Entrepreneurship Final

Problem Set: Average Monthly Net Cash Burn Rate

(Burn-Build)/12

What are the 3 components of the cash conversion cycle? How is each component calculated?

1. Inventory to Sale Conversion Period - Average Inventories/(COGS/365) 2. Sales to Cash Conversion Period - Average Receivables/(Net Sales/365) 3. Purchase to Payment Conversion Period - (Average Payables + Accrued Liabilities)/(COGS/365)

Problem Set: Determine Net Income of Comparable Firm

1. Net Income/Valuation 2. Stock price of comparable firm X Shares outstanding 3. Comparable Net Income = Answer from Step 1 X Answer from Step 2

What are the three ratio components of the ROE model? How is each calculated and what financial dimensions do they measure?

1. Net Profit Margin - Measures profitability of sales - Net Profit/Sales 2. Asset Turnover - Measures how well assets are utilized in the production of sales - Net Sales/Average Total Assets 3. Equity Multiplier - Measures how the firm scales its assets on a base of equity (through liabilities and debt) - Average Total Assets/Average Equity

Identify and describe four efficiency/return ratios that combine data from both the income statement and the balance sheet.

1. Sales-To-Total-Assets - Net Sales/Average Total Assets 2. Operating Return on Assets - EBIT/Average Total Assets 3. Return on Assets - Net Profit/Average Total Assets 4. Return on Equity - Net Income/Average Owner's Equity

What are the three types of comparison that can be made when conducting ratio analyses?

1. Trend Analysis 2. Cross-sectional Analysis 3. Industry Comparables (Benchmark) Analysis

What are the components or stages in the professional venture investing cycle after funds have been raised until closure?

5. Conduct due diligence and actively invest. 6. Arrange harvest or liquidation. 7. Distribute cash and securities proceeds as available.

Innovation

Combining creative ideas with resources and competencies in order to embody that creative idea into a useful, value-creating form and then to successfully commercialize that new product or service or to realize the benefits of that new process.

What is common stock or common equity? What is the purpose of preemptive rights?

Common stock: the least senior claim on a venture's assets (residual ownership) Preemptive rights: the right for existing owners to buy sufficient shares to preserve their ownership share.

Explain the difference between pre-money valuation and post-money valuation.

Pre-money valuation: present value of a venture prior to a new money investment. Post-money valuation: pre-money valuation of a venture plus money injected by new investors.

What is preferred stock? What is participating preferred stock and what is meant by paid in kind (PIK) preferred stock?

Preferred Stock: equity claim senior to common stock and providing preference on dividends and liquidation proceeds. Participating preferred stock: preferred stocks with rights to participate in any dividends paid to common stockholders or stock with an investment repayment provision that must be met before distribution of returns to common stockholders. Paid in Kind (PIK): preferred stock that has the option of paying preferred dividends by issuing more preferred stock.

How do private and public financial markets differ?

Private financial markets are those involving direct two-party negotiations over illiquid non-standardized contracts. Public financial markets are those where transactions involve more liquid securities with standardized contract features.

Innovation Strategy Options

- First Mover - Fast Follower - Niche - Reactive

Advantages of Family Business

- Frugal in good and bad times - They set a high bar for capital expenditures - They carry little debt - They acquire fewer (and smaller) companies - They're more diversified - They're more international - They retain talent better than their competitors do

Challenges to Family Business

- Path dependency - Legacy value - Differences in risk profile between generations - Difficulty passing entrepreneurial commitment to successor generations.

What types of liabilities might show up on a venture's balance sheet?

- Payables - Accrued wages - Bank loan - Other current liabilities - Long-term debts - Capital leases

Growth Strategies

- Penetration - Market Development - Product Development - Diversification

Characteristics of Business Angels

- Self-made, wealthy individuals who invest in early stage ventures in exchange for the excitement of launching a business and a share in any financial rewards. - Have substantial business and financial experience. - Enjoy the thrill of being involved in new ventures.

What are some of the advantages of systematic liquidation?

- the entrepreneur and other owners maintain control throughout the harvest period. - the harvesting of the investment value can be spread out over a number of years. - the time, effort and cost of finding a buyer for the venture can be avoided.

What are some disadvantages of a systematic liquidation?

