounts payable—by an equal amount. The equation stays in balance.

Similarly, if the same company were to borrow $100,000 from a bank, the cash infusion would increase its assets by $100,000 and its liabilities by the same amount. Owners’ equity, also known as shareholders’ or stockholders’ equity, is what is left after total liabilities are deducted from total assets. Thus, a company that has $3 million in total assets and $2 million in liabilities would have owners’ equity of $1 million. H7303-Entrepreneur.indb 227 H7303-Entrepreneur.indb 227 11/2/17 1:15 PM 11/2/17 1:15 PM 228 HBR’s Entrepreneur’s Handbook Assets – Liabilities = Owners’ Equity $3,000,000 – $2,000,000 = $1,000,000 If $500,000 of this same company’s uninsured assets burned up in a ﬁ re, its liabilities would remain the same, but its owners’ equity—what’s left after all claims against the assets are satisﬁ ed—would be reduced to $500,000: Assets – Liabilities = Owners’ Equity $2,500,000 – $2,000,000 = $500,000 Thus, the balance sheet “balances” a company’s assets and liabilities.

Notice, for example, that the total assets equal total liabilities and owners’ equity in the balance sheet of Amalgamated Hat Rack, our sample com- pany (table A-1). The balance sheet also shows how much the company has invested in assets and where the money is invested. Further, the balance sheet indicates how much of those monetary investments in assets comes from creditors (liabilities) and how much comes from owners (equity).

Analysis of the balance sheet can give you an idea of how efﬁ ciently a com- pany is using its assets and how well it is managing its liabilities. Balance-sheet data is most helpful when compared with the same in- formation from one or more previous years. Consider the balance sheet of Amalgamated Hat Rack. First, this statement represents the company’s ﬁ - nancial position at a moment in time: December 31, 2017. A comparison of the ﬁ gures for 2016 against those for 2017 shows that Amalgamated is mov- ing in a positive direction: it has increased its owner’s equity by $397,500. Assets You should understand some details about this ﬁ nancial statement. The balance sheet begins by listing the assets most easily converted to cash: re- ceivables, inventory, and prepaid expenses. These are called current assets, generally, those that can be converted into cash within one year. Next, the balance sheet tallies other assets that are tougher to con- vert to cash—for example, buildings and equipment. These are called plant H7303-Entrepreneur.indb 228 H7303-Entrepreneur.indb 228 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix A: Understanding Financial Statements 229 TABLE A-1 Amalgamated Hat Rack balance sheet as of December 31, 2017 20172016Increase (Decrease) Assets Cash and marketable securities $652,500 486,500 166,000 Accounts receivable 555,000512,000 43,000 Inventory 835,000 755,00080,000 Prepaid expenses 123,00098,00025,000 Total current assets 2,165,500 1,851,500 314,000 Gross property, plant, and equipment 2,100,000 1,900,000 200,000 Less: Accumulated depreciation 333,000 290,500(42,500) Net property, plant, and equipment 1,767,000 1,609,500 157,500 Total assets $3,932,500 3,461,000 471,500 Liabilities and owners’ equity Accounts payable $450,000 430,00020,000 Accrued expenses 98,00077,00021,000 Income tax payable 17,0009,0008,000 Short-term debt 435,000 500,000 (65,000) Total current liabilities 1,000,000 1,016,000 (16,000) Long-term debt 750,000 660,00090,000 Total liabilities 1,750,000 1,676,000 74,000 Contributed capital 900,000 850,00050,000 Retained earnings 1,282,500 935,000347,500 Total owners’ equity 2,182,500 1,785,000 397,500 Total liabilities and owners’ equity $3,932,500 $3,461,000 $471,500 assets or, more commonly, ﬁ xed assets (because it is hard to change them into cash). Because most ﬁ xed assets, except land, depreciate—or become less val- uable—over time, the company must reduce the stated value of these ﬁ xed assets by something called accumulated depreciation. Gross property, plant, and equipment minus accumulated depreciation equals the current book value of property, plant, and equipment. Some companies list goodwill among their assets. If a company has purchased another company for a price above the fair market value of its as- s e t s , t h a t s o - c a l l e d g o o d w i l l i s r e c or d e d a s a n a s s e t . T h i s i s , h o w e v e r, s t r i c t l y H7303-Entrepreneur.indb 229 H7303-Entrepreneur.indb 229 11/2/17 1:15 PM 11/2/17 1:15 PM 230 HBR’s Entrepreneur’s Handbook an accounting ﬁ ction. Goodwill may also represent intangible things such as brand names or the acquired company’s excellent reputation. These may have real value. So too can other intangible assets, such as patents. Finally, we come to the last line of the asset section of the balance sheet. Total assets represent the sum of current and ﬁ xed assets.

Liabilities and owners’ equity Now let’s consider the claims against those assets, beginning with a cate- gory called current liabilities. These liabilities represent the claims of cred- itors and others that typically must be paid within a year; they include short-term IOUs, accrued salaries, accrued income taxes, and accounts payable. This year’s repayment obligation on a long-term loan is also listed under current liabilities.

Subtracting current liabilities from current assets gives you the com- pany’s net working capital. Net working capital is the amount of money the company has tied up in its current (short-term) operating activities. Just how much is adequate for the company depends on the industry and the company’s plans. In the balance sheet shown in table A-1, Amalgamated has $1,165,500 in net working capital. Long-term liabilities are typically bonds and mortgages—debts that the company is contractually obliged to repay, with respect to both interest and principal. According to the aforementioned accounting equation, total assets must equal total liabilities plus owners’ equity. Thus, subtracting total lia- bilities from total assets, the balance sheet arrives at a ﬁ gure for the own- ers’ equity. Owners’ equity comprises retained earnings (net proﬁ ts that accumulate on a company’s balance sheet after any dividends are paid) and contributed capital (capital received in exchange for shares).

Historical values The values represented in many balance-sheet categories may not cor- respond to their actual market values. Except for items such as cash, accounts receivable, and accounts payable, the measurement of each clas- siﬁ cation will rarely be equal to the actual current value or cash value H7303-Entrepreneur.indb 230 H7303-Entrepreneur.indb 230 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix A: Understanding Financial Statements 231 shown. This is because accountants must record most items at their historic cost. If, for example, XYZ’s balance sheet indicated land worth $700,000, that ﬁ gure would represent what XYZ paid for the land way back when. If the land was purchased in downtown San Francisco in 1992, you can bet that it is now worth immensely more than the value stated on the balance sheet. So why do accountants use historic instead of market values? The short answer is that it represents the lesser of two evils. If market values were mandated, then every public company would be required to get a pro- fessional appraisal of every one of its properties, warehouse inventories, and so forth—and would have to do so every year. And how many people would trust those appraisals? So we’re stuck with historic values on the balance sheet.

Managerial issues Although the balance sheet is prepared by accountants, it represents sev- eral important issues for managers.

Working capital Business owners pay substantial attention to the level of working capi- tal, which naturally expands and contracts with sales activities. Too little working capital can put a company in a bad position: the company may be unable to pay its bills or to take advantage of proﬁ table opportunities. Too much working capital, on the other hand, reduces proﬁ tability, because that capital has a carrying cost; it must be ﬁ nanced in some way, usually through interest-bearing loans. Inventory is one component of working capital—unless yours is a ser- vice business that has no inventory. Like working capital, inventory must be balanced between too much and too little. Having lots of inventory on hand allows a company to ﬁ ll customer orders without delay and provides a buffer against potential production stoppages and strikes. The ﬂ ip side of plentiful inventory is the cost of ﬁ nancing and the risk of deterioration in the market value of the inventory itself. Every excess widget in the stock- room adds to the company’s ﬁ nancing costs, and that reduces proﬁ ts. And H7303-Entrepreneur.indb 231 H7303-Entrepreneur.indb 231 11/2/17 1:15 PM 11/2/17 1:15 PM 232 HBR’s Entrepreneur’s Handbook every item that sits on the shelf may become obsolete or less salable as time goes by—again, with a negative impact on proﬁ tability.

The personal-computer business provides a clear example of how ex- cess inventory can wreck the bottom line. Some analysts estimate that the value of ﬁ nished-goods inventory melts away at a rate of approximately 2 percent per day because of technical obsolescence in this fast-moving industry.

Financial leverage You have probably heard someone say, “It’s a highly leveraged situation.” Do you know what “leveraged” means in the ﬁ nancial sense? Financial lever- age refers to the use of borrowed money in acquiring an asset. We say that a company is highly leveraged when the percentage of debt on its balance sheet is high relative to the capital invested by the owners. For example, suppose that you paid $400,000 for an asset, using $100,000 of your own money and $300,000 in borrowed funds. For simplicity, we’ll ignore loan payments, taxes, and any cash ﬂ ow you might get from the investment.

Four years go by, and your asset has appreciated to $500,000. You decide to sell. After paying off the $300,000 loan, you end up with $200,000 in your pocket (your original $100,000 plus a $100,000 proﬁ t). That’s a gain of 100 percent on your personal capital, even though the asset increased in v a lue b y on l y 2 5 p e r c e nt . F i n a nc i a l le v e r a g e m a d e t h i s p o s s i ble . I n c ont r a s t , if you had ﬁ nanced the purchase entirely with your own funds ($400,000), then you would have ended up with only a 25 percent gain. Financial leverage creates an opportunity for a company to gain a higher return on the capital invested by its owners. In the United States and most other countries, tax policy makes ﬁ nancial leverage even more attractive by allowing businesses to deduct the interest paid on loans. But leverage can cut both ways. If the value of an asset drops (or fails to produce the anticipated level of revenue), then leverage works against its owner.

Consider what would have happened in our example if the asset’s value had dropped by $100,000, that is, to $300,000. The owner would have lost the entire $100,000 investment after repaying the initial loan of $300,000. H7303-Entrepreneur.indb 232 H7303-Entrepreneur.indb 232 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix A: Understanding Financial Statements 233 Financial structure of the ﬁ rm The potential downside of ﬁ nancial leverage is what keeps CEOs from maximizing their debt ﬁ nancing. Instead, they seek a ﬁ nancial structure that creates a realistic balance between debt and equity on the balance sheet. Although leverage enhances a company’s potential proﬁ tability as long as things go right, managers know that every dollar of debt increases the riskiness of the business—both because of the danger just cited and because high debt results in high interest payments, which must be paid in good times and bad. Many companies have failed when business reversals or recessions reduced their ability to make timely payments on their loans. When creditors and investors examine corporate balance sheets, they look carefully at the debt-to-equity ratio. They factor the riskiness of the balance sheet into the interest they charge on loans and the return they demand from a company’s bonds. Thus, a highly leveraged company may have to pay 14 percent on borrowed funds instead of the 10 to 12 percent paid by a less leveraged competitor. Investors also demand a higher rate of return for their stock investments in highly leveraged companies. They will not accept high risks without an expectation of commensurately large returns.

The income statement The income statement indicates the results of operations over a speciﬁ ed period. Those last two words are important. Unlike the balance sheet, which is a snapshot of the enterprise’s position at a point in time, the in- come statement indicates cumulative business results within a deﬁ ned time frame. Because it tells you whether the company is making a proﬁ t— that is, whether it has positive or negative net income (net earnings)—the income statement is often referred to as the proﬁ t-and-loss statement, or P&L. It shows a company’s proﬁ tability at the end of a particular time— typically at the end of the month, the quarter, or the company’s ﬁ scal year.

In addition, the income statement tells you how much money the company H7303-Entrepreneur.indb 233 H7303-Entrepreneur.indb 233 11/2/17 1:15 PM 11/2/17 1:15 PM 234 HBR’s Entrepreneur’s Handbook spent to make that proﬁ t—from which you can determine the company’s proﬁ t margin.

As we did with the balance sheet, we can represent the contents of the income statement with a simple equation: Revenues – Expenses = Net Income (or Net Loss) An income statement starts with the company’s revenues: the amount of money that results from selling products or services to customers. A company may have other revenues as well. These are often from invest- ments or interest income from its cash holdings. Various costs and ex- penses—from the costs of making and storing goods, to depreciation of plant and equipment, to interest expense and taxes—are then deducted from revenues. The bottom line—what’s left over—is the net income, or net proﬁ t or net earnings, for the period of the statement.

Consider the meaning of various line items on the income statement for Amalgamated Hat Rack (table A-2). The cost of goods sold is what it cost Amalgamated to manufacture its hat racks. This ﬁ gure includes the cost of raw materials, such as lumber, as well as the cost of turning them into ﬁ nished goods, including direct labor costs. By deducting the cost of goods sold from sales revenue, we get a company’s gross proﬁ t—the rough- est estimation of the company’s proﬁ tability.

