Quiz 1
What asset and financial bubbles have occurred recently? How can bubbles and financial crises lead to entrepreneurial opportunities?
The "dot.com" or Internet bubble burst in 2000. An economic recession that began in 2001 was exacerbated by the 9/11 terrorist attack. The housing asset bubble, fueled by sub-prime mortgages offered to borrowers who could not afford them, burst in 2006. By the second half of 2008, a "perfect financial storm" erupted and possible financial collapse became a reality. Alternative and renewable energy, accompanied by project credit subsidies, production and investment tax credits, and loan guarantees benefited as a result of the recent financial crisis. These developments and other efforts to stimulate economic activity provided many new entrepreneurial opportunities.
[Ethical Issues] Assume that you have been working on a first-generation "prototype" for a new product. An angel investor is waiting in the "wings" wanting to invest in a second-generation model or prototype. Unfortunately you have run out of money and aren't able to finish the initial prototype. The business angel has previously said that she would "walk" if you cannot produce a working first generation prototype. A. What would you attempt to do to "save" your entrepreneurial venture? B. Now let's assume that the angel investor will advance you the financing needed for the second-generation prototype based on your "word" that the first-generation prototype has been completed and is working? What would you do?
A. Many entrepreneurs state that high ethical standards are one of a venture's most important assets and are critical to long-term success and value. Taking the time and money to invest in the venture's character will help ensure that it is an asset rather than a liability. Most would agree that the proper course of action would be one of being honest up front. That is, inform the business angel that you are out of money and thus can't finish the initial prototype. If this causes the business angel to "walk," so be it. Of course, the first order of business is to secure necessary financing to complete the initial prototype. B. The situation has not changed from the suggested actions noted in Part A. Inform the business angel that the initial prototype has not yet been completed because you are out of money. Being honest up front is likely to be in the best interests of the venture (and entrepreneur) in the long-run. Confidence and trust in you (the entrepreneur) by the business angel will be in the best interests of a successful working relationship over time.
[Financing Concepts] The following ventures are at different stages in their life cycles. Identify the likely stage for each venture and describe the type of financing each venture is likely to be seeking and identify potential sources for that financing. A. Phil Young, founder of Pedal Pushers, has an idea for a pedal replacement for children's bicycles. The Pedal Pusher will replace existing bicycle pedals with an easy release stirrup to help smaller children hold their feet on the pedals. The Pedal Pusher will also glow in the dark and will provide a musical sound as the bicycle is pedaled. Phil is seeking some financial help in developing working prototypes B. Petal Providers is a firm that is trying to model the U.S. floral industry after its European counterparts. European flower markets tend to have larger selections at lower prices. Revenues started at $1 million last year when the first "mega" Petal Providers floral outlet was opened. Revenues are expected to be $3 million this year and $15 million next year after two additional stores are opened.
A. Since the venture is still in the idea stage and searching for prototype capital, the venture would be classified in the development stage. While in this stage, the venture will be making efforts to obtain seed financing, which typically comes from the entrepreneur's assets or from family and friends. B. Since the venture has already established sizable revenue and is in the process of growing its venture by opening new stores, the firm has just entered the rapid growth stage.
[Financial Risk and Return Considerations] Explain how you would choose between the following situations. Develop your answers from the perspective of the principles of entrepreneurial finance presented earlier in the chapter. You may arrive at your answers with or without making actual calculations. A. You have $1,000 to invest for one year (this would be a luxury for most entrepreneurs). You can earn a 4% interest rate for one year at the Third First bank or a 5% interest rate at the First Fourth bank. Which savings account investment would you choose and why? B. A "friend" of yours will lend you $10,000 for one year if you agree to repay him $1,000 interest plus returning the $10,000 investment. A second "friend," has only $5,000 to lend to you but wants total funds of $5,400 in repayment at the end of one year. Which loan would you choose and why? C. You have the opportunity to invest $3,000 in one of two investments. The first investment would pay you either $2,700 or $3,300 at the end of one year depending on the success of the venture. The second investment would pay you either $2,000 or $4,000 at the end of one year depending on the success of the venture. Which investment would you choose and why? Now, would your answer change if your investment were only $1? D. An outside venture investor is considering investing $100,000 in either your new venture or in another venture, or invest $50,000 in each venture. At the end of one year, the value of the venture might be either $0 or $1,000,000. The other venture is expected to be worth either $50,000 or $500,000 at the end of one year. Which investment choice (yours, the other venture, or half-and-half) do you think the venture investor would choose to invest in? Why?