- the treatment and taxation of liquidation proceed as ordinary income (rather than capital gains). - the commitment of the entrepreneur's wealth, abilities, and focus to a dying venture, rather than other venture pursuits that might be more lucrative. - acceleration of the rate of decline in the going concern value as other industry participants respond to the reduction in investment.

Problem Set: Contribution Profit Margin

1 - (Variable Cost/Revenue)

What are the three steps typically used to forecast sales for early stage ventures?

1. "Top-down" market driven approach. Estimate what the overall industry or market demand is likely to be next year and over the following four years. 2. Estimate the market share the venture believes it could attain. 3. Attempt to further refine the sales forecast by working with existing and potential customers.

What are the three internal operating schedules that most firms prepare?

1. Cost of production schedule 2. Cost of good sold schedule 3. Inventories schedule

What are the components or stages in the professional venture investing cycle from inception to funding?

1. Determine (next) fund objectives and policies. 2. Organize new fund (usually partnership) 3. Solicit investments in new fund. 4. Obtain commitments for series of capital calls.

Identify and describe the four-step process typically used to forecast sales for seasoned firms.

1. Forecast future growth rates based upon multiple scenarios and their likelihoods as well as reviewing the firm's sales for the past several years. 2. Check the results of the first step with industry growth rates and expected market shares - the "top-down" or "market-share-driven" approach to projecting growth rates. 3. Refine the sales forecast using direct contact with existing and potential customers - the "bottom-up" or "customer-driven" approach to projecting growth rates. 4. Consider the likely impact of major strategic changes including changed in pricing policy, credit policy, marketing approach and R&D developments.

What is meant by the statement that a balance sheet provides a "snapshot" of a venture's financial position as of a point in time?

A balance sheet is known as a snapshot because it is the value of all the accounts at a certain point in time.

Briefly explain how changes in the conversion times of the components of the C3 can be interpreted.

A lengthening of the inventory to sale conversion period indicates less efficient inventory management. A lengthening of the sale to cash conversion period indicates less efficient collections or management of receivables. A decrease in the purchase to payment period indicates a less efficient use of the credit provided by suppliers, employees and the government.

What is a nominal interest rate? Describe a risk-free interest rate and a real rate of interest.

A nominal interest rate is the stated rate of interest. The risk-free interest rate is the interest rate for a debt security that is virtually free of default risk. A real rate of interest in rate of return adjusted for the expected inflation.

Briefly describe what is meant by a statement of cash flows.

A statement of cash flows shows how cash, as reflected in accrual accounting, flowed into and out of a company during a specific period of operation.

What is meant by a venture's operating cycle?

A venture's operating cycle is the time it takes to purchase raw materials, assemble a product, book a sale and collect on it.

Describe the types of resources (assets) needed for a new product venture during its development stage. Comment on the likely revenues and expenses during this early life cycle stage.

Assets (acquire initial assets): - initial cash - office furniture - computers Revenues: - no sales(consequently no money is coming in) Expenses: - rent - utilities - subsistence salary for entrepreneur

Describe the types of resources (assets) needed for a new product venture during its startup stage. Comment on the likely revenues and expenses during this early life cycle stage.

Assets (acquire production assets): - inventories - equipment to produce products and give credit to customers Revenues: - making sales - money begins flowing in Expenses: - additional expenses to produce and market products and to record business transactions

Problem Set: Inventory to Sale Conversion Period

Average Inventories/(COGS/365)

Problem Set: Sale to Cash Conversion Period

Average Receivables/(Net Sales/365)

Diversification Growth Strategy

Backward Integration: A step back (up) in the value-added chain toward the raw materials. Forwards Integration: A step forward (down) in the value-added chain toward the customers. Horizontal Integration: Involves a different, but complementary, value-added chain.

Why is it usually easier to forecast sales from seasoned firms in contrast with early-stage ventures?

Because a seasoned firm generally has an operating history. The forecast of the firm's financials therefore could begin with the firm's historical sales and the past relationships between sales and the other asset and liability accounts. Early-stage ventures have little or no useful historical operating performance against which to benchmark. Competitors' operating histories, however, may provide a useful reference. Nonetheless, when a venture is the pioneer in an industry, it is especially difficult to forecast its financials, since there are no historical or competitor benchmarks to act as a guide to the projections.

