CHAPTER 1

INTRODUCTION AND OVERVIEW

FOCUS
The purpose of this first chapter is to present an overview of what entrepreneurial finance is
about. In doing so we hope to convey to you the importance of understanding and applying
entrepreneurial finance methods and tools to help ensure an entrepreneurial venture is successful.
We present a life cycle approach to the teaching of entrepreneurial finance where we cover
venture operating and financial decisions faced by the entrepreneur as a venture progresses from
an idea through to harvesting the venture.
LEARNING OBJECTIVES
1. Explain the economic importance of small and emerging businesses
2. Describe entrepreneurship and characteristics of entrepreneurs
3. Name the three major source categories for identifying entrepreneurial opportunities
4. ist and describe the seven principles of entrepreneurial finance
5. Discuss entrepreneurial finance and the role of the financial manager
6. Describe the various stages of a successful venture!s life cycle
7. Identify types of financing" and the related investors" by life cycle stage
8. #nderstand the life cycle approach used in this boo$
CHAPTER OUTLINE
%.% ENT&E'&ENE#&()I' *#ND+,ENT+(
+. Who is an Entrepreneur-
.. .asic Definitions
/. Entrepreneurial Traits or /haracteristics
D. 0pportunities Exist .ut Not Without &is$s
%.1 (0#&/E( 0* ENT&E'&ENE#&I+ 0''0&T#NITIE(
+. (ocietal /hanges
.. Demographic /hanges
/. Technological /hanges
%.2 T)E INTE&NET E/0N0,3 +ND E4/0,,E&/E
%.5 '&IN/I'E( 0* ENT&E'&ENE#&I+ *IN+N/E
A. &eal" )uman" and *inancial /apital must be &ented from 0wners
B. &is$ and Expected &eward go )and in )and
C. While +ccounting is the anguage of .usiness" /ash is the /urrency
D. New 6enture *inancing Involves (earch" Negotiation" and 'rivacy
E. + 6enture!s *inancial 0bjective is to Increase 6alue
F. It is Dangerous to +ssume that 'eople +ct +gainst Their 0wn (elf4Interests
G. 6enture /haracter and &eputation can be +ssets or iabilities
%.7 &0E 0* ENT&E'&ENE#&I+ *IN+N/E
%
%.8 T)E (#//E((*# 6ENT#&E I*E /3/E
+. Development (tage
.. (tartup (tage
/. (urvival (tage
D. &apid49rowth (tage
E. ,aturity (tage
%.: *IN+N/IN9 T)&0#9) T)E 6ENT#&E I*E /3/E
+. (eed *inancing
.. (tartup *inancing
/. *irst4&ound *inancing
D. (econd4&ound *inancing
E. ,e;;anine *inancing
*. i<uidity4(tage *inancing
9. (easoned *inancing
%.= I*E /3/E +''&0+/) *0& TE+/)IN9 ENT&E'&ENE#&I+ *IN+N/E
%.> (#,,+&3
DISCUSSION QUESTIONS AND ANSWERS
1. What is entrepreneurship? What are some asi! !hara!teristi!s o" entrepreneurs?
Entrepreneurship is the process of changing ideas into commercial opportunities and creating
value. While there is no prototypical entrepreneur" many are good at recogni;ing commercial
opportunities" tend to be optimistic" and envision and plan for the future.
2. Wh# $o usinesses !%ose or !ease operatin&? What are the primar# reasons 'h# usinesses
"ai%?
Nearly one4half of businesses that fail do so because of economic factors including
inade<uate sales" insufficient profits" and industry wea$ness. ,any of the economic factors
are directly tied to financing concerns ?e.g." insufficient profits for investors@. +lmost 5A
percent of business failures not citing economic factors cite specifically financial causes li$e
excessive debt and insufficient financial capital. The remaining cited reasons for failure
include a lac$ of business and managerial experience" business conflicts" family problems"
fraud" and disasters. ,any businesses close and fail due to financial trouble which is mostly
related to lac$ of sales and unsatisfactory profits.
3. What are three ma(or sour!es or !ate&ories "or "in$in& entrepreneuria% opportunities?
They areB ?%@ societal changes" ?1@ demographic changes" and ?2@ technological changes
4. What is meant # the )a# oom* &eneration+ an$ ho' has it impa!te$ on the ,.-.
e!onom# an$ so!iet#?
1
The Cbaby boomD generation is the large population of people born between %>58 and %>85.
It has put tremendous strains on the economy including education systems" and will impact
the elderly health care systems in the near future.
5. .ro/i$e a rie" histor# o" the e/o%ution o" the in"ormation so!iet#.
While it is difficult to identify specific dates for major technological innovations and
changes" it seems reasonable to say that the seeds of our information society were planted in
the last half of the %>7As. Transatlantic cable telephone service began. The (oviet #nion
launched (putni$ which provided a seed for the idea of global satellite communications.