A. Third First bank: $1,000 x 1.04 = $1,040 First Fourth bank: $1,000 x 1.05 = $1,050 The First Fourth bank loan would be preferred because you would receive $10 more ($1,050 versus $1,040) at the end of one year. This example illustrates the principle: "real, human, and financial capital must be rented from owners." The time value of money is an important component of the rent one pays for using someone else's financial capital. B. First friend: $1,000/$10,000 = 10% interest rate Second friend: $400/$5,000 = 8% interest rate The second friend is offering you a lower interest rate (8% versus 10%) which would be preferred, other things being equal. This example illustrates the principle: "real, human, and financial capital must be rented from owners." The time value of money is an important component of the rent one pays for using someone else's financial capital. However, the dollar amount of financial that is needed also must be considered. For example, if you "need" $10,000 then the lower interest rate $5,000 loan is not a viable option. The only viable choice might be to borrow $10,000 at the 10 percent rate of interest. C. Low Result High Result Expected Value First investment: $2,700 $3,300 ($2,700 + $3,300)/2 = $3,000 Second investment: $2,000 $4,000 ($2,000 + $4,000)/2 = $3,000 A second principle of entrepreneurial finance is: "risk and expected reward go hand in hand." "Risk" is reflected in the dispersion or range of outcomes. Each investment amount is $3,000 and the expected return on average is $3,000 for each investment. However, the second investment is considered to be riskier in that you might actually receive only $2,000 or two-thirds of your investment at the end of one year. Since the investment amounts and expected values are the same, risk-averse investors would prefer the first investment because it has less dispersion risk. However, when investments are very small (or are perceived to be small by a specific investor), some investors might make the riskier investment in the "hope" the highest return will occur. This is sometimes called the "lottery" effect in that investors know there is a high probability that they will lose all of their investment but they are willing to undertake the investment in the hope they will receive the high payoff even though the odds of doing so are very, very small. Bankruptcy or failure situations may also cause the investor (entrepreneur) to choose the riskier investment.For example, let's assume that you will need $3,500 in order to keep your business afloat.Since only the riskier second investment has the possibility of paying at least $3,500, the second investment might be selected. D. Low Result High Result Expected Value Your venture: $0 $1,000,000 ($0 + $1,000,000)/2 = $500,000 Other venture: $50,000 $500,000 ($50,000 + $500,000)/2 = $275,000 Half-and-half: $25,000 $750,000 ($25,000 + $750,000)/2 = $387,500 Under the half-and-half alternative, $50,000 is invested in each venture. The low result outcome is $25,000 ($0 + $25,000) and the high result outcome is $750,000 ($250,000 + $500,000). In actuality there are two more possible outcomes under the half-and-half alternative. They are: $250,000 ($0 + $250,000) and $525,000 ($25,000 + $500,000). Thus, the more complete half-and-half calculation would be: ($25,000 + $250,000 + $525,000 + $750,000)/4 = $387,500. A venture investor who is not very risk averse might choose your venture to invest in since there is a possibility of receiving $1,000,000 in return for putting up $100,000. Of course, such an investor could lose all of his/her investment if the low result occurs. A more risk averse venture investor might choose to invest in only the other venture where he/she could lose only $50,000 of the $100,000 investment if the low result occurs with the possibility of receiving a maximum of $500,000 if the high result possibility occurs. By combining the two venture investments in a "portfolio," the result is often less dispersion risk.In the above example, the lowest amount returned would be $25,000 (instead of zero for just your venture).However, the highest amount returned also would be lower at $750,000 (instead of the possibility of $1,000,000 for your venture).The final decision will depend on the venture investor's willingness to trade off a lower expected return for less dispersion risk.
[Life Cycle Financing] The following ventures have supplied information on how they are being financed. Link the type and sources of financing to where each venture is likely to be in its life cycle. A. Voice River provides media-on-demand services via the Internet. Voice River raised $500,000 of founder's capital in April 2019 and "seed" financing of $1 million in September 2019 from the Sentinak Fund. The firm is currently seeking $6 million for a growth round of financing. B. A. Electronic Publishing raised $200,000 from three private investors and another $200,000 from SOFTLEND Holdings. The financial capital is to be used to complete software development of e-mail delivery and subscription management services.