Define the term "EBIT". How does EBIT differ from a firm's net income or net profit?

EBIT is earnings before interest and taxes to be paid. Net income results from subtracting interest and taxes from EBIT.

Problem Set: Operating Profit Margin

EBIT/Net Sales or (Net Sales - COGS - Operating Expenses)/Net Sales

What is meant by the terms "depreciation" and "accumulated depreciation"?

Depreciation refers to the amount of decrease in value of the firm's long-term depreciable assets based on a preset schedule of the individual assets. Accumulated depreciation is the accrued amount of depreciation the firm has on its existing assets.

Product Development Growth Strategy

Developing and selling new products to people already purchasing the firm's existing products.

What is the difference between the direct comparison method and the direct capitalization method?

Direct comparison applies a direct comparison ratio to the related venture quantity and need not have any discounting interpretation. It can be used with stock variables like "dollars per square foot". Direct capitalization capitalizes earnings by discounting using a cap rate implied by a comparable ratio. There is a direct discounting interpretation. It is really restricted to flow variables like earnings, cash flows and dividends.

Define the term "EBITDA"

Earnings before interest, taxes, depreciation and amortization.

Penetration Growth Strategy

Encouraging existing customers to buy more of the firm's current products and relies on taking market share from competitors and/or expanding the size of the existing market.

Describe the basic venture capital (VC) method for estimating a venture's value.

Estimates the venture's value by projecting only a terminal flow to investors at the exit event.

Define the terms (a) explicit forecast period and (b) terminal or horizon value as they relate to a venture's discounted cash flow valuation.

Explicit forecast period is a two to ten year period in which the venture's financial statements are explicitly forecasted. Terminal or horizon value is the value of the venture at the end of the explicit forecast period.

What is staged financing?

Financing provided in sequences of rounds rather than all at one time.

Fast Follower Innovation Strategy

Firm must be very good with innovation and have strong R&D and be good at figuring out why the first mover was so hot so you can jump in fast and grab the market.

Reactive Innovation Strategy

Firms that are followers and have a focus on operations. Have a wait and see approach and look for low risk opportunities. Will copy proven innovation.

Problem Set: Breakeven Point in Sales Units

Fixed Cost/Revenue per Unit - Variable Cost per Unit

Niche Innovation Strategy

Focus on specific niche market, requires a close connections to customers on what they want as far as product differentiation.

What are four measures used to indicate how efficiently the venture is in generating profits on its sales? Describe how each measure is calculated.

Gross Profit Margin - Gross Profit/Net Sales Operating Profit Margin - EBIT/Net Sales Net Profit Margin - Net Income/Net Sales NOPAT Margin - (EBIT*(1-Tax Rate))/Net Sales

What are generally accepted accounting principles (GAAP)?

Guidelines that set out the manner and form of presenting accounting information.

Market Development Growth Strategy

Selling the firm's existing products to new groups of customers. - New geographical market: selling in new locations - New demographic market: selling to a different demographic - New product use: selling an existing product which may have a new use to a new group of buyers.

What is seed and startup financing?

Include the entrepreneur's physical and financial assets, family and friends, business angels, venture capitalists.

What is first-round financing that occurs during the survival life cycle stage?

Includes financing from: - Business operations - Venture capitalists - Suppliers and customers - Government assistance programs - Commercial banks

Besides the cash budget, what additional financial statements are projected monthly in conjunction with short-term financial planning?

Income Statement Balance Sheet Statement of Cash Flows

Define Inflation. What is meant by an inflation premium?

Inflation is the general rise in prices that is not due to increases in product quality. An inflation premium is the additional interest required due to the expectation of future inflation.

First Mover Innovation Strategy

Innovation culture Able to create and then dominate the market against fast followers.

What is meant by a prime rate?

Interest rate charged by banks to their highest quality (lowest default risk) business customers.

What is an interest rate? What is default risk?

Interest rate is the rate one must pay to borrow capital. Default risk is risk that a borrower will not pay the interest and/or principal on a loan.

What is meant by a cash budget? Describe how a cash budget is prepared.

It is a financial tool showing the inflows and outflows of the firm's cash balance over a period of time. It is calculated by determining all of the cash-basis expenses and revenues the firm has over a period of time to find out how cash is being built and burned.