Transistors replaced vacuum tubes in computers. /ompilers opened the door to higher level
programming languages. The development of the computer CchipD was underway" and the
forerunner of the Internet was constructed.
6. 0o' $oes the 1nternet net'or2 $i""er "rom a tra$itiona% one3to3man# roa$!ast net'or2?
In a broadcast networ$" there is typically one information CsenderD and many Creceivers.D
The internet provides a broadcast networ$ that is Cmany4to4manyD meaning each connection
in the networ$ can be both a CsenderD and a Creceiver.D Thus" as each new member is added"
the value of the networ$ grows exponentially.
7. What are some o" the t#pes o" "irms that are ne!essar# to ui%$ an$ operate an e""i!ient
man#3to3man# net'or2?
Internet service providers ?I('s@ provide the lin$s whereby individuals and businesses can
communicate with each other and exchange information via the Internet. E4commerce firms
conduct web4based commerce transactions. /lic$ and mortar firms have established Web
sites" and sometimes separate subsidiaries" as a way to using the Internet to leverage their
existing physical assets" intangible assets such as brand loyalties" and distribution systems.
Dot4com firms create and reinvent business opportunities based on existing and evolving
technologies associated with doing business on the Internet.
8. 1$enti"# the "our %a#ers or "irm !ate&ories use$ to measure the si4e o" the 1nternet e!onom#.

Internet Infrastructure ayer" Internet Intermediary ayer" Internet /ommerce ayer" Internet
+pplications Infrastructure ayer
5. What is e3!ommer!e? Des!rie some metri!s that ha/e een re!ent%# $e/e%ope$ in terms o"
e3!ommer!e.
E4commerce is conducting web4based commerce transactions over the Internet. +ctivities
include mar$eting and selling online and electronic retailing. + number of Internet4spawned
metrics and terms have been invented to gauge and measure e4commerce activities. 0ne
measure is the number of ChitsD or uni<ue visitors in a specified period. /omputer users who
visit the same site many times in a specified time period are $nown as Ceyeballs.D C&eachD is
the percentage of total Web users in the #.(. who visited a Web site in a given time period.
2
+dditional e4commerce metrics in use are average minutes per visitor per time period and
pages viewed in a specified time period. There is also an increasing focus on Ccost per
additionD which reflects how cost effective a venture is in finding new customers and Cchurn
ratesD that measure how successful a venture is in $eeping its customers.
16. 1$enti"# the se/en prin!ip%es o" entrepreneuria% "inan!e.
The seven principles areB
?%@ &eal" human" and financial capital must be rented from owners
?1@ &is$ and expected reward go hand in hand
?2@ While accounting is the language of business" cash is the currency
?5@ New venture financing involves search" negotiation" and privacy
?7@ + venture!s financial objective is to increase value
?8@ It is dangerous to assume that people act against their own self4interests
?:@ 6enture character and reputation can be assets or liabilities
11. What is the "inan!ia% &oa% o" the entrepreneuria% /enture? A%so+ 'hat are the ma(or
!omponents "or estimatin& /a%ue?
The venture!s financial goal is to maximi;e the value of the venture to its owner?s@. The
major components of estimating value are projected free cash flow ?cash generated in a
specified time period that exceeds funds needed to operate" pay creditors" and invest in the
assets needed to grow the venture@ and its ris$ ?including the timing and reali;ed amount@.
12. Brie"%# $is!uss the %i2e%# importan!e o" an entrepreneur7s !hara!ter an$ reputation on the
su!!ess o" a /enture. What ro%e $oes so!ia% responsii%it# p%an in the operation o" an
entrepreneuria% /enture.
+ survey of successful entrepreneur is by Timmons and (tevenson indicated that a majority
felt that having high ethical standards was the most important factor in the long4term success
of their ventures. Ta$ing the time and money to invest in the venture!s character will help
ensure that it is an asset rather than a liability.

,any entrepreneurial ventures provide great societal benefit through their introduction of
new products and services. They also foster competition in existing mar$ets providing more
economically attractive prices for existing products and services. In many cases an
entrepreneurial venture!s social contribution is reflected in its commercial success. The two
need not be mutually exclusive.
13. From an a&en!# re%ationship stan$point+ $es!rie the possi%e t#pes o" pro%ems or !on"%i!ts
o" interest that !ou%$ inhiit attemptin& to ma8imi4e a /enture7s /a%ue.
+gency relationships arise when CprincipalsD hire CagentsD to perform specified activities or
services. .usinesses are involved in two primary agency relationshipsB ?%@ owner4manager
conflicts" and ?1@ manager4debtholder conflicts. The owner4manager agency problem exists
when managers have personal goals that compete with maximi;ing the value of the venture.
