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ENTREPRENEURIAL FINANCEFinance and Business Strategies for the Serious Entrepreneur
By STEVEN ROGERS ROZA MAKONNEN
McGraw-HillCopyright © 2009 The McGraw-Hill Companies, Inc.
All right reserved.
Chapter OneThe Entrepreneurial Spectrum
The 1990s could be called the original "entrepreneurship generation." Never before had the entrepreneurial spirit been as strong, in America and abroad, as it was during that decade. More than 600,000 new businesses were created at the beginning of the 1990s, with each subsequent year breaking the record of the previous one for start-ups. By 1997, entrepreneurs were starting a record 885,000 new businesses a year—that's more than 2,400 a day. This astonishing increase in new companies was more than 4 times the number of firms created in the 1960s, and more than 16 times as many as during the 1950s, when 200,000 and 50,000, respectively, were being created each year. This unprecedented growth in entrepreneurial activity was evidenced across all industries, including manufacturing, retail, real estate, and various technology industries. This decade was also an "equal opportunity" time, as the entrepreneurial euphoria of the 1990s was shared by both genders and across all ethnicities and races. I've always believed that the beauty of entrepreneurship is that it is colorblind and gender-neutral.
New evidence indicates that this 1990s generation of entrepreneurs may actually be surpassed in upcoming years by the members of "Generation Y," or those born between the years 1977 and 1994. This should come as no surprise when one considers that this group grew up during entrepreneurship's golden age and later saw its parents laid off or downsized out of "lifetime" corporate jobs. Generation Y has also spent most of its life and virtually all of its postsecondary years in a digital age, where technology has significantly reduced the barriers of entry for start-ups. The members of Generation Y, who may have seen VHS tapes and record albums only at neighborhood garage sales or museums, are now enrolling in college entrepreneurship classes at a rate that is roughly seven times what it was just six years ago. Jeff Cornwall, the entrepreneurial chair at Belmont University in Nashville, characterizes Generation Y's increase in entrepreneurial interest well: "Forty percent or more of students who come into our undergraduate entrepreneurship program as freshmen already have a business. It's a whole new world."
In a recent survey of business owners, the functional area they cited as being the one in which they had the weakest skill was the area of financial management—accounting, bookkeeping, the raising of capital, and the daily management of cash flow. Interestingly, these business owners also indicated that they spent most of their time on finance-related activities. Unfortunately, the findings of this survey are an accurate portrayal of most entrepreneurs—they are comfortable with the day-to-day operation of their businesses and with the marketing and sales of their products or services, but they are very uncomfortable with the financial management of their companies. Entrepreneurs cannot afford this discomfort. They must realize that financial management is not as difficult as it is made out to be. It must be used and embraced because it is one of the key factors for entrepreneurial success.
This book targets prospective and existing "high-growth" entrepreneurs who are not financial managers. Its objective is to be a user-friendly book that will provide these entrepreneurs with an understanding of the fundamentals of financial management and analysis that will enable them to better manage the financial resources of their business and create economic value. However, the book is not a course in corporate finance. Rather, entrepreneurial finance is more integrative, including the analysis of qualitative issues such as marketing, sales, personnel management, and strategic planning. The questions that will be answered will include: What financial tools can be used to manage the cash flow of the business efficiently? Why is valuation important? What is the value of the company? Finally, how, where, and when can financial resources be acquired to finance the business?
Before we immerse ourselves in the financial aspects of entrepreneurship, let us look at the general subject of entrepreneurship.
TYPES OF ENTREPRENEURS
There are essentially two kinds of entrepreneurs: the "mom-and-pop" entrepreneur, a.k.a. the "lifestyle" entrepreneur, and the "high-growth" entrepreneur.
The Lifestyle Entrepreneur
Lifestyle entrepreneurs are those entrepreneurs who are primarily looking for their business to provide them with a decent standard of living. They are not focused on growth; rather, they run their business almost haphazardly, with minimal or no systems in place. They do not necessarily have any strategic plans regarding the growth and future of their business and gladly accept whatever the business produces. Their objective is to manage the business so that it remains small and provides them with enough income to maintain a certain, typically middle-class, lifestyle. For example, Sue Yellin, a small-business consultant, says she is determined to remain a one-person show, earning just enough money to live comfortably and "feed my cat Fancy Feasts."
While they may have started out as lifestyle entrepreneurs, some owners ultimately become, voluntarily or involuntarily, high-growth entrepreneurs because their business grows despite their original intention. For example, the Inc. magazine 500 is composed of 500 successful high-growth entrepreneurs. When a survey was taken of these entrepreneurs, their answers for the completion of the statement, "My original goals when I started the company ..." suggest that almost 20 percent were originally lifestyle entrepreneurs, given the following responses:
* Company to grow as fast as possible: 50.9 percent.
* Company to grow slowly: 29.4 percent.