What does an income statement measure or track over time?

It is a performance measure of a firm's operations over a period of time. Many different accounts that make up the income statement are used to determine trends in costs and revenues.

Define the term default risk premium.

It is the additional premium required to compensate for the possibility of the firm's defaulting on the loan.

Describe the cash conversion cycle (C3).

It is the operating cycle less the days of short-term credit extended by suppliers, employees and government (the purchase to payment cycle)

Why must a balance sheet be in "balance"?

It must be in balance because the amount of total assets must be equivalent to the sum of the firm's total liabilities and owner's equity. That is the basic accounting formula.

Financial Bootstrapping

Minimizing the need for financial capital and finding unique ways of financing a new venture. Minimizing costs is a way to minimize the need for additional capital.

What is the meaning of leverage ratios? What are typical ratios used for relating total debt to a venture's assets and/or its equity?

Leverage ratios indicate the extent to which the venture is in debt and its ability to repay its debt obligations. Typical ratios used are: - total-debt-to-total-assets ratio - debt-to-equity ratio - equity multiplier

What is a liquidity risk premium? What is a maturity risk premium?

Liquidity risk premium is the additional rate charged when a debt instrument cannot be sold quickly at a fair price. Maturity risk premium is charged for the inherent increased risk in long-term debt contracts.

Describe the differences between variable expenses and fixed expenses.

Variable expenses depend upon the level of production. Fixed expenses are items that are independent from production levels and will be incurred regardless.

Describe how a firm's net working capital (NWC) is measured and how the NWC-to-total-assets ratio is calculated. What does this ratio measure?

NWC: Current Assets - Current Liabilities NWC-to-total-assets ratio: NWC/Average Total Assets This ratio measures liquidity of the firm with a higher percentage indicating a higher liquidity.

What is meant by net cash build and net cash burn?

Net Cash Build: the sum of cash flows from operations and investing is positive. Net Cash Burn: the sum of cash flows from operations and investing is negative.

Problem Set: Estimate a Firm's Terminal Value

Next Year's Expected Cash Flow/(Venture Investor's Required Rate of Return - Constant Future Growth Rate)

Describe how pseudo dividends are used in the equity valuation method.

Pseudo dividend: excess cash not needed for investment in the assets or operations to carry out the business plan. Pseudo dividends can be used to conduct an equity method valuation by altering the projected financial statements to pay out the maximum dividend feasible each period and incorporating the recovery of those dividends when the capital is needed for the execution of the business plan or by using a formula approach to directly calculate the pseudo dividends.

Problem Set: Nominal Interest Rate

Real Risk Free Interest Rate + Maturity Risk Premium + Inflation Premium + Default Risk Premium on Similar Debt + Liquidity Premium

What is a bond rating?

Reflects the default risk of a firm's bonds as judged by a bond-rating agency.

Define the required cash and surplus cash. Why does it matter how we treat surplus cash for valuation purposes?

Required cash: amount of csh needed to cover a venture's day to day operations. Surplus cash: cash remaining after required cash, all operating expenses and reinvestments are made. To get an appropriate valuation, we separate required cash (treated as an investment) from surplus cash (allowed to flow through to equity holders).

What does short-term financial planning involve?

Short-term financial planning usually involved projecting monthly financial statements and concentrating on a venture's cash needs. Most initial business plans contain monthly projected (pro-forma) financial statements for at least one year, and sometimes for two or more years. These short horizon forecasts directly address whether a venture is expected to generate - or otherwise obtain- the required cash to meet its coming obligations. w

Explain how projected economic scenarios can be used to help forecast a firm's sales growth rate.

Since future state if the economy cannot be known, sales forecasts should be based on specific macroeconomic scenarios that reflect expected values based on probabilities assigned to possible outcomes.

Why is the conversion feature in convertible preferred important for venture investors?

The conversion features allow the venture investor to participate in the venture's success as reflected in equity appreciation. This is where the majority of return on investment in a successful venture will come.

Provide a description of the financing cost implications associated with a venture's need for additional funds.