A. Voice River received development funds in the form of founders' capital and seed financing. It is currently seeking first round financing at the startup stage B. Electronic Publishing is still in the development stage. It has raised funds from angels and an early stage venture capital firm.
Identify the major sources, as well as the players, associated with each type of financing for each life cycle stage.
Development Stage - Entrepreneur's assets, family and friends Startup Stage - Entrepreneur's assets, family, friends, business angels, venture capitalists Survival Stage - Business operations, venture capitalists, suppliers, customers, government assistance programs, and commercial banks Rapid-Growth Stage - Business operations, suppliers, customers, commercial banks, and investment bankers Early-Maturity Stage - Business operations, commercial banks and investment bankers
Identify the types of financing that typically coincide with each stage of a successful venture's life cycle.
Development Stage - Seed Financing Startup Stage - Startup Financing Survival Stage - First-Round Financing Rapid Growth Stage - Second-Round, Mezzanine and Liquidity-Stage Financing Maturity Stage - Obtaining bank loans, issuing bonds and issuing stocks
What is entrepreneurial finance and what are the responsibilities of the financial manager of an entrepreneurial venture?
Entrepreneurial finance is the application and adaptation of financial tools and techniques to the planning, funding, operations, and valuation of an entrepreneurial venture. The practice of financial management in entrepreneurial finance involves record keeping, financial planning, the management of operations and assets, and the acquiring of new assets and the financing of those assets necessary to grow the venture over its lifetime.
What is entrepreneurship? What are some basic characteristics of entrepreneurs?
Entrepreneurship is the process of changing ideas into commercial opportunities and creating value. While there is no prototypical entrepreneur, many are good at recognizing commercial opportunities, tend to be optimistic, and envision a plan for the future.
How do public and private financial markets differ?
Public financial markets are markets where standardized contracts or securities are traded on organized securities exchanges. Private financial markets are markets where customized contracts or securities are negotiated, created, and held with restrictions on how they can be transferred.
What is the entrepreneurial process?
The entrepreneurial process comprises: developing opportunities, gathering resources, and managing and building operations with the goal of creating value.
Identify the seven principles of entrepreneurial finance.
The seven principles are: (1) Real, human, and financial capital must be rented from owners (2) Risk and expected reward go hand in hand (3) While accounting is the language of business, cash is the currency (4) New venture financing involves search, negotiation, and privacy (5) A venture's financial objective is to increase value (6) It is dangerous to assume that people act against their own self-interests (7) Venture character and reputation can be assets or liabilities
Explain the statement: "The time value of money is not the only cost involved in renting someone's financial capital."
The total cost of renting someone's financial capital is typically significantly higher than just the time value of money due to the possibility that the venture won't be able to pay. The rent is risky or uncertain requiring an expected compensation in addition to the time value of money for the renting agreement to be put in place.
What is the financial goal of the entrepreneurial venture? What are the major components for estimating value?
The venture's financial goal is to maximize the value of the venture to its owner(s). The major components of estimating value are projected free cash flow (cash generated in a specified time period that exceeds funds needed to operate, pay creditors, and invest in the assets needed to grow the venture) and its risk (including the timing and realized amount).
From an agency relationship standpoint, describe the possible types of problems or conflicts of interest that could inhibit maximizing a venture's value.
There are two basic types of conflicts. Owner-manager (agency) conflicts occur when there are differences between managers' self-interests and the interests of the owners who hired the managers. There is also the possibility of owner-debtholder conflicts that take the form of a divergence of the owners' and lenders' self-interests as the venture gets close to bankruptcy. Agency relationships arise when "principals" hire "agents" to perform specified activities or services.Businesses are involved in two primary agency relationships: (1) owner-manager conflicts, and (2) manager-debtholder conflicts. The owner-manager agency problem exists when managers have personal goals that compete with maximizing the value of the venture.The manager-debtholder conflict exists when debtholders make loans to firms but give responsibility to managers for deciding on the firm's risk of failure or bankruptcy.When loans are initially made, interest rates reflect the then current riskiness of the firm.Subsequently, managers may, on behalf of the owners, make the firm riskier for the benefit of owners at the expense of debtholders.
What are the five stages in the life-cycle of a successful venture?
They are: (1) Development Stage, (2) Startup Stage, (3) Survival Stage, (4) Rapid-Growth Stage, and (5) Early-Maturity Stage.