The next major category of cost is operating expenses. These expenses include administrative employee salaries, rents, and sales and marketing costs, a s well a s other costs of business not directly at tr ibuted to the cost of manufacturing a product. The lumber for making hat racks would not be included here; the cost of the advertising and the salaries of Amalgamated administrative employees would be included. Depreciation is counted on the income statement as an expense, even though it involves no out-of-pocket payments. As described earlier, depre- ciation is a way of estimating the “consumption” of an asset, or the dimin- ishing value of equipment, over time. A laptop, for example, loses about one-ﬁ fth of its value each year. Thus, the company would not expense the H7303-Entrepreneur.indb 234 H7303-Entrepreneur.indb 234 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix A: Understanding Financial Statements 235 full value of a laptop in the ﬁ rst year of its purchase but rather would de- crease its value as it is actually used over a span of ﬁ ve years. The idea behind depreciation is to recognize the diminished value of certain assets. By subtracting operating expenses and depreciation from the gross proﬁ t, we get operating earnings. These earnings are often called earnings before interest and taxes, or EBIT. We’re now down to the last reductions in the path that revenues follow on their way to the bottom line. Interest expense is the interest charged on loans a company has taken out. Income tax—tax levied by the government on corporate income—is the ﬁ nal charge.

What revenues are left are referred to as net income, or earnings. If net income is positive—as it is in the case of Amalgamated—we have a proﬁ t, what the for-proﬁ t company lives for.

Making sense of the income statement As with the balance sheet, our analysis of a company’s income statement is greatly aided when presented in a multiperiod format. By using several time TABLE A-2 Amalgamated Hat Rack income statement For the period ending December 31, 2017 Retail sales $2,200,000 Corporate sales 1,000,000 Total sales revenue 3,200,000 Less: Cost of goods sold 1,600,000 Gross proﬁ t 1,600,000 Less: Operating expenses 800,000 Less: Depreciation expenses 42,500 Earnings before interest and taxes (EBIT) 757,500 Less: Interest expense 110,000 Earnings before income taxes 647,500 Less: Income taxes 300,000 Net income $347,500 H7303-Entrepreneur.indb 235 H7303-Entrepreneur.indb 235 11/2/17 1:15 PM 11/2/17 1:15 PM 236 HBR’s Entrepreneur’s Handbook points, we can spot trends and turnarounds. Most annual reports make multiperiod data available, often going back ﬁ ve or more years. Amalga- mated’s income statement in multiperiod form is depicted in table A-3. In this multiyear format, we observe that Amalgamated’s annual retail sales have grown steadily, and its corporate sales have stagnated and even declined slightly. Operating expenses have stayed about the same, however, even as total sales have expanded. That’s a good sign that management is holding the line on the cost of doing business. The company’s interest expense has also declined, perhaps because it has paid off one of its loans.

The bottom line, net income, has shown healthy growth.

The cash-ﬂ ow statement The cash-ﬂ ow statement, the last of the three essential ﬁ nancial statements, is the least used and understood. This statement details the reasons that TABLE A-3 Amalgamated Hat Rack multiperiod income statement, 2015–2017 For the period ending December 31 2017 2016 2015 Retail sales $2,200,000 2,000,000 1,720,000 Corporate sales 1,000,000 1,000,000 1,100,000 Total sales revenue 3,200,000 3,000,000 2,820,000 Less: Cost of goods sold 1,600,000 1,550,000 1,400,000 Gross proﬁt 1,600,000 1,450,000 1,420,000 Less: Operating expe nses 800,000 810,000 812,000 Less: Depreciation expenses 42,500 44,50045,500 Earnings before interest and taxes (EBIT) 757,500 595,500 562,500 Less: Interest expense 110,000 110,000 150,000 Earnings before income taxes 647,500 485,500 412,500 Less: Income taxes 300,000 194,200 165,000 Net income $347,500 291,300 247,500 H7303-Entrepreneur.indb 236 H7303-Entrepreneur.indb 236 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix A: Understanding Financial Statements 237 the amount of cash (and cash equivalents) changed during the accounting period. More speciﬁ cally, it reﬂ ects all changes in cash as af fected by oper- ating activities, investments, and ﬁ nancing activities. Like the bank state- ment you receive for your checking account, the cash-ﬂ ow statement tells how much cash was on hand at the beginning of the period and how much was on hand at the end. It then describes how the company acquired and spent cash in a particular period. The uses of cash are recorded as negative ﬁ gures, and sources of cash are recorded as positive ﬁ gures.

If you’re a manager in a large corporation, changes in the company’s cash ﬂ ow typically don’t have an impact on your day-to-day function- ing. Nevertheless, it’s a good idea to stay up-to-date with your company’s cash-ﬂ ow projections, because they may come into play when you prepare your budget for the upcoming year. For example, if cash is tight, you will probably want to be conservative in your spending. Alternatively, if the company is ﬂ ush with cash, you may have opportunities to make new in- vestments. If you’re a manager in a small company (or its owner), you’re probably keenly aware of your cash-ﬂ ow situation and feel its impact almost every day. The cash-ﬂ ow statement is useful because it indicates whether your company is turning accounts receivable into cash—and that ability is ulti- mately what will keep your company solvent. Solvency is the ability to pay bills as they come due. As we did with the other statements, we can conceptualize the cash- ﬂ ow statement in terms of a simple equation: Cash Flow from Proﬁ t + Other Sources of Cash – Uses of Cash = Change in Cash Again using the Amalgamated Hat Rack example, we see that in its year 2017 cash-ﬂ ow statement, the company generated a positive cash ﬂ ow of $166,000 (table A-4). The statement shows that cash ﬂ ows from opera- tions ($291,000), from investing activities (–$200,000), and from ﬁ nanc- ing ($75,000) produced $166,000 in additional cash. H7303-Entrepreneur.indb 237 H7303-Entrepreneur.indb 237 11/2/17 1:15 PM 11/2/17 1:15 PM 238 HBR’s Entrepreneur’s Handbook TABLE A-4 Amalgamated Hat Rack cash-ﬂow statement for the year ending December 31, 2017 Net income$347,500 Operating activities Accounts receivable (43,000) Inventory (80,000) Prepaid expenses (25,000) Accounts payable 20,000 Accrued expenses 21,000 Income tax payable 8,000 Depreciation expense 42,500 Total changes in operating assets and liabilities (56,500) Cash ﬂow from operations 291,000 Investing activities Sale of property, plant, and equipment 267,000* Capital expenditures (467,000) Cash ﬂow from investing activities (200,000) Financing activities Short-term debt decrease (65,000) Long-term borrowing 90,000 Capital stock 50,000 Cash dividends to stockholders — Cash ﬂow from ﬁnancing activities 75,000 Increase in cash during year $ 166,000 * Assumes sale price was at book value; the company had yet to start depreciating this asset. The cash-ﬂ ow statement doesn’t measure the same thing as the income statement. If there is no cash transaction, then it cannot be reﬂ ected on a cash-ﬂ ow statement. Notice, however, that net income at the top of the cash-ﬂ ow statement is the same as the bottom line of the income state- ment; it’s the company’s proﬁ t. Through a series of adjustments, the cash- ﬂ ow statement translates this net income into a cash basis.

The statement’s format reﬂ ects the three categories of activities that affect cash. Cash can be increased or decreased because of (1) operations; (2) the acquisition or sale of assets, that is, investments; or (3) changes in debt or stock or other ﬁ nancing activities. Let’s consider each activity in turn, starting with operations: H7303-Entrepreneur.indb 238 H7303-Entrepreneur.indb 238 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix A: Understanding Financial Statements 239 • Accounts receivable and ﬁ nished-goods inventory represent items the company has produced but for which it hasn’t yet received payment. Prepaid expenses represent items the company has paid for but has not yet consumed. These items are all subtracted from cash ﬂ ow.

• Accounts payable and accrued expenses represent items the com- pany has already received or used but for which it hasn’t yet paid.

Consequently, these items add to cash ﬂ ow.

Now consider investments, which include the following:

• Gains realized from the sale of plant, property, and equipment. In other words, these gains are realized from converting investments into cash.

• Cash that the company uses to invest in ﬁ nancial instruments and plant, property, and equipment. The latter investments are often shown as capital expenditures.

The cash-ﬂ ow statement shows that Amalgamated has sold a building for $267,000 and has made capital expenditures of $175,000, for a net ad- dition to cash ﬂ ow of $92,000. Cash ﬂ ow versus proﬁ t Many people think of proﬁ ts as cash ﬂ ow. Don’t make this mistake. For a particular period, proﬁ t may or may not contribute positively to cash ﬂ ow. For example, if this year’s proﬁ t derives from a huge sale made in November, the sale may be booked as revenues in the ﬁ scal period, thus adding to proﬁ t. But if payment for that sale is not received until the next accounting period, it goes on the books as an account receivable, and that reduces cash ﬂ ow. H7303-Entrepreneur.indb 239 H7303-Entrepreneur.indb 239 11/2/17 1:15 PM 11/2/17 1:15 PM 240 HBR’s Entrepreneur’s Handbook Fina l ly, we c ome t o c a sh-ﬂ ow changes from ﬁ nancing activities. Amal- gamated has raised money by increasing its short-term debt, by borrow- ing in the capital markets, and by issuing capital stock, thereby increasing its available cash ﬂ ow. The dividends that Amalgamated pays ($50,000), however, must be paid out of cash ﬂ ow and thus represent a decrease in cash ﬂ ow.

There’s a lot more to ﬁ nancial statements and their interpretation than we can provide in this short primer, but you now have a basis for learning more. The statements generated by your small startup will be fairly simple in any case, and you can learn more as you work with your accountant or ﬁ nancial ofﬁ cer, and as your company grows. H7303-Entrepreneur.indb 240 H7303-Entrepreneur.indb 240 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix B Breakeven Analysis Whether they are planning their new business or deciding whether to offer new products or services, entrepreneurs need to know the point at which they will begin making money. Breakeven analysis is a handy tool for this purpose. It can tell you how much (or how much more) you need to sell to pay for a ﬁ xed investment—in other words, at what point you will break even. With that information in hand, you can look at market demand and competitors’ market shares to determine whether it’s realistic to expect to sell that much. Breakeven analysis can also help you think through the impact of changing price and volume relationships. More speciﬁ cally, the breakeven calculation helps you determine the volume at which the total after-tax contribution from a product line or an investment covers its total ﬁ xed costs. But before you can calculate this value, you need to understand the components that go into it.

Making the calculation To calculate breakeven, you must ﬁ rst understand three accounting con- cepts: ﬁ xed costs, variable costs, and contribution margin. H7303-Entrepreneur.indb 241 H7303-Entrepreneur.indb 241 11/2/17 1:15 PM 11/2/17 1:15 PM 242 HBR’s Entrepreneur’s Handbook • Fixed costs: These costs stay mostly the same, no matter how many units of a product or service are sold—costs such as insurance, management salaries, and rent or lease payments. For example, the rent on the production facility will remain the same whether the company makes ten thousand or twenty thousand units, and so will the cost of insurance.

• Va r i a b l e c o s t s: These costs change with the number of units pro- duced and sold; examples include utilities, labor, and the costs of raw materials. The more units you make, the more you consume these items. Sales commissions are another variable cost.

• Contribution margin: This is the amount of money that every sold unit contributes to paying for ﬁ xed costs. It is deﬁ ned as net unit revenue minus variable (or direct) costs per unit.

With these concepts, we can make the calculation. We are looking for the solution to this straightforward equation: Breakeven Volume = Fixed Costs ÷ Unit Contribution Margin Here’s how we do it. First, ﬁ nd the unit contribution margin by sub- tracting the variable costs per unit from the net revenue per unit. Then divide the total ﬁ xed costs, or the amount of the investment, by the unit contribution margin. The quotient is the breakeven volume, that is, the number of units that must be sold if all ﬁ xed costs are to be covered.

Let’s consider a hypothetical situation. Amalgamated Hat Rack is planning to sell its new plastic wall-mounted hat rack for $75 per unit.

The company’s variable cost per unit is $22. It will spend $100,000 (a ﬁ xed cost) for the plastic extruder that will make these hat racks. Thus $75 (Price per Unit) – $22 (Variable Cost per Unit) = $53 (Unit Contribution Margin) H7303-Entrepreneur.indb 242 H7303-Entrepreneur.indb 242 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix B: Breakeven Analysis 243 Therefore $100,000 (Total Investment Required) ÷ $53 (Unit Contribution Margin) = 1,887 Units The preceding calculations indicate that Amalgamated must sell 1,887 hat racks to break even on its $100,000 investment. At this point, Amalgamated must decide whether the breakeven vol- ume is achievable: Is it realistic to expect to sell 1,887 additional hat racks, and if so, how quickly? A breakeven complication Our hat rack breakeven analysis represents a simple case. It assumes that costs are distinctly ﬁ xed or variable, that costs and unit contributions will not change as a function of volume (i.e., that the sale price of the item under consideration will not change at different levels of output; rent will stay the same whether one thousand or ten thousand units are produced and sold). These assumptions may not hold in your more complicated world. Up to a certain level of production, your rent may be ﬁ xed and then increase by 50 percent as you rent a secondary facility to handle expanded output.