* Start small and stay small: 5.8 percent.
* No plan at all: 13.8 percent.
Finally, one of the most prominent stories of a lifestyle entrepreneur turned high-growth entrepreneur is that of Ewing Marion Kauffman, who started his pharmaceutical company, Marion Laboratories, in 1957 with the objective of "just making a living" for his family. He ultimately grew the firm to over $5 billion in annual revenues by 1986, creating wealth for himself (he sold the company in 1989 for over $5 billion) and for 300 employees, who became millionaires.
The High-Growth Entrepreneur
The high-growth entrepreneur, on the other hand, is proactively looking to grow annual revenues and profits exponentially. This type of entrepreneur has a plan that is reviewed and revised regularly, and the business is run according to this plan. Unlike the lifestyle entrepreneur, the high-growth entrepreneur runs the business with the expectation that it will grow exponentially, with the byproduct being the creation of wealth for himself, his investors, and possibly his employees. One of the best stories of high-growth entrepreneurship is Google, which will be discussed in greater detail later. The high-growth entrepreneur understands that a successful business is one that has basic business systems—financial management, cash flow planning, strategic planning, marketing, and so on—in place. Inc. magazine surveyed a group of entrepreneurs who were identified as "changing the face of American Business" and found that these entrepreneurs were high-growth entrepreneurs, demonstrated by the fact that not only were they millionaires, but they grew their firms from median sales of $146,000 with 4.5 employees to median sales of $11 million with 219 employees. These data also show that these entrepreneurs grew their companies efficiently, since their sales per employee increased from $32,444 to $50,228, a 55 percent improvement.
Wilson Harrell, a former entrepreneur and current Inc. magazine columnist, did a fantastic job of describing the difference between these two types of entrepreneurs. The first description is that of a lifestyle entrepreneur:
Let's say a man buys a dry cleaning shop. He goes to work at 7 a.m. At 7 p.m. he comes home, kisses the wife, grabs the kids, and goes off to a school play. At his office you'll see plaques all over the walls: Chamber of Commerce, Rotary Club, the local Republican or Democratic club. He's a pillar of the community, and everybody loves him, even the bankers.
Change the scenario. After the man buys the dry cleaning shop, he goes home and tells his wife, "Dear, we're going to mortgage this house, borrow money from everyone we can, including your mother and maybe even your brother, and hock everything else, because I'm about to buy another dry cleaner. Then I'll hock the first to buy another, and then another, because I'm going to be the biggest dry cleaner in this city, this state, this nation!"
The second scenario obviously describes the life of a high-growth entrepreneur who has the long-term plan of dominating the national dry cleaning industry by acquiring competitors, first locally and then nationally. His financing plan is to leverage the assets of the cleaners to obtain commercial debt from traditional sources such as banks, combined with "angel" financing from relatives.
Unfortunately, not all entrepreneurs who seek high growth can attain it. Sometimes circumstances outside of their control can hamper their growth plans. For example, one entrepreneur in Maine complained that he could not grow his business because of labor shortages in the region. He said, "I'm disgusted by the labor situation around here. People don't want to get ahead. It adds up to businesses staying small."
THE ENTREPRENEURIAL SPECTRUM
When most people think of the term entrepreneur, they envision someone who starts a company from scratch. This is a major misconception. As the entrepreneurial spectrum in Figure 1-1 shows, the tent of entrepreneurship is broader and more inclusive. It includes not only those who start companies from scratch (i.e., start-up entrepreneurs), but also those people who acquired an established company through inheritance or a buyout (i.e., acquirers). The entrepreneurship tent also includes franchisors as well as franchisee. Finally, it also includes intrapreneurs, or corporate entrepreneurs. These are people who are gainfully employed at a Fortune 500 company and are proactively engaged in entrepreneurial activities in that setting. Chapter 13 is devoted to the topic of intrapreneurship. But be it via acquisition or start-up, each entrepreneurial process involves differing levels of business risk, as highlighted in Figure 1-1.
While the major Fortune 500 corporations, such as IBM, are not entrepreneurial ventures, IBM and others are included on the spectrum simply as a business point of reference. Until the early 1980s, IBM epitomized corporate America: a huge, bureaucratic, and conservative multibillion-dollar company where employees were practically guaranteed lifetime employment. Although IBM became less conservative under the leadership of Louis Gerstner, the first non-IBM-trained CEO of the company, it has always represented the antithesis of entrepreneurship, with its "Hail to IBM" corporate anthem, white shirts, dark suits, and policies forbidding smoking and drinking on the job and strongly discouraging them off the job. In addition to the IBM profile, another great example of the antithesis of entrepreneurship was a statement made by a good friend, Lyle Logan, an executive at Northern Trust Corporation, a Fortune 500 company, who proudly said, "Steve, I have never attempted to pass myself off as an entrepreneur. I do not have a single entrepreneurial bone in my body. I am very happy as a corporate executive." As can be seen, the business risk associated with an established company like IBM is low. Such companies have a long history of profitable success and, more importantly, have extremely large cash reserves on hand.
