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At EcoShore Innovations, we prioritize renewable energy solutions to power our floating infrastructure projects sustainably. Our team of specialists mixes solar, wind, and tidal energy technologies into our designs, ensuring competent operation and minimal environmental impact. Additionally, our coastal engineering experts use innovative techniques to create strong infrastructure that withstands the impacts of climate change, such as erosion and flooding. Through inclusive stakeholder engagement, weempower local communities to shape the development of their coastal areas, fostering trust, collaboration, and social equity. With EcoShoreInnovations at the forefront, Taiwan’s coastal future is one of sustainability, resilience, and vibrant community living.

The one primer you need to develop your entrepreneurial
skills.

hether you’re imagining your new business to be the next big thing in Silicon
Valley, a pivotal B2B provider, or an anchor in your local community, the HBR

Entrepreneur’s Handbook is your essential resource for getting your company
off the ground.

Starting an independent new business is rife with both opportunity and risk. And as an
entrepreneur, you’re the one in charge: your actions can make or break your business. You
need to know the tried-and-true fundamentals—from writing a business plan to getting
your first loan. You also need to know the latest thinking on how to create an irresistible
pitch deck, mitigate risk through experimentation, and develop unique opportunities
through business model innovation.

The HBR Entrepreneur’s Handbook addresses these challenges and more with practical
advice and wisdom from Harvard Business Review’s archive. Keep this comprehensive
guide with you throughout your startup’s life—and increase your business’s odds for
success.

In the HBR Entrepreneur’s Handbook you’ll find:

▪ Step-by-step guidance through the entrepreneurial process

▪ Concise explanations of the latest research and thinking on entrepreneurship from
Harvard Business Review contributors such as Marc Andreessen and Reid Hoffman

▪ Time-honed best practices

▪ Stories of real companies, from Airbnb to eBay

STAY INFORMED.
JOIN THE DISCUSSION.
VISIT HBR.ORG

US$29.99 MANAGEMENT

Everything You Need
to Launch and Grow
Your New Business

Entrepreneur’s
Handbook

Entrepreneur’s H
andbook

ISBN-13: 978-1-63369-368-5

9 781633 693685

9 0 0 0 0

Harvard
Business
Review
Entrepreneur’s
Handbook

H7303-Entrepreneur.indb iH7303-Entrepreneur.indb i 11/2/17 1:14 PM11/2/17 1:14 PM

H7303-Entrepreneur.indb iiH7303-Entrepreneur.indb ii 11/2/17 1:14 PM11/2/17 1:14 PM

Harvard
Business
Review
Entrepreneur’s
Handbook
Everything You Need
to Launch and Grow
Your New Business

Harvard Business Review Press

Boston, Massachusetts

H7303-Entrepreneur.indb iiiH7303-Entrepreneur.indb iii 11/2/17 1:14 PM11/2/17 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.
Special editions, including books with corporate logos, customized covers, and
letters from the company or CEO printed in the front matter, as well as excerpts
of existing books, can also be created in large quantities for special needs.

For details and discount information for both print and
ebook formats, contact [email protected],

tel. 800-988-0886, or www.hbr.org/bulksales.

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 ivH7303-Entrepreneur.indb iv 11/2/17 1:14 PM11/2/17 1:14 PM

Contents

Introduction 1

PART ONE

Preparing for the Journey

1. Is Starting a Business Right for You? 11

PART TWO

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 vH7303-Entrepreneur.indb v 11/2/17 1:14 PM11/2/17 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 viH7303-Entrepreneur.indb vi 11/2/17 1:14 PM11/2/17 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 1H7303-Entrepreneur.indb 1 11/2/17 1:14 PM11/2/17 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 an 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 2H7303-Entrepreneur.indb 2 11/2/17 1:14 PM11/2/17 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 everywhere (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

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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 overview 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 4H7303-Entrepreneur.indb 4 11/2/17 1:14 PM11/2/17 1:14 PM

Introduction�5

how to begin to test your business model with real customers. It also 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.

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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, many growing 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.

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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?”

Additional resources

The back of this book contains material you may fi nd useful. Appendix A

is a primer on fi nancial statements. If you haven’t studied accounting or

haven’t thought about it for a long time, this material will bring you up

to speed. Go to appendix B for details of breakeven analysis not covered

elsewhere in the book. Appendix C provides an overview of the methods

used to determine the value of business enterprises. The appendix won’t

make you a master of this very technical and specialized subject, but

it will teach you enough that you can deal intelligently with valuation

experts. Finally, appendix D is taken directly from the US Securities and

Exchange Commission site. It explains Rule 144 on the sale of restricted

and control stock. Few readers will ever need to understand Rule 144,

but those who do may fi nd this useful reading.