Labor costs may in reality be a hybrid of ﬁ xed and variable. And as you push more of your product into the market, you may have to offer price discounts, which will reduce contribution per unit. You must adjust the breakeven calculation to accommodate these untidy realities.

Operating leverage Your goal as an entrepreneur, of course, is not to break even but to make a proﬁ t. After you’ve covered all your ﬁ xed costs with the contributions of many unit sales, every subsequent sale contributes directly to proﬁ ts. As we observed earlier, Unit Net Revenue – Unit Variable Cost = Contribution to Proﬁ t H7303-Entrepreneur.indb 243 H7303-Entrepreneur.indb 243 11/2/17 1:15 PM 11/2/17 1:15 PM 244 HBR’s Entrepreneur’s Handbook You can see at a glance that the lower the unit variable cost, the greater the contribution to proﬁ ts. In the pharmaceutical business, for example, the unit cost of cranking out and packaging a bottle of a new drug may be less than $1. Yet if the company can sell each bottle for $100, a whopping sum of $99 contributes to corporate proﬁ ts after sales have gotten beyond the breakeven point! The trouble is that the pharmaceutical company may have invested $400 million up front in ﬁ xed product-development costs just to get the ﬁ rst bottle out the door. It will have to sell many bottles of the new medication just to break even. But when it does, proﬁ ts can be extraordinary. The relationship between ﬁ xed and variable costs is often described in terms of operating leverage. Companies whose ﬁ xed costs are high relative to their variable costs are said to have high operating leverage. The phar- maceutical business, for example, generally operates with high operating leverage. Now consider the opposite: low operating leverage. Here, ﬁ xed costs are low relative to the total cost of producing each unit of output. A con- sulting business is a good example of one that functions with low operating leverage. The ﬁ rm has a minimal investment in equipment and other ﬁ xed expenses. The bulk of its costs are the fees it pays its consultants, which vary depending on the actual hours they bill to the ﬁ rm.

Operating leverage is a great thing after a company passes its breakeven point, but it can cause substantial losses if breakeven is never achieved. In other words, it’s risky. Managers accordingly give much thought to ﬁ nding the right balance between ﬁ xed and variable costs. H7303-Entrepreneur.indb 244 H7303-Entrepreneur.indb 244 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix C Valuation: What Is Your Business Really Worth?

What is your business worth? This is a question that most entrepreneurs must eventually answer because they are either buying an existing busi- ness or selling one of their own. And answering it correctly is extremely important. If you pay too much for a business, your rate of return will be disappointing. Similarly, if you underestimate the value of an entity you are selling, you will shortchange yourself without knowing it.Valuing an ongoing business—large or small—is neither easy nor exact.

In most cases, it is the domain of experts. But as an entrepreneur, you should be familiar with the various valuation approaches used by those experts and understand the strengths and weaknesses of these techniques.

We’ll discuss these approaches here. But before we get started, consider these cautions. The true value of a business is never completely certain, because of two problems. First, dif- ferent valuation methods consistently fail to produce the same outcome, H7303-Entrepreneur.indb 245 H7303-Entrepreneur.indb 245 11/2/17 1:15 PM 11/2/17 1:15 PM 246 HBR’s Entrepreneur’s Handbook even when meticulously calculated. Second, the product of valuation meth- ods is only as good as the data and the estimates we bring to them, and the numbers are often incomplete, unreliable, or based on projections. For ex- ample, one method depends heavily on estimates of future cash ﬂ ows, and even in the very best cases, these estimates will only be close. In the worst cases, they will stray far from the mark. Another consideration is that a company is worth different amounts to different parties. Different prospective buyers are likely to assign dif- ferent values to the same set of assets. For example, if you were a book collector who already owned ﬁ rst editions of every Hemingway novel ex- cept For Whom the Bell Tolls , then that book would be much more valu- able to you than it would be to another collector who owned only one or two ﬁ rst-edition Hemingways. The reason? For you, the acquisition would complete a set, whose value is greater than the sum of the individual vol- u me s c on sider e d s epa r at ely. Bu si ne s s e s lo ok on a c qu i sit ion s w it h a si m i l a r perspective. The acquisition of a small high-tech company, for example, might provide the acquirer with the technology it needs to leverage its other operations. This difference in how parties value an asset explains, in part, why many ﬁ rms are purchased for more than the market value of their existing shares. Also keep in mind that, as we’ve said, valuation is the province of spe- cialists. Among other reasons, a small and closely held business typically turns to professional appraisers when its value must be established for a sale or when it needs to determine the value of its shares when an ESOP is used. When large public ﬁ rms or their business units are the subjects of a valuation, executives generally turn to a variety of full-service account- ing, investment banking, or consulting ﬁ rms. Many of these vendors have departments devoted entirely to mergers and acquisitions, in which valua- tion issues are a central focus. A well-rounded entrepreneur cannot be an expert in these matters, but you should understand the nature of various valuation methods along with their strengths and weaknesses. Valuation problems often arise in the context of closely held busi- nesses—that is, businesses with only a few owners—or in the sale of an op- erating unit of a public company. In neither case are there publicly traded H7303-Entrepreneur.indb 246 H7303-Entrepreneur.indb 246 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix C: Valuation 247 ownership shares. Public markets for ownership, such as NASDAQ or the New York Stock Exchange, make value more transparent. Everyday buying and selling in these markets establishes a company’s per-share price. And that price, multiplied by the number of outstanding shares, often provides a basis for a fair approximation of a company’s value at a point in time. But this basis is not available in the absence of public trading.

Asset-based valuations One way to value an enterprise is to determine the value of its assets. There are four approaches to asset-based valuations: equity book value, adjusted book value, liquidation value, and replacement value.

Equity book value Equity book value, the simplest valuation approach, uses the balance sheet as its primary source of information. Here’s the formula: Equity Book Value = Total Assets – Total Liabilities To test this formula, consider the balance sheet of Amalgamated Hat Rack Company, which we encountered in appendix A. Table A-1 showed total assets of $3,932,500 and total liabilities of $1,750,000 for 2017. The difference—the equity book value—is $2,182,500. Notice that equity book value is the same as total owners’ equity. In other words, if you reduce the balance-sheet (or book) value of the business’s assets by the amount of its debts and other ﬁ nancial obligations, you have its equity value.

This equity-book-value approach is easy and quick. And it is common for executives in a particular industry to roughly calculate their company’s value in the context of equity book value. For example, one owner might contend that their company is worth at least book value in a sale because that was the amount that they invested in the business. But equity book value is not a reliable guide for businesses in many industries. Assets are placed on the balance sheet at their historical costs, which may not represent their value today. The value of balance-sheet H7303-Entrepreneur.indb 247 H7303-Entrepreneur.indb 247 11/2/17 1:15 PM 11/2/17 1:15 PM 248 HBR’s Entrepreneur’s Handbook assets may be unrealistic for other reasons as well. Consider Amalgam- ated’s assets:• Accounts receivable could be suspect if many accounts are uncollectible.

• Inventory reﬂ ects historic cost, but inventory may be worthless or less valuable than its stated balance-sheet value because of spoil- age or obsolescence. Or some inventory may be undervalued.

• Property, plant, and equipment depreciation should also be closely examined—particularly for land. If Amalgamated’s property was put on the books in 1995—and if it happens to be in the heart of San Francisco—then its real market value may be ten or twenty times the 1995 ﬁ gure.

The preceding hypotheticals are only a few examples of why book value is not always true market value.

Adjusted book value The weaknesses of the quick-and-dirty equity-book-value approach have led some to adopt adjusted book value, which attempts to restate the value of balance-sheet assets to realistic market levels. Consider the inﬂ uence of adjusted book value in a leveraged buyout of a major retail store chain.

At the time of the analysis, the store chain had an equity book value of $1.3 billion. After its inventory and property assets were adjusted to their appraised values, however, the enterprise’s value leaped to $2.2 billion—an increase of 69 percent. When asset values are adjusted, appraisers must determine the real value of any listed intangibles, such as goodwill and patents. Goodwill is usually an accounting ﬁ ction created when one company buys another at a premium to book value—that is, at a price higher than book value. The premium must be put on the balance sheet as goodwill. But to a potential buyer, the intangible asset may have no value. H7303-Entrepreneur.indb 248 H7303-Entrepreneur.indb 248 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix C: Valuation 249 Liquidation value Liquidation value is similar to adjusted book value. It attempts to restate balance-sheet values in terms of the net cash that would be realized if as- sets were disposed of in a quick sale and all company liabilities were paid off or otherwise settled. This approach recognizes that many assets, espe- cially inventory and ﬁ xed assets, usually fetch less than they would if the sale were made more deliberately.

Replacement value Some people use replacement value to obtain a rough estimate of value.

This method simply estimates the cost of reproducing the business’s as- sets. Of course, a buyer may not want to replicate all the assets included in the sale price of a company. In this case, the replacement value represents more than the value that the buyer would place on the company.

The various asset-based valuation approaches described here generally share some strengths and weaknesses. On the positive side, asset-based methods are easy and inexpensive to calculate. They are also easy to under- stand. On the negative side, both equity book value and liquidation value fail to reﬂ ect the actual market value of assets. And all these approaches fail to recognize the intangible value of an ongoing enterprise, which de- rives much of its wealth-generating power from human knowledge, skill, and reputation.

Earnings-based valuation Another approach to valuing a company is to capitalize its earnings. This involves multiplying one or another income-statement earnings ﬁ gure (e.g., earnings before income tax) by some ﬁ gure. Some earnings-based methods, however, are more sophisticated. H7303-Entrepreneur.indb 249 H7303-Entrepreneur.indb 249 11/2/17 1:15 PM 11/2/17 1:15 PM 250 HBR’s Entrepreneur’s Handbook Earnings multiple For a publicly traded company, the current share price multiplied by the number of outstanding shares indicates the market value of the company’s equity. Add to this the value of the company’s debt, and you have the total value of the enterprise. In other words, the total value of the company is the equity of the owners plus any outstanding debt. Why add the debt?

Consider your own home. When you go to sell your house, you don’t set the price at the level of your equity in the property. Rather, its value is the total of the outstanding debt and your equity interest. Similarly, the value of a company is the shareholders’ equity plus the liabilities. This is often referred to as the enterprise value.For a public company whose shares are priced by the market every business day, pricing the equity is straightforward. But what about a closely held corporation, whose share price is generally unknown because such a ﬁ rm does not trade in a public market? We can reach a value estimate by using the known price-earnings multiple (often called the P/E ratio) of similar enterprises that are publicly traded. The P/E-multiple approach to share value begins with this formula: Share Price = Current E arnings × Multiple We calculate the multiple from comparable publicly traded companies as follows: Multiple = Share Price ÷ Current Earnings Thus, if XYZ Corporation’s shares are trading at $50 per share and its current earnings are $5 per share, then the multiple is 10. In stock market parlance, we’d say that XYZ is trading at ten times earnings. We can use this multiple approach to price the equity of a nonpublic corporation if we can ﬁ nd one or more similar enterprises with known P/E multiples. Finding such companies is a challenge, because no two enter- H7303-Entrepreneur.indb 250 H7303-Entrepreneur.indb 250 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix C: Valuation 251 prises are exactly alike. Because of the uniqueness of every business, valua- tion experts recognize their work as part science and part art.

To examine this method further, let’s return to our sample ﬁ rm. Be- cause Amalgamated Hat Rack is a closely held ﬁ rm, we have no readily available benchmark for valuing its shares. But let’s suppose that we did identify a publicly traded company (or, even better, several companies) similar to Amalgamated in most respects—in terms of both industry and size. We’ll call one of these ﬁ rms Acme Corporation. And let’s suppose that Acme’s P/E multiple is 8. Let’s also suppose that our crack researchers have discovered that another company, this one private and in the same industr y as A malgamated, was recently acquired at roughly the same mul- tiple: 8. This gives us conﬁ dence that our multiple of 8 is in the ballpark.