The cost of obtaining additional funds may be explicit, such as additional interest expense associated with debt. Interest expense shows up directly on the projected income statement and, in turn, impacts the AFN shown on the balance sheet. In contrast, added "costs" associated with obtaining equity capital from venture capitalists and other investors are based on the expected rates of return the investors receive when they exit their investments. These implicit costs do not show up on the projected financial statements.

Briefly describe venture debt capital and venture equity capital.

Venture debt capital is raised from individuals, venture lenders and other financial institutions. Venture equity capital comes from founding entrepreneurial team, business angels, and venture capitalists. In some instances, debt and/or preferred stock convertible into shares of common equity is held by venture investors.

What is a venture's contribution profit margin?

The portion of the sale of a product that contributes to covering the fixed costs. 1 - (Variable Cost/Revenue)

What is the importance of the relationship between a venture's current liabilities and its total debt?

The portion of total debt that is "current" represents those liabilities that will come due within the next year. The percentage of debt held in current liabilities is a reasonable glimpse of the venture's reliance on debt soon requiring an outlay of cash. Ventures with higher percentages are more likely to need to restructure their liabilities in the near future.

What is accrual accounting?

The practice of recording economic activity when it is recognized rather than waiting until it is realized.

Briefly describe the process for projecting financial statements.

The process begins by projecting top-line sales forecasts annually for a specified forecast period and for a stepping-stone year. We then generally use a percent-of sales method to first forecast annual income statements.

What is the meaning of harvesting a venture?

The process of exiting a privately held business venture to unlock the owners' investment value.

What is a systematic liquidation of a venture?

The process of liquidating the firm by distributing the cash flows of the firm to the owners. This usually happens when the firm is in the mature stage and their free cash flow exceeds the amount needed to maintain sustainable growth.

Describe the equity valuation method.

The process of projecting and then discounting the relevant cash flows available to equity investors.

Describe how the relative value method is used to value a firm's equity.

The relative value method estimates a firm's value by examining how comparable firms are valued based on value-related multiples. Comparable firms are firms with lines of business, size, and growth characteristics similar to the firm being valued. Multiples-based valuations may be used to value the firm's enterprise value or its direct equity value similar to the application of DCF methods. Analysts often estimate a firm's enterprise value by calculating multiples of EBITDA. This works because EBITDA gives a "crude" estimate of cash flow available to both debt holders and equity holders.

Identify and describe the two components of the ROA model in terms of what financial dimensions they measure.

The two components of the ROA model are the net profit margin and the sales-to-total-assets ratio. Net profit margin measures the amount of sales that become net profit. Sales-to-total-assets measures how much the firm generates in sales with one dollar of assets.

What is a venture's present value? Does the past matter?

The value today of all future cash flows discounted to the present at the rate of return required by investors. The value of the venture is not directly related to the quantity of past efforts in cash or sweat. While accounting for the past is all well and good, an investor seeks to quantify and value the future.

Briefly describe the typical types of accounts that are found in the current assets of a new venture.

Typical current asset accounts are cash, which includes cash accounts and marketable securities, accounts receivable, inventory and other current assets.

What are the basic design features for financial securities used in venture investing?

Typically, venture investing securities need to address the type of financial claim (equity, debt, convertible) and the voting rights assigned. It is common for the security to have debt-like seniority in promised payments and be convertible in to an equity claim in successful ventures. There is almost always some claim of equity-like ownership.

What are unicorns? How might their exit values be impacted when they go public?

Unicorns are high-expected-growth companies with valuations in excess of $1 billion. Such ventures have been questioned for not going public or, when they do, doing so at a price below previous rounds, creating concern that the private valuations in excess of $1 billion are inflated. Planning welcome exits is important even for exceptionally well-funded ventures, including the rare unicorns.

Describe how the costs of debt and equity differ from the perspective of accounting measures.

While accountants recognize that financial capital has a cost and recommend its complete inclusion in performance appraisal and decision making, historical accounting for this cost is incomplete, at least in formal financial statements. Unlike debt, much of equity's cost is not an expense in a traditional accounting sense; only part of this cost (i.e. dividends) is reflected in historical financial statements. There is virtually no historical accounting for the non-dividend component of equity cost, even though it is clear that it increases with cuts in dividends.

Cap Rate

r-g spread between the discount rate and the growth rate of the cash flow in terminal value period.