The appendixes are followed by a glossary that provides definitions

of key terms.

Finally, the book includes a “Further Reading” section. There you’ll
fi nd suggestions of books and articles—both recent and classics—that

provide more detailed information or unique insights into the topics cov-

ered in these chapters.

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H7303-Entrepreneur.indb 8H7303-Entrepreneur.indb 8 11/2/17 1:14 PM11/2/17 1:14 PM

PART ONE

Preparing for
the Journey

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H7303-Entrepreneur.indb 10H7303-Entrepreneur.indb 10 11/2/17 1:14 PM11/2/17 1:14 PM

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 11H7303-Entrepreneur.indb 11 11/2/17 1:14 PM11/2/17 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 12H7303-Entrepreneur.indb 12 11/2/17 1:14 PM11/2/17 1:14 PM

TA
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H7303-Entrepreneur.indb 13H7303-Entrepreneur.indb 13 11/2/17 1:14 PM11/2/17 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 know when your tactics for connecting with them aren’t working,

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.

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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.”

• While expressing passion for your business or idea can help if

you are trying to secure funding from a less experienced source—

relatives or semiprofessional angel investors, for example—

professional funders prefer strong preparation and a calm

demeanor, which they associate with good leadership, over

passion.

• As former venture capitalist and entrepreneur Dan Isenberg

writes, “Passion is an emotion that blinds you.” If you are

too emotionally attached to your venture, you won’t see its

problems objectively or be able to correct course when you

need to.

Sources: Cal Newport, “Solving Gen Y’s Passion Problem,” HBR.org, September 18, 2012;
Harvard Business Review, “For Founders, Preparation Trumps Passion,” Harvard Business
Review, July–August 2015; Harvard Business Review, “How Venture Capitalists Really Assess
a Pitch,” Harvard Business Review, June 2017; Daniel Isenberg, “The Danger of Entrepre-
neurial Passion,” HBR.org, January 6, 2010.

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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-

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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

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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-

formation before I can make this decision,” an entrepreneur must make the

best of uncertainty and move forward. Standing still and waiting for more

information isn’t an option.

This kind of pressure builds particularly around deal making. Success-

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

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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.”

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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 20H7303-Entrepreneur.indb 20 11/2/17 1:14 PM11/2/17 1:14 PM

PART TWO

Defi ning Your
Enterprise

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H7303-Entrepreneur.indb 22H7303-Entrepreneur.indb 22 11/2/17 1:14 PM11/2/17 1:14 PM

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 will 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 23H7303-Entrepreneur.indb 23 11/2/17 1:14 PM11/2/17 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-

hood mechanics wouldn’t be equipped or trained to deal with these cars 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

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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?

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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.

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TABLE 2-1

Market evaluation for the Electric Car Care Center

Aspect of
the market Cesar’s evaluation Cesar’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.

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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.

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Shaping an Opportunity�29

The lean startup

This methodology, 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)

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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: Strategyzer, “Canvases, Tools and More,” accessed July 12, 2017, www.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 streams

Customer
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 30H7303-Entrepreneur.indb 30 11/2/17 1:14 PM11/2/17 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
Everything,” 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.

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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 Alfred E. Osborne Jr., director of UCLA’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

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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

Risk0

FIGURE 2-2

The risk-versus-return trade-off

H7303-Entrepreneur.indb 33H7303-Entrepreneur.indb 33 11/2/17 1:14 PM11/2/17 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 service?

• Will the business be dominated by fi xed or variable costs?

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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 growth. 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 35H7303-Entrepreneur.indb 35 11/2/17 1:14 PM11/2/17 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 1a 42,000 42,000 42,000
Equipment loan 2b 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

Total expenses 471,000 623,400 824,400

Profi ts before tax (21,000) 76,600 175,600
Tax 0 22,980 35,400

Profi ts after 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 36H7303-Entrepreneur.indb 36 11/2/17 1:14 PM11/2/17 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 opportunities lack durability 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 37H7303-Entrepreneur.indb 37 11/2/17 1:14 PM11/2/17 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 38H7303-Entrepreneur.indb 38 11/2/17 1:14 PM11/2/17 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 39H7303-Entrepreneur.indb 39 11/2/17 1:14 PM11/2/17 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 40H7303-Entrepreneur.indb 40 11/2/17 1:14 PM11/2/17 1:14 PM

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 41H7303-Entrepreneur.indb 41 11/2/17 1:14 PM11/2/17 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.”