With this information, let’s revisit Amalgamated’s income statement presented in appendix A (table A-2), where we ﬁ nd that its net income (earnings) is $347,500. Plugging the relevant numbers in to the following formula, we estimate Amalgamated’s value: Earnings × Appropriate Multiple = Equity Value $347,500 × 8 = $2,780,000 Remember that this is the value of the company’s equity. To ﬁ nd the total enterprise value of Amalgamated, we must add the total of its interest-bearing liabilities. Table A-1 in appendix A shows that the com- pany’s interest-bearing liabilities (short-term and long-term debt) for 2017 are $1,185,000. Thus, the value of the entire enterprise is as follows: Enterprise Value = Equity Value + Value of Interest-Bearing Debt $3,955,000 = $2,780,000 + $1,175,000 The effectiveness of the multiple approach to valuation depends partly on the reliability of the earnings ﬁ gure. The most recent earnings might, for example, be unnaturally depressed by a onetime write-off of obsolete H7303-Entrepreneur.indb 251 H7303-Entrepreneur.indb 251 11/2/17 1:15 PM 11/2/17 1:15 PM 252 HBR’s Entrepreneur’s Handbook inventory or pumped up by the sale of a subsidiary company. For this rea- son, you have to factor out random and nonrecurring items. Similarly, you should review expenses to determine that they are normal—neither extraordinarily high nor extraordinarily low. For example, inordinately low maintenance charges over a period would pump up near-term earn- ings but would result in extraordinary expenses in the future for deferred maintenance. Similarly, nonrecurring windfall sales can also distort the earnings picture.In small, closely held companies, you need to pay particular attention to the salaries of the owner-managers and the members of their families. If these salaries have been unreasonably high or low, an adjustment of earn- ings is required. You should also assess the depreciation rates to deter- mine their validity and, if necessary, to make appropriate adjustments to reported earnings.

Earnings before interest and taxes (EBIT) multiple The reliability of the multiple approach to valuation just described depends on the comparability of the ﬁ rm or ﬁ rms used as proxies for the target company. In the Amalgamated example, we relied heavily on the observed earnings multiple of Acme Corporation, a publicly traded company whose business is similar to Amalgamated’s. Unfortunately, these two compa- nies could produce equal operating results and yet indicate much different bottom-line proﬁ ts to their shareholders.

How is this possible? The answer is twofold. The two companies show different bottom lines because of how they are ﬁ nanced and because of taxes. If a company is heavily ﬁ nanced with debt, its interest expenses will be large, and those expenses will reduce the total dollars available to the owners at the bottom line. Similarly, one company’s tax bill might be much higher than the other’s for some reason that has little to do with its future wealth-producing capabilities. And taxes reduce bottom-line earnings. Consider the hypothetical scenario in table C-1. Notice that the two companies produce the same earnings before interest and taxes (EBIT).

But because Acme uses more debt and less equity in ﬁ nancing its assets, H7303-Entrepreneur.indb 252 H7303-Entrepreneur.indb 252 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix C: Valuation 253 its interest expense is much higher ($350,000 versus $110,000). This dra- matically reduces its earnings before income taxes compared with that of Amalgamated. Even though each pays an equal percentage in income taxes, Acme ends up with substantially lower bottom-line earnings.

This earnings variation between two otherwise comparable enterprises would produce different equity values. You can circumvent the problem by using EBIT instead of bottom-line earnings in the valuation process.

Some practitioners go one step further and use the EBITDA (EBIT plus de- preciation and amortization) multiple. Depreciation and amortization are noncash charges against bottom-line earnings—accounting allocations that tend to create differences between otherwise similar ﬁ rms. By using EBITDA in the valuation equation, you avoid this potential distortion.

Discounted cash-ﬂ ow method The earnings-based methods just described are based on historical perfor- mance—what happened last year. But past performance is no assurance of future results. If you were making an offer to buy a local small business, chances are that you’d base your offer on its ability to produce proﬁ ts in the years ahead. Similarly, if your company were hatching plans to acquire Amalgamated Hat Rack, it would be less interested in what Amalgamated earned in the past than in what it is likely to earn in the future under new management.

TABLE C-1 Hypothetical income statements of Amalgamated Hat Rack and Acme Corporation Amalgamated Acme Earnings before interest and taxes $757,500 $757,500 Less: Interest expense $110,000 $350,000 Earnings before income tax $647,500 $407,400 Less: Income tax $300,000 $187,000 Net income $347,500 $220,500 H7303-Entrepreneur.indb 253 H7303-Entrepreneur.indb 253 11/2/17 1:15 PM 11/2/17 1:15 PM 254 HBR’s Entrepreneur’s Handbook We can direct our earnings-based valuation toward the future by using a more sophisticated valuation method: discounted cash ﬂ ow (DCF). The DCF valuation method accounts for the time value of money (concepts be- yond the scope of this volume but described in many books on ﬁ nance).

DCF determines value by calculating the present value of a business’s fu- ture cash ﬂ ows, including its terminal value. Because those cash ﬂ ows are available to both equity holders and debt holders, DCF can reﬂ ect the value of the enterprise as a whole or can be conﬁ ned to the cash ﬂ ows left avail- able to shareholders. The DCF method has numerous strengths:

• It recognizes the time value of future cash ﬂ ows.

• It is future oriented and estimates future cash ﬂ ows in terms of what the new owner could achieve.

• It accounts for the buyer’s cost of capital.

• It does not depend on comparisons with similar companies— comparisons that are bound to be different in various dimensions (e.g., earnings-based multiples).

• It is based on real cash ﬂ ows instead of accounting values.

On the downside, the DCF method assumes that future cash ﬂ ows, including the terminal value, can be estimated with reasonable accuracy.

This is rarely the case for cash-ﬂ ow estimates made far into the future.

Clearly, the information given here will not make you an expert valu- ation practitioner, but with a little reﬂ ection, it should put you in a better position to deal with those practitioners in negotiating the sale of your own company or the purchase of another. Summing up The important but diﬃ cult subject of business valuation can be summarized in three types of approaches: H7303-Entrepreneur.indb 254 H7303-Entrepreneur.indb 254 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix C: Valuation 255 ■Asset-based: This valuation approach includes the use of equity book value, adjusted book value, liquidation value, or replacement value. In gen- eral, these methods are easy to calculate and to understand but have nota- ble weaknesses. Except for replacement and adjusted book methods, they fail to reﬂ ect the actual market values of assets; they also fail to recognize the intangible value of an ongoing enterprise, which derives much of its wealth-generating power from human knowledge, skill, and reputation.

■Earnings-based: This valuation approach includes the price-earnings method, the EBIT method, and the EBITDA method. The earnings-based approach is generally superior to asset-based methods, but it depends on the availability of comparable businesses whose P/E multiples are known.

■Discounted-cash-ﬂ ow-based: This method includes the time value of money. The DCF method has many advantages, the most important being its future-looking orientation. The method estimates future cash ﬂ ows in terms of what a new owner could achieve. It also recognizes the buyer’s cost of capital. The major weakness of the method is the diﬃ culty inherent in producing reliable estimates of future cash ﬂ ows.

In the end, these approaches to valuation are bound to produce diﬀ erent out- comes. Even the same method applied by two experienced professionals can pro- duce diﬀ erent results. For this reason, most appraisers use more than one method in approximating the true value of an asset or a business. H7303-Entrepreneur.indb 255 H7303-Entrepreneur.indb 255 11/2/17 1:15 PM 11/2/17 1:15 PM H7303-Entrepreneur.indb 256 H7303-Entrepreneur.indb 256 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix D Selling Restricted and Control Securities:

SEC Rule 144 The trading of common stock acquired before an IPO is restricted by the US Securities and Exchange Commission (SEC). Several rules govern how that restriction can be lifted. Here is the SEC’s own description of its key rule governing restricted shares.When you acquire restricted securities or hold control securities (see the next section for deﬁ nitions), you must ﬁ nd an exemption from the SEC’s registration requirements to sell them in a public marketplace. Rule 144 allows public resale of restricted and control securities if various condi- tions are met. This overview tells you what you need to know about selling your restricted or control securities. It also describes how to have a restric- tive legend removed. H7303-Entrepreneur.indb 257 H7303-Entrepreneur.indb 257 11/2/17 1:15 PM 11/2/17 1:15 PM 258 HBR’s Entrepreneur’s Handbook What are restricted and control securities?

Restricted securities are securities acquired in unregistered, private sales from the issuing company or from an afﬁ liate of the issuer. Investors typ- ically receive restricted securities through private placement offerings, Regulation D offerings, employee stock ownership plans, as compensa- tion for professional services, or in exchange for providing seed money or startup capital to the company. Rule 144(a)(3) identiﬁ es which sales pro- duce restricted securities. Control securities are those held by an afﬁ liate of the issuing company.

An afﬁ liate is a person, such as an executive ofﬁ cer, a director, or a large shareholder, in a relationship of control with the issuer. Control means the power to direct the management and policies of the company in question, whether through the ownership of voting securities, by contract, or other- wise. If you buy securities from a controlling person or an afﬁ liate, you take re s t r ic t e d se c u r it ie s , e ven i f t he y were not re s t r ic t e d i n t he a f ﬁ liate’s hands.

If you acquire restrictive securities, you will almost always receive a certiﬁ cate stamped with a “restrictive” legend. The legend indicates that the securities may not be resold in the marketplace unless they are reg- istered with the SEC or are exempt from the registration requirements.

Certiﬁ cates for control securities usually are not stamped with a legend.

What are the conditions of Rule 144?

If you want to sell your restricted or control securities to the public, you can meet the applicable conditions set forth in Rule 144. The rule is not the exclusive means for selling restricted or control securities, but it provides a safe-harbor exemption to sellers. The rule’s ﬁ ve conditions are summarized below:

1. Holding period: Before you may sell any restricted securities in the marketplace, you must hold them for a certain period. If the company that issued the securities is a “reporting company” in that it is subject to the reporting requirements of the Securities H7303-Entrepreneur.indb 258 H7303-Entrepreneur.indb 258 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix D: Selling Restricted and Control Securities 259 Exchange Act of 1934, then you must hold the securities for at least six months. If the issuer of the securities is not subject to the report- ing requirements, then you must hold the securities for at least one year. The relevant holding period begins when the securities were bought and fully paid for. The holding period only applies to restricted securi ties. Because securities acquired in the public mar- ket are not restricted, there is no holding period for an afﬁ liate who purchases securities of the issuer in the marketplace. But the resale of an afﬁ liate’s shares as control securities is subject to the other conditions of the rule.

Additional securities purchased from the issuer do not affect the holding period of previously purchased securities of the same class. If you purchased restricted securities from another nonafﬁ li- ate, you can tack on that nonafﬁ liate’s holding period to your hold- ing period. For gifts made by an afﬁ liate, the holding period begins when the afﬁ liate acquired the securities and not on the date of the gift. In the case of a stock option, including employee stock options, the holding period begins on the date the option is exercised and not the date it is granted.

2. Current public information: There must be adequate current infor- ma tion about the issuing company publicly available before the sale can be made. For reporting companies, this condition generally means that the companies have complied with the periodic report- ing requirements of the Securities Exchange Act of 1934. For non- reporting companies, this means that certain company information, including information about the nature of its business, the identity of its ofﬁ cers and directors, and its ﬁ nancial statements, is publicly available.

3. Trading volume formula: If you are an afﬁ liate, the number of equity securities you may sell during any three-month period cannot exceed the greater of 1 percent of the outstanding shares of the same class being sold, or if the class is listed on a stock exchange, the greater of 1 percent or the average reported weekly trading volume H7303-Entrepreneur.indb 259 H7303-Entrepreneur.indb 259 11/2/17 1:15 PM 11/2/17 1:15 PM 260 HBR’s Entrepreneur’s Handbook during the four weeks preceding the ﬁ ling of a notice of sale on Form 144. Over-the-counter (OTC) stocks, including those quoted on the OTC Bulletin Board and the Pink Sheets, can only be sold using the 1 percent measurement.

Ordinary brokerage transactions: If you are an afﬁ liate, the sales must be handled in all respects as routine trading transactions, and brokers may not receive more than a normal commission. Neither the seller nor the broker can solicit orders to buy the securities.

5. Filing a notice of proposed sale with the SEC: If you are an af- ﬁ liate, you must ﬁ le a notice with the SEC on Form 144 if the sale involves more than ﬁ ve thousand shares or the aggregate dollar amount is greater than $50,000 in any three-month period. If I am not an aﬃ liate of the issuer, what conditions of Rule 144 must I comply with?

If you are not (and have not been for at least three months) an afﬁ liate of the company issuing the securities and have held the restricted securities for at least one year, you can sell the securities without regard to the condi- tions in Rule 144 discussed above. If the issuer of the securities is subject to the Exchange Act reporting requirements and you have held the securities for at least six months but less than one year, you may sell the securities as long as you satisfy the current public-information condition.