Franchising accounts for 40 percent of all retail sales in the United States, employs over 18 million people and accounts for roughly $1.5 trillion in economic output. Like a big, sturdy tree that continues to grow branches, a well-run franchise can spawn hundreds of entrepreneurs. The founder of a franchise—the franchisor—is a start-up entrepreneur, such as Bill Rosenberg, who founded Dunkin' Donuts in the 1950s and now has approximately 7,400 stores in 30 countries. These guys sell enough donuts in a year to circle the globe ... twice! Rosenberg's franchisees (more than 5,500 in the United States alone), who own and operate individual franchises, are also entrepreneurs. They take risks, operate their businesses expecting to gain a profit, and, like other entrepreneurs, can have cash flow problems. The country's first franchisees were a network of salesmen who in the 1850s paid the Singer Sewing Machine Company for the right to sell the newly patented machine in different regions of the country. The franchise system ultimately became popular as franchisees began operating in the auto, oil, and food industries. Today, it's estimated that a new franchise outlet opens somewhere in the United States every 8 minutes.
Franchisees are business owners who put their capital at risk and can go out of business if they do not generate enough profits to remain solvent. By one estimate, there are over 750,000 individual franchise business units in America, of which 10,000 are home-based. The average initial investment in a franchise, not including real estate, is approximately $250,000. Examples include Mel Farr, the owner of five auto dealerships. Farr's auto group is just 1 of 15 subsidiaries in his business empire—valued at more than $573 million. Another such entrepreneur is Valerie Daniels-Carter, the founder of a holding company that manages 70 Pizza Hut and 36 Burger King restaurants that total over $85 million in combined annual revenue. Additional data from the International Franchise Association and the U.S. Department of Commerce, given in Table 1-1, shows that the number of franchised establishments is continually and rapidly growing and has more than doubled since 1970.
Because a franchise is typically a turnkey operation, its business risk is significantly lower than that of a start-up. The success rate of franchisees is between 80 and 97 percent, according to research by Arthur Andersen and Co., which found that only 3 percent of franchises had gone out of business five years after starting their business. Another study undertaken by Arthur Andersen found that of all franchises opened between 1987 and 1997, 85 percent still operated with their original owner, 11 percent had new owners, and 4 percent had closed. The International Franchise Association reports that 70 percent of franchisors charge an initial fee of $30,000 or less.
Max Cooper is one of the largest McDonald's franchisees in North America, with 45 restaurants in Alabama. He stated his reasoning for becoming a franchisee entrepreneur as follows:
You buy into a franchise because it's successful. The basics have been developed and you're buying the reputation. As with any company, to be a success in franchising, you have to have that burning desire. If you don't have it, don't do it. It isn't easy.
An acquirer is an entrepreneur who inherits or buys an existing business. This list includes Howard Schultz, who acquired Starbucks Coffee in 1987 for approximately $4 million when it had only 6 stores. Today, more than 40 million customers a week line up for their caffe mochas, cappuccinos, and caramel macchiatos in 12,400 Starbucks locations in 37 countries. Annual revenues top $7.8 billion, and, according to the company's SEC filings, the ownership team opened 2,199 new Starbucks outlets in the year 2006 alone!
The list of successful acquirers also includes folks like Jim McCann, who purchased the almost bankrupt 1–800-Flowers in 1983, turned it around, and grew annual revenues to $782 million by 2006. Another successful entrepreneur who falls into this category is Cathy Hughes, who over the past 27 years has purchased 71 radio stations that presently generate $371 million in annual revenues, making her broadcasting company, Radio One (NYSE), the seventh largest in the nation. The 51 stations have a combined value of $2 billion.
One of the most prominent entrepreneurs who fall into this category is Wayne Huizenga, Inc. magazine's 1996 Entrepreneur of the Year and Ernst & Young's 2005 World Entrepreneur of the Year. His reputation as a great entrepreneur comes partially from the fact that he is one of the few people in the United States to have ever owned three multibillion-dollar businesses. Like Richard Dreyfuss's character in the movie Down and Out in Beverly Hills, a millionaire who owned a clothes hanger—manufacturing company, Wayne Huizenga is living proof that an entrepreneur does not have to be in a glamorous industry to be successful. His success came from buying businesses in the low- or no-tech, unglamorous industries of garbage, burglar alarms, videos, sports, hotels, and used cars.
Excerpted from ENTREPRENEURIAL FINANCE by STEVEN ROGERS ROZA MAKONNEN Copyright © 2009 by The McGraw-Hill Companies, Inc.. Excerpted by permission of McGraw-Hill. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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