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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 (see

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 43H7303-Entrepreneur.indb 43 11/2/17 1:14 PM11/2/17 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.

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TABLE 3-1

Business model analogies

Try adapting one of these basic forms.

Analogy How 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, sidestepping 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.

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 45H7303-Entrepreneur.indb 45 11/2/17 1:14 PM11/2/17 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 46H7303-Entrepreneur.indb 46 11/2/17 1:14 PM11/2/17 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 percent 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

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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

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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 starting 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

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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 service.

• 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-

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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 USAA caters exclusively to active-duty and retired

military offi cers and their families. After decades of serving this

population, USAA 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.

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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

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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

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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 4: 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 half fi nished. The other half is to create alignment between

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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 UCLA’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

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56�Defi ning Your Enterprise

Network eff ects and strategy

In supply-side economies, fi rms achieve market power by controlling re-

sources, ruthlessly increasing 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.

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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-savvy, time-starved households. But those cus-

tomers balked at the higher price of buying their weekly groceries. To them,

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

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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

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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 growth of ride-share services like Uber and Lyft? 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

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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-

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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.

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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

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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.

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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.

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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 lawyers.

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.

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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

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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 with 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 privy to decisions, decision mak-

ing may be slower and more diffi cult than in a sole proprietorship.

Disputes can tie the partnership in knots.

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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 ts until they have gotten back an

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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

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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

contributed by shareholders when they purchase stock issued directly from

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

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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.

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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

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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

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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.

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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

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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-

preneurial organization plans to pursue it. To be effective, 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.

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78�Defi ning Your Enterprise

In this chapter, we’ll discuss the merits of a business plan and explain

some of the alternatives before we describe the elements that go into a good

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-

’em-dead business plans.

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

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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-heavy, and numbers-heavy 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

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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.

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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 wise 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

Contents
I. 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

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82�Defi ning Your Enterprise

The contents should be followed by an executive summary. 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 further than this—after all, they probably have an enormous

pile of other proposals vying 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

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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

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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

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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 industry operates. Also consider how your competi-

tors may react to your success—what happens if they copy your best-selling

product? How will you maintain your customers’ loyalty?

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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.

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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.]

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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.

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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 the team section of your business plan gets the most attention from read-

ers, the marketing plan runs a close second. Investors know that marketing

is the activity most associated with success or failure. All 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 5-1

Lo-Sugar key team members

Team member Position Salary

Joanne Galloway CEO $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

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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

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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.

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92�Defi ning Your Enterprise

TABLE 5-2

Forecasted revenues by distribution channel (percentage of sales)

Distribution channel 2018 2019 2020

Health food stores $112,000 (100%) $160,000 (80%) $200,000 (38%)

Supermarkets 0 40,000 (20%) 80,000 (15%)

Private-label business 0 0 240,000 (46%)

Total sales $112,000 (100%) 200,000 (100%) 520,000 (99%)

TABLE 5-3

Marketing expense 2018 2019 2020

Sales commissions $11,000 (10%) $20,000 (9%) $52,000 (9%)

Research �70,000 (63%) �80,000 (36%) �85,000 (15%)

Promotion �20,000 (18%) �32,000 (15%) �50,000 (9%)

Total expense $101,000 (91%) 132,000 (60%) 187,000 (33%)

Style

Every business plan is a combination of style and substance. Not being

wordsmiths, most entrepreneurs concentrate on the substance and short-

change the style. That’s unfortunate, because inattention to style makes a

plan dull and diffi cult to read.

Some successful entrepreneurs work with a writer who has experience

in business plan writing. Others act as their own wordsmiths and observe

the rules of good writing: use words sparingly, keep sentences simple,

make the most of design elements, and use graphics judiciously.

Use words sparingly
In the business world, shorter is always better if it communicates the re-

quired information. So heed rule 17 in William Strunk and E. B. White’s

timeless Elements of Style, and omit needless words:

Vigorous writing is concise. A sentence should contain no unnec-

essary words; a paragraph no unnecessary sentences; for the same

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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 information is important, it should be provided in

a separate sentence.