Can the securities be sold publicly if the conditions of Rule 144 have been met?

Even if you have met the conditions of Rule 144, you can’t sell your re- stricted securities to the public until you’ve gotten the legend removed from the certiﬁ cate. Only a transfer agent can remove a restrictive legend.

But the transfer agent won’t remove the legend unless you’ve obtained the consent of the issuer—usually in the form of an opinion letter from the issuer’s counsel—that the restrictive legend can be removed. Unless this H7303-Entrepreneur.indb 260 H7303-Entrepreneur.indb 260 11/2/17 1:15 PM 11/2/17 1:15 PM Appendix D: Selling Restricted and Control Securities 261 happens, the transfer agent lacks the authority to remove the legend and permit execution of the trade in the marketplace.

To have the legend removed, an investor should contact the company that issued the securities, or the transfer agent for the securities, to ask about the procedures for removing a legend. Removing the legend can be a complicated process requiring you to w ork with an attorney who special- izes in securities law.

What if a dispute arises over whether I can remove the legend?

If a dispute arises over whether a restrictive legend can be removed, the SEC will not intervene. Removal of a legend is a matter solely in the discre- tion of the issuer of the securities. State law, not federal law, covers disputes about the removal of legends. Thus, the SEC will take no action in any de- cision or dispute about removing a restrictive legend. H7303-Entrepreneur.indb 261 H7303-Entrepreneur.indb 261 11/2/17 1:15 PM 11/2/17 1:15 PM H7303-Entrepreneur.indb 262 H7303-Entrepreneur.indb 262 11/2/17 1:15 PM 11/2/17 1:15 PM Glossary ACCELERATOR A time-limited cohort program for early-stage businesses that comes with equity investment. ACCOUNTS PAYABLE A category of balance-sheet liabilities representing moneys owed by the company. ACCOUNTS RECEIVABLE A category of balance-sheet assets representing moneys owed to the company by customers and others. ACID-TEST RATIO The ratio of so-called quick assets (cash, marketable se- curity, and accounts receivable) to current liabilities. Unlike the current ratio, inventory is left out of the calculation. ADJUSTED BOOK VALUE A reﬁ nement of the book-value method of valua- tion that attempts to restate the value of certain assets on the balance sheet according to realistic market values. AMORTIZATION A noncash expense that effectively reduces the balance- sheet value of an intangible asset over its presumed useful life. ANGEL INVESTOR A high-net-worth individual, usually a successful busi- nessperson or professional, who provides early-stage capital to a startup business in the form of debt, ownership capital, or both. ASSETS The balance-sheet items in which a company invests so that it can conduct business. Examples include cash and ﬁ nancial instruments, inven- tories of raw materials and ﬁ nished goods, land, buildings, and equipment. H7303-Entrepreneur.indb 263 H7303-Entrepreneur.indb 263 11/2/17 1:15 PM 11/2/17 1:15 PM 264 Glossary Assets also include moneys owed to the company by customers and oth- ers—an asset category referred to as accounts receivable.

BALANCE SHEET A ﬁ nancial statement that describes the assets owned by the business and shows how those assets are ﬁ nanced—with the funds of creditors (liabilities), the equity of the owners, or both. Also known as the statement of ﬁ nancial position. BOND A debt security usually issued with a ﬁ xed interest rate and a stated maturity date. The bond issuer has a contractual obligation to make peri- o d i c i n t e r e s t p a y m e n t s a n d t o r e d e e m t h e b o n d a t i t s f a c e v a l u e o n m a t u r i t y. BOOTSTRAP FINANCING A form of startup ﬁ nancing in which the found- ers rely on their own personal ﬁ nancial resources and those of friends, family, employees, and suppliers to launch the business. BREAKEVEN ANALYSIS A form of analysis that helps determine how much (or how much more) a company needs to sell to pay for the ﬁ xed invest- ment—in other words, at what point the company will break even on its cash ﬂ ow. BUSINESS MODEL A conceptual description of an enterprise’s revenue sources, cost drivers, investment size, and success factors and how they work together. BUSINESS PLAN A document that explains a business opportunity, iden- tiﬁ es the market to be served, and provides details about how the entre- preneurial organization plans to pursue it. Ideally it describes the unique qualiﬁ cations that the management team brings to the effort, deﬁ nes the resources required for success, and forecasts results over a reasonable time horizon. CAPITAL MARKETS The ﬁ nancial markets in which long-term debt instru- ments and equity securities—including private placements—are issued and traded. CASH-FLOW STATEMENT A ﬁ nancial statement that details the reasons for cha nge s i n c a sh (a nd c a sh equ iva lent s) du r i ng t he a c c ou nt i ng per iod. More H7303-Entrepreneur.indb 264 H7303-Entrepreneur.indb 264 11/2/17 1:15 PM 11/2/17 1:15 PM Glossary 265 speciﬁ cally, it reﬂ ects all changes in cash as affected by operating activi- ties, investments, and ﬁ nancing activities.

C CORPORATION In the United States, an entity chartered by the state and treated as a person under the law. The C corporation can have an inﬁ nite number of owners. Ownership is evidenced by shares of company stock.

The entity is managed on behalf of shareholders—at least indirectly—by a board of directors. COLLATERAL An asset pledged to the lender until the loan is satisﬁ ed. COMMERCIAL PAPER A short-term ﬁ nancing instrument used primarily by large, creditworthy corporations as an alternative to short-term bank borrow ing. Most paper is sold at a discount to its face value and is redeem- able at face value on maturity. COMMON STOCK (or COMMON SHARES) A security that represents a frac- tional ownership interest in the corporation that issued it. COST OF GOODS SOLD On the income statement, what it costs a company to produce its goods and services. This ﬁ gure includes raw materials, pro- duction, and direct labor costs. CURRENT ASSETS Assets that are most easily converted to cash: cash equivalents such as certiﬁ cates of deposit and US Treasury bills, receiv- ables, and inventory. Under generally accepted accounting principles, cur- rent assets are those that can be converted into cash within one year. CURRENT LIABILITIES Liabilities that must be paid in one year or sooner; these typically include short-term loans, salaries, income taxes, and ac- counts payable. CURRENT RATIO Current assets divided by current liabilities. This ratio is often used as a measure of a company’s ability to meet currently maturing obligations. DEBT RATIO The ratio of debt to either assets or equity in a company’s ﬁ - nancial structure. H7303-Entrepreneur.indb 265 H7303-Entrepreneur.indb 265 11/2/17 1:15 PM 11/2/17 1:15 PM 266 Glossary DEPRECIATION A noncash expense that effectively reduces the balance- sheet value of an asset over its presumed useful life. DISCOUNTED CASH FLOW (DCF) A method based on the time value of money, it c a lculates va lue by ﬁ nding the present value of a business’s future cash ﬂ ows. DUE DILIGENCE With respect to a public offering of securities, the inves- tigation of facts and statements of risk made in the issuer’s registration statement. EBIT A measure of a ﬁ rm’s proﬁ ts that calculates its earnings before inter- est and taxes. EMPLOYEE STOCK OWNERSHIP PLAN (ESOP) In the United States, a for- mal plan under which corporate shares are acquired by the plan on behalf of employees, for whom it is a tax-qualiﬁ ed retirement plan. ENTERPRISE VALUE The value of a company’s equity plus its debt. EQUITY BOOK VALUE The value of total assets less total liabilities. EQUITY CAPITAL Capital contributed to a business that provides rights of ownership in return. EXECUTIVE SUMMARY In a business plan, a short section that compel- lingly explains the opportunity, shows why it is timely, describes how the company plans to pursue it, outlines the entrepreneur’s expectation of re- sults, and includes a thumbnail sketch of the company and the manage- ment team. FINANCIAL LEVERAGE See “leverage.” FIXED ASSETS Assets that are difﬁ cult to convert to cash—for example, buildings and equipment. Sometimes called plant assets. FIXED COSTS Costs that are incurred by the business and stay about the same, no matter how many goods or services are produced. H7303-Entrepreneur.indb 266 H7303-Entrepreneur.indb 266 11/2/17 1:15 PM 11/2/17 1:15 PM Glossary 267 GOODWILL An intangible balance-sheet asset. If a company has pur- chased another company for a price above the fair market value of its as- sets, that “goodwill” is recorded as an asset. Goodwill may also represent intangible things such as the acquired company’s excellent reputation, its brand names, or its patents, all of which may have real value. GROSS PROFIT Sales revenues less the cost of goods sold. The roughest measure of proﬁ tability. Also called gross margin. INCOME STATEMENT A ﬁ nancial statement that indicates the cumulative results of operations over a speciﬁ ed period. Also referred to as the proﬁ t- and-loss statement, or P&L. INCUBATOR A development program for new businesses. Incubators usu- ally either operate as a nonproﬁ t or charge a venture for rent (coworking space is shared with other young companies). Work with an incubator is not limited to the early stages of a venture’s development; some incubators specialize in later-phase growth. INITIAL PUBLIC OFFERING (IPO) A corporation’s ﬁ rst offering of its shares to the public. INVENTORY The supplies, raw materials, components, and so forth that a company uses in its operations. It also includes work in process—goods in various stages of production—as well as ﬁ nished goods waiting to be sold or shipped. IPO See “initial public offering.” LEVERAGE The degree to which the activities of a company are sup- ported by liabilities and long-term debt as opposed to owners’ capital contributions. LEVERAGED BUYOUT The purchase of a company using a signiﬁ cant amount of borrowed funds in addition to the buyer’s own equity. Their equity is thus “leveraged” to provide more capital for the purchase. The H7303-Entrepreneur.indb 267 H7303-Entrepreneur.indb 267 11/2/17 1:15 PM 11/2/17 1:15 PM 268 Glossary company’s cash ﬂ ow provides the collateral for the loans and is used to repay them over time.

LIABILITY A claim against a company’s assets. LIMITED-LIABILITY CORPORATION (LLC) A hybrid form of company struc- ture, combining beneﬁ ts of both a partnership and a corporation. LIMITED PARTNERSHIP A hybrid form of organization hav ing both limited and general partners. The general partner (there may be more than one) assumes management responsibility and unlimited liability for the busi- ness and must have at least a 1 percent interest in proﬁ ts and losses. The limited partner (or partners) has no voice in management and is legally liable only for the amount of his or her capital contribution plus any other debt obligations speciﬁ cally accepted. MINIMUM VIABLE PRODUCT In product development, an initial offering with limited features that allows developers to test their assumptions about what customers value, how the product performs in the market, and so forth. NET INCOME The “bottom line” of the income statement. Net income is revenues less expenses less taxes. Also referred to as net earnings or net proﬁ ts. NET WORKING CAPITAL Current assets less current liabilities; the amount of money a company has tied up in short-term operating activities. NETWORK EFFECTS A phenomenon in which a product’s value for users increases as the number of users of that product increases. OPERATING EARNINGS On the income statement, gross margin less oper- ating expenses and depreciation. Often called earnings before interest and taxes, or EBIT. OPERATING EXPENSES On the balance sheet, a category that includes ad- ministrative expenses, employee salaries, rents, sales and marketing costs, H7303-Entrepreneur.indb 268 H7303-Entrepreneur.indb 268 11/2/17 1:15 PM 11/2/17 1:15 PM Glossary 269 as well as other costs of business not directly attributed to the cost of man- ufacturing a product.

OPERATING LEVERAGE The extent to which a company’s operating costs are ﬁ xed instead of variable. For example, a company that relies heavily on machinery and very few workers to produce its goods has a high operating leverage. OWNERS’ EQUITY What, if anything, is left over after total liabilities are deducted from total assets. Owners’ equity is the sum of capital contrib- uted by owners plus their retained earnings. Also known as shareholders’ equity. PARTNERSHIP A business entity with two or more owners. In the United States, it is treated as a proprietorship for tax and liability purposes.

Earnings are distributed according to the partnership agreement and are treated as personal income for tax purposes. Thus, like the sole proprie- torship, the partnership is simply a conduit for generating income for its partners. PITCH DECK A slide presentation created to describe a new business ven- ture to potential investors. PIVOT A substantive adjustment to a startup’s strategy, business model, or offering, often in response to market feedback or testing. PLATFORM (ALSO “MULTISIDED PLATFORM”) A business that brings to- gether producers and consumers and facilitates exchanges and interactions, often in reference to digital businesses such as eBay, Uber, and Alibaba, but also describing the models of companies like malls and temp agencies. PREFERRED STOCK An equity-like security that pays a speciﬁ ed dividend and has a superior position to common stock in case of distributions or liquidation. PRESENT VALUE The monetary value today of a future payment discounted at some annual compound interest rate. H7303-Entrepreneur.indb 269 H7303-Entrepreneur.indb 269 11/2/17 1:15 PM 11/2/17 1:15 PM 270 Glossary PRICE-EARNINGS MULTIPLE The price of a share of stock divided by earn- ings per share. PRIVATE PLACEMENT The sale of company stock to one or a few private investors instead of to the public. PROFIT Financial gain, calculated as the difference between revenue and expenses. PROFIT-AND-LOSS STATEMENT (P&L) See “income statement.” PROFIT MARGIN The percentage of every dollar of sales that makes it to the bottom line. Proﬁ t margin is net income after tax divided by net sales.

Sometimes called the return on sales. PRO FORMA FINANCIAL STATEMENT Financial statement (balance sheet or income statement) containing hypothetical or forecast data. PROSPECTUS A for ma l document that prov ides f ull disclosure to potentia l investors about the company, its business, its ﬁ nances, and the way it in- tends to use the proceeds of its securities issuance. In its preliminary form, it is known as a red herring. RED HERRING See “prospectus.” REPLACEMENT VALUE A valuation approach that estimates the cost of re- producing an asset, rather than the more common reliance on an asset’s book value. RETAINED EARNINGS Annual net proﬁ ts that accumulate on a company’s balance sheet after dividends are paid. REVENUE The amount of money that results from selling products or ser- vices to customers. ROAD SHOW A series of meetings between company ofﬁ cials and prospec- tive investors, usually held in major cities around the country in conjunc- tion with a forthcoming issue of corporate securities. The investors can put H7303-Entrepreneur.indb 270 H7303-Entrepreneur.indb 270 11/2/17 1:15 PM 11/2/17 1:15 PM Glossary 271 questions to the CEO or CFO about the company and the intended offering of securities.

ROUNDS (FUNDING) One way of deﬁ ning the stage of a startup’s growth.

The seed stage is the ﬁ rst funding round, when the venture ﬁ rst borrows capital to ﬁ nance growth, typically from family or friends. The Series A round is the next stage, often involving angel investors. Finally, the Se- ries B round takes the company to scale and often involves venture capital. S CORPORATION In the United States, a closely held corporation whose tax status is the same as the partnership’s but whose participants enjoy the liability protections granted to corporate shareholders. In other words, it is a conduit for passing proﬁ ts and losses directly to the personal income tax returns of its shareholders, whose legal liabilities are limited to the amount of their capital contributions. SEED INVESTMENT See “rounds (funding).” SERIAL ENTREPRENEUR An individual who has started multiple busi- nesses over time. SERIES (FUNDING) See “rounds (funding).” SOLE PROPRIETORSHIP A business owned by a single individual. In the United States, this owner and the business are one and the same for tax and legal liability purposes. The proprietorship is not taxed as a separate entity. Instead, the owner reports all income and deductible expenses for the business on Schedule C of his or her personal income tax return. STRATEGY A plan that will differentiate the enterprise and give it a com- petitive advantage. TIMES-INTEREST-EARNED RATIO Earnings before interest and taxes di- vided by interest expense. Creditors use this ratio to gauge a company’s ability to make future interest payments in the face of ﬂ uctuating operat- ing results. VARIABLE COSTS Costs that rise or fall with the volume of output. H7303-Entrepreneur.indb 271 H7303-Entrepreneur.indb 271 11/2/17 1:15 PM 11/2/17 1:15 PM 272 Glossary VENTURE CAPITALIST (VC) A high-risk investor who seeks an equity po- sition in a startup or an early-growth company having high potential. In return for capital, the VC typically takes a signiﬁ cant percentage owner- ship of the business and a position on its board. WARRANT A security that gives the holder the right to purchase common shares of the warrant-issuing company at a stated price for a stated period.

The stated price is generally set higher than the current valuation of the shares. WORKING CAPITAL See “net working capital.” H7303-Entrepreneur.indb 272 H7303-Entrepreneur.indb 272 11/2/17 1:15 PM 11/2/17 1:15 PM Further Reading Part 1: Preparing for the Journey Articles Andreessen, Marc, and Adi Ignatius. “In Search of the Next Big Thing,” Harvard Business Review , May 2013 (product #R1305G ). Cofounder and partner of VC ﬁ rm Andreessen Horowitz talks about the challenges of entrepreneurship today.

Bhidé, Amar. “The Questions Every Entrepreneur Must Answer,” Harvard Busi- ness Review , November–December 1996 (product #96603). A classic article:

entrepreneurs tend to have a bias for action, but they should also step back and ask themselves about their personal goals as well as the company’s strateg y.

Butler, Timothy. “Hiring an Entrepreneurial Leader,” Harvard Business Review, March–April 2017 (product #1702E). A Harvard Business School professor describes new research that shows what makes the most successful entrepre- neurial leaders.

Valencia, Jordana. “How Founders Can Recognize and Combat Depression.” HBR.org, February 17, 2017. Entrepreneurs are 30 percent more likely to experience depression than their nonentrepreneurial counterparts; this article discusses how to address it—and how to avoid it to begin with. Books Ruback, Richard S., and Royce Yudkoff. HBR Guide to Buying a Small Business (HBR Guide Series). Boston: Harvard Business Review Press, 2016. If you want to run your own company but don’t want to start it from scratch, consider buy- ing an existing small business. Part 2: Deﬁ ning Your Enterprise Articles Blank, Steve. “Why the Lean Start-Up Changes Every thing.” Harvard Business Review , May 2013 (product #1305C). Introducing an experimental approach to creating a new business. H7303-Entrepreneur.indb 273 H7303-Entrepreneur.indb 273 11/2/17 1:15 PM 11/2/17 1:15 PM 274 Further Reading Brown, Tim. “Design Thinking.” Harvard Business Review, June 2008 (product #R0806E). How to imbue innovation with a human-centered approach.

Hagiu, Andre, and Simon Rothman. “Network Effects Aren’t Enough.” Harvard Business Review , April 2016 (product #R1604D). How to avoid the pitfalls of platform businesses with rapid grow th.

Kavadias, Stelios, et al. “The Transformative Business Model.” Harvard Business Review , October 2016 (product #R1610H). How an innovative business model can change your industry and build your business.

Ladd, Ted. “The Limits of the Lean Start-Up Method.” HBR.org, March 7, 2016. The lean startup method can work, but there are other things to keep in mind.

Ovans, Andrea. “What Is a Business Model?” HBR.org, January 23, 2015. A primer on business models and how thinking about the concept has evolved over the last two decades.

Magretta, Joan. “Why Business Models Matter.” Harvard Business Review, May 2002 (product #R0205F). What a business model is, how it differs from strat- eg y, and why it’s important.

McGrath, Rita Gunther. “Transient Advantage.” Harvard Business Review, June 2013 (product #R1306C). Why sustainable competitive advantage is no longer a viable goal, and what smart companies can do to stay ahead of the competition.

Sahlman, William A. “How to Write a Great Business Plan.” Harvard Business Re- view , July–August 1997 (product #97409). A classic article by a seasoned scholar with deep experience in new ventures describes what ﬁ nanciers look for in a business plan. He explains that most plans waste too much ink on numbers and devote too little space to the information that truly matters to experienced in- vestors: the people who will run the venture, the opportunity and its economic underpinnings, the context of the venture, and the risk-versus-reward situation.

Thomke, Stefan, and Donald Reinertsen. “Six My ths of Product Development.” Harvard Business Review , May 2012 (product #R1205E). Product development is different from manufacturing and needs to be managed in a new way.

Van Alstyne, Marshall W., et al. “Pipelines, Platforms, and the New Rules of Strat- egy.” Harvard Business Review , April 2016 (product #R1604C). Platform busi- nesses such as online marketplaces and exchanges are in the spotlight for their impressive grow th. How do they achieve such impressive grow th, and how does their structure change what we know about strateg y? Books Harvard Business Review. Creating Business Plans (HBR 20-Minute Manager Series). Boston: Harvard Business Review Press, 2014. The fundamentals of crafting a business plan.

Osterwalder, Alexander. Business Model Generation: A Handbook for Visionaries, Game Changers, and Challengers . New York: Wiley, 2010. A guide for entrepre- neurs looking to experiment and iterate on their business models.

Ries, Eric. The Lean Startup: How Today’s Entrepreneurs Use Continuous Inno- vation to Create Radically Successful Businesses. New York: Crown, 2011. The book that ﬁ rst introduced lean entrepreneurship in detail.

Sheen, Raymond, with Amy Gallo. HBR Guide to Building Your Business Case (HBR Guides Series). Boston: Harvard Business Review Press, 2015. For entre- preneurs and innovators in large organizations alike, a guide to crafting an appealing business case document. H7303-Entrepreneur.indb 274 H7303-Entrepreneur.indb 274 11/2/17 1:15 PM 11/2/17 1:15 PM Further Reading 275 Part 3: Financing Your Business Articles Anderson, Chris. “How to Give a Killer Presentation.” Harvard Business Review, June 2013 (product #R1306K). The curator of TED talks gives a primer on how to hook your audience.

Mulcahy, Diane. “Six My ths About Venture Capitalists.” Harvard Business Re- view , May 2013 (product #R1305E). A clear-eyed view of the VC ecosystem for entrepreneurs.

Mullins, John. “Use Customer Cash to Finance Your Start-Up.” Harvard Business Review , July–August 2013 (product #F1307A). Many scalable, tech-oriented startups are ﬁ nding ways to get early funding from their customers—and to avoid having to seek outside capital.

Zider, Bob, and Hal R. Varian. “How Venture Capital Works.” Harvard Business Review , November–December 1998 (product #98611). A classic on the model that drives venture capitalists. Books Baehr, Evan, and Evan Loomis. Get Backed: Craft Your Story, Build the Perfect Pitch Deck, and Launch the Venture of Your Dreams . Boston: Harvard Business Review Press, 2016. A handbook for writing a pitch deck—and presenting it to potential funders.

Berinato, Scott. Good Charts: The HBR Guide to Making Smarter, More Persua- sive Data Visualizations . Boston: Harvard Business Review Press, 2016. How to create the most persuasive data visualizations for your business plan or pitch deck.

Bussgang, Jeffrey, Mastering the VC Game: A Venture Capital Insider Reveals How to Get from Start-Up to IPO on Your Terms. New York: Portfolio, 2011. Learn more about the venture-capitalist ecosystem so that you can gain the right partner for your business.

Duarte, Nancy. HBR Guide to Persuasive Presentations (HBR Guides Series). Bos- ton: Harvard Business Review Press, 2012. Master the art and science of high- stakes pitches, from a deck that tells a simple, compelling story to an authentic speaking style that conveys your competence.

Harvard Business Review. HBR Guide to Finance Basics for Managers (HBR Guides Series). Boston: Harvard Business Review Press, 2012. What you need to know about the numbers. Part 4: Scaling Up Articles Bower, Joseph L., and Clay ton M. Christensen. “Disruptive Technologies: Catch-ing the Wave.” Harvard Business Review , January–February 1995 (product #95103). The seminal article on disruptive innovation.

Christensen, Clay ton M., and Michael Overdorf. “Meeting the Challenge of Dis- ruptive Change.” Harvard Business Review , March 2000 (product #R00202). H7303-Entrepreneur.indb 275 H7303-Entrepreneur.indb 275 11/2/17 1:15 PM 11/2/17 1:15 PM 276 Further Reading How established organizations can stay innovative and avoid being disrupted by new entrants.

Churchill, Neill C., and Virginia L. Lewis. “Five Stages of Small Business Grow th.” Harvard Business Review , May 1983 (product #83301). This classic describes the path from startup to established business, addressing the common prob- lems arising at speciﬁ c stages in their development.

Govindarajan, Vijay. “Great Innovators Create the Future, Manage the Present, and Selectively Forget the Past.” HBR.org, March 31, 2016. How to go beyond being an ambidextrous organization—executing for today and innovating for tomorrow—to also get beyond the values and beliefs that keep you tied to the past.

Hoffman, Reid, and Tim Sullivan. “Blitzscaling.” Harvard Business Review, April 2016 (product #R1604B). How to manage the spectacularly rapid grow th expe- rienced by some startup wunderkinds.

Zook, Chris, and James Allen. “Reigniting Grow th.” Harvard Business Review, March 2016 (product #R1603F). Using the “founder’s mentality” to keep grow- ing even as a more established company. Books Christensen, Clay ton M. The Innovator’s Dilemma , 2nd ed. Boston: Harvard Business Review Press, 2013. A more detailed look at Christensen’s theory of disruptive innovation. Part 5: Looking to the Future Articles Wasserman, Noam. “The Founder’s Dilemma.” Harvard Business Review, Febru- ary 2008 (product #R0802G). A classic article that asks founders, Do you want to be rich, or do you want to be king? H7303-Entrepreneur.indb 276 H7303-Entrepreneur.indb 276 11/2/17 1:15 PM 11/2/17 1:15 PM Sources Introduction Blank, Steve. “Why the Lean Start-Up Changes Every thing.” Harvard Business Review , May 2013.