Packing more information into each sentence is not necessarily

bad; nor does it necessarily violate rules of grammar. However, complex

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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 strategy in a sentence of fi fteen or fewer words. If your strategy has

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.

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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:

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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

Weight Watchers.

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?

Text-only example:

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

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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

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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 2011 2013

+10%
8.6%

3.6%

+14%
+12%
+10%
+8%
+6%
+4%
+2%
0%

-2%
-4%
-6%

1990 1995 2000 2005 2010 2015

ANNUAL GROWTH IN HEALTH CARE SPENDING
Annual Growth is Declining

National Health Spending GDP

PERCENTAGE CHANGE OVER PREVIOUS YEAR
Change in Health Spending and GDP

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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.

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PART THREE

Financing
Your Business

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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

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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 rms. Some 37 percent of US employment can be attributed 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

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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

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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

growth 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

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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).

80
%

70
%

60
%

50
%

40
%

30
%

20
%

10
%

67.2%

13.6%

51.8%

34.0%

20.9%

11.9%

7.7%

7.5%

6.5%

3.8%

Have not used finance

Personal savings

Bank loans

Credit card

Family

Business acquaintances

Angel investors

Close 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.

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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

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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.

Trade credit
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

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110�Financing Your Business

TABLE 6-3

Liabilities and owners’ equity

Current liabilities

Current 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 Kickstarter or Indiegogo. In 2015 alone, over $2 billion of funding was

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

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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,

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112�Financing Your Business

TABLE 6-4

The four institutions that support startups

Incubators
Angel
investors Accelerators Hybrid

Duration 1 to 5 years Ongoing 3 to 6 months 3 months to
2 years

Cohorts No No Yes No

Business model Rent; nonprofi t Investment Investment; can
also be nonprofi t

Investment; can
also be nonprofi t

Selection Noncompetitive Competitive,
ongoing

Competitive,
cyclical

Competitive,
ongoing

Venture stage Early or late Early Early Early

Education Ad hoc, human
resources, legal

None Seminars Various incubator
and accelerator
practices

Mentorship Minimal, tactical As needed by
investor

Intense, 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

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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.

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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

probably need more cash if your growth is strong or if your strategy is to build

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

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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

are more eager to extend short-term demand loans, seasonal lines of credit,

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.

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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 Assets ÷ 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 cash 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 confi 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

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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.

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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.

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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

adversity. For example, if EBIT were to be cut in half because 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 heavy debt is owners’ equity. Equity capital is ob-

tained through the sale of shares to investors, including the entrepreneur.

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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 growth is a powerful 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.

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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, growth 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

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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

growth 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.

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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

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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)

2000 1999 1998

Net cash provided by operating
activities

$100,148 $62,852 $6,041

Net cash used in investing activities (206,054) (603,363) (53,024)

Net cash provided by fi nancing
activities

85,978 725,027 72,159

Net increase (decrease) in cash and
cash equivalents

(19,928) 184,516 25,176

Cash and cash equivalents at end of
year (after accounting for beginning
balance)

201,873 221,801 37,285

Source: eBay 10-K report, 2000.

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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

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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.

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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 with 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

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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-

term asset—is just as bad. Some people take out second mortgages 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.

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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.

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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 growth.

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

business should be run. Make no mistake, by accepting equity funding, you

are ceding some measure of the control of your business.

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132�Financing Your Business

For these growth-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:

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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

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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 only when you’ve raised at least a third or even a half of the total

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.

If your business is local or regional, you’ll want to 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 lawyer, 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

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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 with an angel, how do you persuade them to fund 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.

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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-

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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 provide useful advice. (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.

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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.

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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 lawyers, 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.

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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

MoneyMoney

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.

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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

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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

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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.

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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.

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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 heavy 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

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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.)

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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.

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H7303-Entrepreneur.indb 148H7303-Entrepreneur.indb 148 11/2/17 1:14 PM11/2/17 1:14 PM

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

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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:

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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

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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

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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 with 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.

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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:

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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, and 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)

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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 9-1

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.

1995 2000 2005 2010 2015

8
Median time to IPO in years

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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. Private 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)

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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.

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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.

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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.

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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

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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

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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)

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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.

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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.

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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

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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.

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PART FOUR

Scaling Up

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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

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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.

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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 growth 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 growth 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

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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 growth 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?

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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 division, 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

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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.

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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 ed people if it hopes to grow. Consider a management consult-

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

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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.