Brown, Morgan Brown. “Airbnb: The Grow th Story You Didn’t Know.” https:// grow thhackers.com/grow th-studies/airbnb.

Bygrave, William D., ed. The Portable MBA in Entrepreneurship , 2nd ed. New York: J. Wiley & Sons, 1997.

McIntyre, Douglas A. “Airbnb Reaches $25.5 Billion Valuation,” 24/7 Wall St.

November 21, 2015, http://247wallst.com/services/2015/11/21/airbnb -reaches -25-5-billion-valuation.

Texiera, Thales S., and Morgan Brown. “Airbnb, Etsy, Uber: Growing from One Thousand to One Million Customers,” Case 516-108. Boston: Harvard Business School, June 7, 2016. What’s ahead Gordon Mills, Karen, and Brayden McCarthy. “The State of Small Business Lend-ing: Innovation and Technolog y and the Implications for Regulation.” Working paper 17-042. Boston: Harvard Business School, 2016. Chapter 1: Is Starting a Business Right for You?

Ideas and drive Gergen, Christopher, and Gregg Vanourek. “Vision(ary) Entrepreneur,” HBR.org, August 14, 2008. People skills Baehr, Evan, and Evan Loomis. Get Backed: Craft Your Story, Build the Perfect Pitch Deck, Launch the Venture of Your Dreams . Boston: Harvard Business Review Press, 2015.

Isenberg, Daniel. “Entrepreneurial Passion.” HBR.org, January 6, 2010.

Onyemah, Vincent, Martha Rivera Pesquera, and Abdul Ali. “What Entrepreneurs Get Wrong.” Harvard Business Review , May 2013. H7303-Entrepreneur.indb 277 H7303-Entrepreneur.indb 277 11/2/17 1:15 PM 11/2/17 1:15 PM 278 Sources Ruback, Richard S., and Royce Yudkoff. HBR Guide to Buying a Small Business (HBR Guide Series). Boston: Harvard Business Review Press, 2017. Work style Kuemmerle, Walter. “A Test for the Fainthearted,” Harvard Business Review, May 2012. Financial savvy HBS Working Knowledge. “Skills and Behaviors That Make Entrepreneurs Suc- cessful.” Harvard Business School, June 6, 2016. Entrepreneurial background Bricklin, Dan. “Natural-Born Entrepreneur,” Harvard Business Review, Septem- ber 2001, 53–59. Chapter 2: Shaping an Opportunity Evaluating the opportunity Hagiu, Andrei, and Simon Rothman. “Network Effects Aren’t Enough.” HBR.org, April 2016.

Timmons, Jeffr y A. New Venture Creation , 6th ed. Burr Ridge, IL: McGraw Hill-Irwin, 2004.

———. “Opportunity Recognition.” In The Portable MBA in Entrepreneurship , 2nd ed. Edited by William D. Bygrave. New York: J. Wiley & Sons, 1997.

Vermeulen, Freek. “What So Many Strategists Get Wrong About Digital Disrup- tion.” HBR.org , January 3, 2017. Chapter 3: Building Your Business Model and Strategy Ovans, Andrea. “What Is a Business Model?” HBR.org, January 23, 2015. Deﬁ ning your business model Blank, Steve. “Why the Lean Start-Up Changes Every thing.” Harvard Business Review , May 2013.

Fallon, Nicole. “Accelerator Programs 101: How to Apply and What to Expect.” Business News Daily , June 5, 2015.

Gilad, Benjamin. “How a Food-Ordering App Broke into a Crowded Market.” Har- vard Business Review , November 25, 2015.

Hamermesh, Richard G., and Paul W. Marshall, “Note on Business Model Analysis for the Entrepreneur.” Class note 9-802-048. Boston: Harvard Business School Publishing, 2002.

Hathaway, Ian. “What Startup Accelerators Really Do.” HBR.org, March 1, 2016.

Magretta, Joan. “Why Business Models Matter.” Harvard Business Review, May 2002.

Ovans, Andrea. “What Is a Business Model?” HBR.org, January 23, 2015.

Salz, Pegg y Anne. “The Changing Economics of App Development.” HBR.org, November 4, 2015. H7303-Entrepreneur.indb 278 H7303-Entrepreneur.indb 278 11/2/17 1:15 PM 11/2/17 1:15 PM Sources 279 Statista. “Number of Apps Available in Leading App Stores as of March 2017.” www.statista.com/statistics/276623/ number-of-apps-available-in-leading-app-stores. Deﬁ ning your strategy Andreessen, Marc, and Adi Ignatius. “In Search of the Next Big Thing.” Harvard Business Review , May 2013.

Hagiu, Andrei, and Simon Rothman. “Network Effects Aren’t Enough.” HBR.org, April 2016.

Henderson, Bruce. “The Origin of Strateg y.” Harvard Business Review, November– December 1989.

Johnson, Mark W., Clay ton M. Christensen, and Henning Kagermann. “Reinvent- ing Your Business Model.” Harvard Business Review, December 2008.

Ladd, Ted. “The Limits of the Lean Startup Method.” HBR.org, March 7, 2016.

McGrath, Rita Gunther. “Transient Advantage.” Harvard Business Review, June 2013.

Osborne, Alfred E. Memo to writer, March 21, 2004.