This kind of creative thinking—and risk taking—allowed Uber to grow

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

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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.

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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.

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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.

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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. Harvard 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,

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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 heavy 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.

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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 design a military vehicle that is fuel-effi 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

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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 winning 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 alert 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

less time for hands-on involvement. While young, small, simple enterprises

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

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186�Scaling Up

TABLE 11-1

Four leadership approaches

Leader’s focus

Content Behavior Results Context

Situation Young, small, sim-
ple enterprise

Somewhat larger,
more involved
enterprise

Large, 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
prescription

Too 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

Tone-setting
events

Key skills,
tools

Action

Decisions

Policies

Procedures

Behavior audit

Plans

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

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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:

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188�Scaling Up

Your funders

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, with 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

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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,

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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.)

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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.

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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-

tailed in business building: negotiating with suppliers, sales, setting up pro-

cedures and control systems, dealing with people problems, scrambling for

money, and delegating tasks. Unfortunately, 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.

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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.

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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 service, 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.

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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 technology 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

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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

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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,’

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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

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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 will 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.

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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 champions. Network with influential people within 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 recognition—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

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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

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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.

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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

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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

with 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.

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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

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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.”

Tips for making good innovation decisions

Keeping the entrepreneurial spirit alive means continually pushing into

uncharted terrain with R&D projects, market initiatives, and human re-

source investments. Each of these areas involves making decisions with-

out perfect information, under conditions of uncertainty. Here are a few

tips that can help you make those decisions as well as possible:

• Exclude friends and “yes people” from your leadership team and

board of directors. You need solid advice and blunt, honest feed-

back as you consider investment in an innovative idea.

• Surround yourself with people who have complementary skills

and diff erent approaches to analyzing issues and making deci-

sions. Listen to their suggestions and arguments, even when you

disagree. These other voices can help you avoid walking off a cliff .

• Learn when to cut your losses. You cannot win the game if you

don’t play. But don’t play every game to the end. Like a good

poker player, recognize when you’re pouring resources into a los-

ing hand, and have the courage to walk away with your losses.

• Double-check your assumptions. What looks rosy can be a disas-

ter if those assumptions are not realistic.

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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.

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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.

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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.

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PART FIVE

Looking to
the Future

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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

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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 buying 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,

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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.

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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

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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

result in both a loss of employment and a loss of retirement fund value. 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.

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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

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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.

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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

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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

space. Rather, it should correspond with what other investors have paid 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

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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 future earnings, after 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.

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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.

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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

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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.

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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.

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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

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Appendix A: Understanding Financial Statements�229

TABLE A-1

Amalgamated Hat Rack balance sheet as of December 31, 2017

2017 2016
Increase

(Decrease)

Assets
Cash and marketable securities $652,500 486,500 166,000
Accounts receivable 555,000 512,000 43,000
Inventory 835,000 755,000 80,000
Prepaid expenses 123,000 98,000 25,000

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 $450,000 430,000 20,000
Accrued expenses 98,000 77,000 21,000
Income tax payable 17,000 9,000 8,000
Short-term debt 435,000 500,000 (65,000)

Total current liabilities 1,000,000 1,016,000 (16,000)

Long-term debt 750,000 660,000 90,000

Total liabilities 1,750,000 1,676,000 74,000

Contributed capital 900,000 850,000 50,000
Retained earnings 1,282,500 935,000 347,500

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-

sets, that so-called goodwill is recorded as an asset. This is, however, strictly

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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

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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

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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

value by only 25 percent. Financial leverage made this possible. In contrast,

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.

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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

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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, as well as other costs of business not directly attributed 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

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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

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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 44,500 45,500

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

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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 affected 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.

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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:

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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.

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240�HBR’s Entrepreneur’s Handbook

Finally, we come to cash-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.

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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.

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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.

• Variable costs: 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)

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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

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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.

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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,

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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-

umes considered separately. Businesses look on acquisitions with a similar

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

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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

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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.

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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.

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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-

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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

industry as Amalgamated, 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

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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,

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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

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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:

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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.

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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.

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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

restricted securities, even if they were not restricted in the affi 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

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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

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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.

4. 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

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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.

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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.

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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-

odic interest payments and to redeem the bond at its face value on maturity.

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

changes in cash (and cash equivalents) during the accounting period. More

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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

borrowing. 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.

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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 calculates value 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.

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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

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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 having 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,

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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.

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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 formal document that provides full disclosure to potential

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

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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.

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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.”

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