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H7303-Entrepreneur.indb 284 H7303-Entrepreneur.indb 284 11/2/17 1:15 PM 11/2/17 1:15 PM Index accelerators, 47–48, 111–113, 142 access-based positioning, 51–52 accounting equation, 227–228 accounting software, 65 accounts payable, 239 accounts receivable, 239, 248 accrued expenses, 239 acid-test ratio, 117 adjusted book value, 248 advice, 78–79 advisory boards, 188, 190–191 agile development, 29–30, 31 Airbnb, 1–2, 16, 46–47, 55, 57, 173 A kamai Technolog ies, 162–164 Alibaba, 55, 56, 57 alignment, with strategy, 54–55 Amazon, 173 ambidextrous organizations, 209 Andreessen, Marc, 188 Angel Capital Association, 134 angel investors, 106, 131–136connecting with, 134–135 getting funding from, 135–136 groups and networks, 135 overview of, 132–134 AngelList, 134 Apple Computer, 50–51, 104–105, 138, 203 asset-based valuations, 247–249 assets in accounting equation, 227–228 on balance sheet, 228–230 current, 228 ﬁ xed, 228–229 intangible, 230 matching ﬁ nancing and, 128–129 selling, 219–220 balance sheets, 91, 227–233 bank accounts, 65 bank loans, 110, 115–118, 121 behav ior management, 183, 186 Benchma rk Capit a l, 145–146 Blockbuster, 175 board members, 190–191 board of directors, 90 bonds, 127 bootstrap ﬁ nancing, 105 Bost on Beer C ompa ny, 1 9, 178–179 breakeven analysis, 241–244 Bricklin, Dan, 19 budgets, 79 bulleted lists, 95–96 business appraisers, 222 business brokers, 218–219 business entities C corporations, 70–72, 76 choosing form of, 74–76 general partnerships, 67–69, 76 limited liability companies, 73–74, 76 limited partnerships, 69–70, 76 S corporations, 72–73, 76 sole propr ietorships, 63–66, 76 business life c ycles, 103–105 business-model canvas, 29–30 business models Airbnb, 46–47 analogies, 45 building, 41–49 H7303-Entrepreneur.indb 285 H7303-Entrepreneur.indb 285 11/2/17 1:15 PM 11/2/17 1:15 PM 286 Index in business plan, 85 canvas, 29–30 considerations for, 43–46 discovery plan in, 48–49 power of, 42, 43 sample, 44 testing, 46–47 business opportunities. See opportunities business owners, children of, 19. See also entrepreneurs; founders business plans beneﬁ ts of, 78–79 changing nature of, 79–80 company, offering, and strateg y in, 83–86 contents, 81–82 design elements in, 95–96 executive summary in, 81–82 ﬁ nancial plans in, 91 format, 81 goals in, 84–85 graphics in, 96–98 interests of readers and, 98 key elements of, 80–92 marketing plans in, 89–90 operating plans in, 90–91 opportunity in, 82–83 overview of, 77–78 ownership information in, 86 style of, 92–99 team description in, 86–89 business t y pes, 103–105 business valuation, 146, 220–222, 245–255 Bygrave, William, 1 capital debt, 115–120, 122 equity, 70–71, 106, 120–121, 131 cash ﬂ ow versus proﬁ t, 239 shearing, 219 cash-ﬂ ow statements, 91, 236–240 cashing out, 213–223 C corporations, 70–72, 76 advantages of, 71 disadvantages of, 71–72 celebration, 202 change, being prepared for, 57–58 charts, in business plans, 96–98 Chesky, Brian, 1–2 closely held businesses, 246–247, 252 collateral, 118 commercia l ba nk loa ns, 110, 121 commercial paper, 127 company organization, 63–76 C corporations, 70–72, 76 choosing form of, 74–76 general partnerships, 67–69, 76 limited liability companies, 73–74, 76 limited partnerships, 69–70, 76 S corporations, 72–73, 76 sole propr ietorships, 63–66, 76 company valuation, 146, 220–222, 245–255 competition analyzing the, 38–39 being prepared for, 58–60 competitive advantage, 49–50 intellec tua l proper t y a nd, 86 strategy for gaining, 49–60 sustainability of, 60 competitors analysis of, in business plan, 85 differences between, 50 strat eg y t o prot ec t aga inst , 175–176 complacency, 197–198 content management, 182–183, 186 content s sec tion, of business pla n, 81–82 contex t management, 184–185, 186 contribution margin, 242 control, 202 copycat businesses, 58–59 copyrights, 86 Corning, 196 corporate venture capital, 137 corporations board of directors, 90 C, 70–72, 76 S, 72–73, 76 cost drivers, 43 costs of goods sold, 234 cost structure, 33–34 creative destruction, 3 creativity, 13, 198. See also innovation credit histor y, 118 business models ( continued) H7303-Entrepreneur.indb 286 H7303-Entrepreneur.indb 286 11/2/17 1:15 PM 11/2/17 1:15 PM Index287 critical activities, 54 critical success factors, 43 crowdfunding, 110–111 crowdsourcing, 106 current assets, 117, 228 current liabilities, 117, 230 current ratio, 117 customer complaints, listening to, 15 customer development, 28, 29, 31 customer focus, 197 customer va lue, 25–26, 31 deal making, 18 debt ﬁ nancing, 115–120, 122 debt ratio, 119–120 d e b t - t o - e q u i t y r a t i o , 1 1 9 –1 2 0 , 1 5 1 , 21 9 , 2 3 3 demand-side economies of scale, 56 depreciation, 234, 248 design elements, in business plans, 95–96 differentiation, 50 discounted cash-ﬂ ow (DCF) valuation, 222, 253–254 discovery plan, 48–49 disintermediation, 38 “doi ng bu s i ne s s a s” c er t i ﬁ cate, 65 double taxation, 71–72, 74 due diligence, for IPOs, 160 durability, of opportunity, 32, 37–38 earnings-based valuation, 221–222, 249–253 earnings before interest and taxes (EBIT), 120, 221, 235 earnings before interest and taxes (EBIT) multiple, 252–253 earnings before interest and taxes plus depreciation and amortization (EBITDA), 221, 253 earnings multiple, 250–252 eBay, 37, 55, 57, 123–127, 145–146, 150, 17 1, 189 economies of scale, 56 Edison, Thomas, 1 employees alignment between strateg y and, 54–55 with entrepreneurial attitudes, 208 motivation of, 201–202 employee stock ownership plans (ESOPs), 216–217, 220 enterprise value, 146 entrepreneurial background, 13, 19–20 entrepreneurial forums, 142–143 entrepreneurial grow th, sustaining, 17 1–180 entrepreneurial spirit, 195–210 entrepreneurs cashing out by, 213–223 role of, 3–4 skills and traits of, 11–20 entrepreneurship deciding to choose, 11–20 deﬁ nition of, 1 process of, 12 r isk a nd, 2, 18, 32–33 entry barriers, 37 equity book value, 247–248 equit y capita l, 70–7 1, 106, 110, 120–121, 131 established ﬁ rms challenges for, 196–198 complacency and, 197–198 existing-customers problem, 197 innovation and, 195–196 size of, 196–197 Etsy, 37, 55 executive coaches, 188–189 executive summary, in business plan, 81–82 existing-customers problem, 197 exit strategies, 213–223 experimental approach, 28 experimental mindset, 17–18 external environment, analyzing for threats and opportunities, 52–53 Fa cebook , 56 failure c auses, 174, 183, 198, 233 comfort with, 13, 208 consequences, 118, 199 encouraging, 15, 57, 199, 205 fast, 15, 57, 205 21-H7303-IX.indd 287 21-H7303-IX.indd 287 11/16/17 8:42 AM 11/16/17 8:42 AM 288 Index pressure to avoid, 18, 89, 199 rate, of new businesses, 2, 105, 116, 121, 140 feedback, 14–15, 187 “ﬁ ctitious name” certiﬁ cate, 65 ﬁ nancial leverage, 232 ﬁ nancial plan, 91 ﬁ nancial projections, 79 ﬁ nancial sav v y, 13, 18–19 ﬁ nancial statements, 225–240 balance sheets, 91, 227–233 in business plan, 91 cash-ﬂ ow statement, 91, 236–240 income statement, 233–236 reasons for, 226 ﬁ nancial structure of ﬁ rm, 233 ﬁ nancing, 32, 39 accelerators, 111–113 angel investors, 106, 131–136 bonds, 127 bootstrap, 105 business plans and, 78 commercia l ba nk loa ns, 110 commercial paper, 127 crowdfunding, 110–111 debt, 115–120, 122 at eBay, 123–127 equity, 70–71, 106, 110, 120–121, 131 grow th-stage, 115–130 IPOs, 121, 122, 126–127, 137, 149–167 matching assets and, 128–129 maturity-phase, 122–123 prefer red st ock , 128, 140 –141 private placement, 166 seed investment , 105, 109, 132 Series A, 132, 133 Series B, 132 sources of, 107, 122 startup-stage, 103–113 tips for, 138–139 trade credit, 109–110 venture capital, 106, 121, 122, 132, 136–147 warrants, 166–167 ﬁ nancing activities, 240 ﬁ nished-goods inventory, 239 ﬁ rms ﬁ nancial structure of, 233 high-growth, 104–105 Main Street, 104 selling, 217–220 ﬁ rst-mover a dva nt age, 17 1–172 ﬁ ve-forces model, 56 ﬁ xed assets, 229 ﬁ xed costs, 34, 242, 244 Forbes Midas List, 143 Ford, Henry, 195 founders. See also entrepreneurs growth and, 181–193 leadership by, 186–189, 192–193 opportunities that ﬁ t with capabilities of, 32, 35, 36 passion of, 14–15 stepping aside by, 189, 192–193 Gebbia, Joe, 1–2 General Electric Company, 1 general partnerships, 67–69, 76 advantages of, 68 disadvantages of, 68–69 goal orientation, 16 goa ls, in business pla n, 84 –85 goodwill, 230 Google, 56 GoViral, 139 g raphic s, in business pla ns, 96–98 growth i mpa c t of, 172–174 leadership for, 181–193 market expansion and, 176–177 rapid, 172 scaling up, 177–180 st rat eg y, 174 –17 7 sustaining, 171–180 growth-stage ﬁ nancing debt, 115–120 at eBay, 123–127 equity, 120–122 matching assets and, 128–129 other external ﬁ nancing, 127–128 harvesting methods, 214–220 headings, in business plan, 95 failure ( continued ) H7303-Entrepreneur.indb 288 H7303-Entrepreneur.indb 288 11/2/17 1:15 PM 11/2/17 1:15 PM Index289 Hewlett-Packard (HP), 172–173 high-growth ﬁ r ms, 104–105 hiring decisions, 208 historical values, on balance sheet, 230–231 Hoffman, Reid, 171, 202–203 Honda , 196 hypothesis testing, 28 IBM, 198–199 idea champions, 201 ideas, 12 idea-to-commercialization process, 204–205 income statement, 91, 233–236 pro forma, 35, 36, 42, 91 incrementalism, 58 incubators, 47–48 incumbents, 59–60 initial public offerings (IPOs), 121, 149–167 a lter natives to, 166–167 candidates for, 152–154 day of, 162–164 eBay, 126–127 expense of, 151–152 for investment harvesting, 214–215 overview of, 149–150 preparation for, 154 process for, 154, 158–161 pros and cons of, 150–152 role of investment ba nk in, 161–165 a s source of c apita l, 122 time spent on, 152 timing of, 155–159 values for, 220–221 venture capitalists and, 137 innovation ambidextrous organizations and, 209 decisions about, 207 entrepreneurial spirit and, 195–196 established ﬁ rms and, 196–198 existing-customers problem and, 197 idea-to-commercialization process, 204–205 learning and, 200–201 personal involvement with, 203–204 physical environment and, 199–200 portfolio thinking and, 205–207 preserving culture of, 198–202 reward systems for, 201–202 risk and, 200–201 size and, 196–197 strategic direction and, 202–203 vision and, 202–203 intangible assets, 230 intellectual property, 86 interest expense, 235 internal capabilities, 53 internal cash ﬂ ow, 122, 125–126 internet economy, 56 intrinsic motivation, 16 intrinsic rewards, 201–202 inventory, 231–232, 239, 248 investment ba nk s, 121, 158, 161–165, 215 investment harvesting, 213–223 investment size, 43 investors. See also venture capital/ capitalists advice from, 188 angel, 106, 131–136 earning trust of, 14–15, 144 jobs, new businesses as creators of, 4, 104 Jumpstart Out Business Startups (JOBS) Act, 111 knowledge sharing, 201 Koch, Jim, 19, 178–179 leadership, 181–193 approaches, 182–186 behav ior management, 183, 186 content management, 182–183, 186 contex t management, 184–185, 186 founders and, 186–189, 192–193 results management, 184, 186 lean startups, 28, 29–30 learning, 200–201 lea r n ing c u r ve, 175–176 legal regulations, 16–17 leverage ﬁ nancial, 232 operating, 243–244 21-H7303-IX.indd 289 21-H7303-IX.indd 289 11/16/17 8:42 AM 11/16/17 8:42 AM 290 Index leveraged buyouts, 218 liabilitiesin accounting equation, 227–228 on balance sheet, 230 current, 117, 230 long-term, 230 liability C corporations and, 70 S corporations and, 72–73 selling business and, 220 limited-liability companies (LLCs), 73–74, 76 limited partnerships, 69–70, 76 LinkedIn, 171, 202 liquidation value, 249 loans, 115–120, 121 lockup agreements, 215 long-term liabilities, 230 Main Street ﬁ rms, 104 management buyouts, 217–218 management skills, 182 management team in business plan, 86–89 in established businesses, 196–197 growth and, 181–193 opportunities that ﬁ t with capabilities of, 32, 35, 36 selling to, 217–218 market evaluation, 25–27 marketing plan, 48–49, 89–90 markets, expansion to new, 176–177 maturity-phase ﬁ nancing, 122–123 McDonald’s, 185 mergers and acquisitions (M& As), 215–216 motivation, 16, 201–202 need-based positioning, 51 Netﬂ ix, 175 net income, 235 network effects, 38, 55–57 net working capital, 230 Newman, Paul, 19 Newman’s Own, 19 new owners, selling business to, 218–220 Omidyar, Pierre, 123–124, 126–127, 150, 189 online lenders, 118 operating earnings, 235 operating expenses, 234 operating leverage, 243–244 operating plans, 90–91 opportunities, 1 economics of, 34–35 evaluation of, 28–39 experimental approach to, 28 identifying, 13, 52–53 presentation in business pla n, 82–83 questions to ask yourself about, 39 shaping, 23–40 strategies to address, 53–54 organizational culture, 198–202 outsourcing, 139, 178–179 owners’ equity, 109, 110, 227–228, 230 ownership, in business plan, 86 paradox of success, 197–198 participative management, 208 partnerships general, 67–69, 76 limited, 69–70, 76 passion, 13, 14–15 patents, 86, 230 PayPal, 171, 202 peer-to-peer lending networks, 118 people skills, 12–15 physical environment, 199–200 pitch deck 5, 80, 82, 96, 142 style of writing, 94 plant assets, 228, 229 platform businesses, 55, 57, 171 play opportunities, 200 portfolio thinking, 205–207 Pratt’s Guide to Private Equity & Venture Capital Sources , 142 , 143 prefer red st ock , 128, 140 –141 presentations, to venture capitalists, 143, 144 –145 price-earnings multiple (P/E ratio), 250 H7303-Entrepreneur.indb 290 H7303-Entrepreneur.indb 290 11/2/17 1:15 PM 11/2/17 1:15 PM Index291 pricing, 176 private placement, 166 problem identiﬁ cation, 12, 24–26, 28 process innovations, 195 product-based businesses, 178 professional management, 187, 192–193 proﬁ t , versus c a sh ﬂ ow, 239 proﬁ t-and-loss statement. See income statement proﬁ t margin, 33, 176 proﬁ t potential, 31, 32–35 proﬁ t structure, 33–34 pro forma income statement, 35, 36, 42, 91 progress, 3–4 prospectus, 160, 164 public offerings. See initial public offerings (IPOs) Pure Storage, 155–159 quick assets, 117 QuickBooks, 65 rapid grow th, 172 recognition, 201–202 red herrings, 160, 164 registration statement, 159, 160 rejuvenation, 202 replacement value, 249 resources, 53 results management, 184, 186 return, risk and, 32–33 revenue forecasts, 91 revenue sources, 43 reward systems, 201–202 risk, 2, 18, 28, 32–33, 47, 53, 141, 200–201 road shows, 160 rules, stretching, 16–17 sales projections, 91 SBA loans, 119 scaling up, 177–180 scandals, 17 Schumpeter, Joseph, 3 S corporations, 72–73, 76 SEC Rule 144, 215, 257–261 Securities and Exchange Commission (SEC), 111, 226 seed investment , 105, 109, 132 self-assessment, 11–20 selling of business, 217–220 Series A funding, 132, 133 Series B funding, 132 ser vice businesses, 177–178 share distribution, 165 share pr ice, 160, 164 shearing, 219 short-term results, 152 simple sentences, in business plans, 92–95 skills people, 12–15 technical, 182 Small Business Administration (SBA), 11, 119 sole propr ietorships, 63–66, 76 advantages of, 64, 66 disadvantages of, 66 tips for starting, 65 Southwest Airlines, 50, 54 speed to market, 37–38 startup costs, 107–109 startup ventures ﬁ nancing, 103–113 lean startups, 28, 29–30 risk and, 2 strategic direction, 202–203 strategic positions, 51–52 strategy activities that support, 54 alignment with, 54–55 in business plan, 85 change and, 57–58 competition and, 58–60 deﬁ ning, 41, 49–60 g row t h, 174 –17 7 implementation, 55 network effects and, 55–57 for platform businesses, 55, 57 sample, 58–59 steps for formulating, 52–55 subheadings, in business plan, 95 21-H7303-IX.indd 291 21-H7303-IX.indd 291 11/16/17 8:42 AM 11/16/17 8:42 AM 292 Index success, paradox of, 197–198 supply-chain ﬁ rms, 104 supply-side economics, 56 taxation business entities and, 74 C cor porations a nd, 7 1–72, 74 team members, in business plan, 86–89 technical advances, 195 technical skills, 182 10 -K ﬁ lings, 152 text blocks, in business plans, 95–96 threats identiﬁ cation of, 52–53 strategies to address, 53–54 3M, 196 times interest earned ratio, 120 Toyota, 50, 196 trade credit, 109–110, 128 trademarks, 86 trust, 144 Uber, 16–17, 55, 173, 178 underwriters, 158, 165, 215 valuation methods, 220–222, 245–255 value chains, 42 variable costs, 34, 242, 244 variety-based positioning, 51 VCgate, 143 venture capital/capitalists, 132, 136–147 advice from, 188 alternatives to, 139 business plans and, 80 connecting with, 141–143 corporate, 137 downsides of, 145–147 ﬂ ow of, 140 dur ing g row th stage, 121, 122 locators, 143 overview of, 136–139 present at ions t o, 143, 144 –145 process for, 139–141 proﬁ ts for, 32 during startup stage, 106 virtual reality, 111 VisiCalc, 19 vision, 13, 202–203 visuals, in business plans, 96–98 warrants, 166–167 wealth diversiﬁ cation, 213–214 web-based marketplace, 171 We b v a n , 17–18 , 57 Whitman, Meg, 189 working capital, 231–232 workspaces, 199–200 work style, 13, 16–18 w r iting st yle, of business pla ns, 92–98 Y Combinator, 111 H7303-Entrepreneur.indb 292 H7303-Entrepreneur.indb 292 11/2/17 1:15 PM 11/2/17 1:15 PM