5
The manager4debtholder conflict exists when debtholders ma$e loans to firms but give
responsibility to managers for deciding on the firm!s ris$ of failure or ban$ruptcy. When
loans are initially made" interest rates reflect the then current ris$iness of the firm.
(ubse<uently" managers may" on behalf of the owners" ma$e the firm ris$ier for the benefit of
owners at the expense of debtholders.
14. What is entrepreneuria% "inan!e an$ 'hat are the responsii%ities o" the "inan!ia% mana&er o"
an entrepreneuria% /enture?
Entrepreneurial finance is the application and adaptation of financial tools and techni<ues to
the planning" funding" operations" and valuation of an entrepreneurial venture. The practice
of financial management in entrepreneurial finance involves record $eeping" financial
planning" the management of operations and assets" and the ac<uiring of new assets and the
financing of those assets necessary to grow the venture over its lifetime.
15. What are the "i/e sta&es in the %i"e3!#!%e o" a su!!ess"u% /enture?
They areB ?%@ Development (tage" ?1@ (tartup (tage" ?2@ (urvival (tage" ?5@ &apid49rowth
(tage" and ?7@ ,aturity (tage
16. 9e' /entures are su(e!t to perio$i! introspe!tion on 'hether the# shou%$ !ontinue or
aan$on. E8p%ain the t#pes o" in"ormation #ou 'ou%$ e8pe!t to &ather an$ ho' it 'ou%$ e
use$ in ea!h sta&e to ai$ an entrepreneur7s approa!h to the /enture7s "uture.
Types of information to be gathered would be income statements" balance sheets" cash flow
statements" general economic conditions" and product mar$et conditions. These would all be
stac$ed up against original projections to determine the feasibility of achieving the ventures
goals.
17. 1$enti"# the t#pes o" "inan!in& that t#pi!a%%# !oin!i$e 'ith ea!h sta&e o" a su!!ess"u% /enture7s
%i"e !#!%e.
Development (tage E (eed *inancing
(tartup (tage E (tartup *inancing
(urvival (tage E *irst4&ound *inancing
&apid 9rowth (tage E (econd4&ound" ,e;;anine and i<uidity4(tage *inancing
,aturity (tage E 0btaining ban$ loans" issuing bonds and issuing stoc$s
18. 1$enti"# the ma(or sour!es+ as 'e%% as the p%a#ers+ asso!iate$ 'ith ea!h t#pe o" "inan!in& "or
ea!h %i"e !#!%e sta&e.
Development (tage E Entrepreneur!s assets" family and friends
(tartup (tage E Entrepreneur!s assets" family" friends" business angels" venture capitalists
(urvival (tage E .usiness operations" venture capitalists" suppliers" customers" government
assistance programs" and commercial ban$s
7
&apid49rowth (tage E .usiness operations" suppliers" customers" commercial ban$s" and
investment ban$ers
,aturity (tage E .usiness operations" commercial ban$s and investment ban$ers
15. Des!rie the %i"e !#!%e approa!h "or tea!hin& entrepreneuria% "inan!e.
The life cycle approach to entrepreneurial finance considers major operating and financial
decisions faced by entrepreneurs as they manage their ventures during the five life cycle
stages that were previously identified. (ee *igure %.2.
INTERNET ACTIVITIES
1. We3sur"in& e8er!ise: De/e%op #our o'n %ist o" the "i/e most important so!ieta% or e!onomi!
tren$s !urrent%# shapin& our so!iet# an$ pro/i$in& ma(or usiness opportunities. ,se the
Wor%$ Wi$e We to &enerate potentia% /enture i$eas re%ate$ to the tren$s an$ to &ather
!ommentar# an$ statisti!s on them.
(tudents can be directed to do generic web searches on CmegatrendsD or CdemographicsD or
Cemerging technologiesD or similar terms to start their process of building their own list of
five societal or economic trends. The instructor can draw on personal experiences" recent
impressions from the Wall (treet Fournal and .usiness Wee$ to supplement any discussion
of the students! lists.
2. Determinin& se/era% )resour!es* a/ai%a%e "rom the -ma%% Business A$ministration "or
entrepreneurs that mi&ht e use"u% in startin&+ "inan!in&+ an$ mana&in& an entrepreneuria%
/enture. ;he -BA We site in http:<<'''.sa.&o/<a$/o< "or in"ormation re%atin& to re!ent
annua% numers o" emp%o#er "irm irths an$ the importan!e o" sma%% usinesses to the ,.-.
e!onom#.
The Instructor can use the provided lin$ to update the textboo$!s data on the number of
employer firm births and the impact of small businesses on the #.(. economy.
EXERCISES/PROBLEMS AND ANSWERS
1. ;he "o%%o'in& /entures are at $i""erent sta&es in their %i"e !#!%es. 1$enti"# the %i2e%# sta&e
"or ea!h /enture an$ $es!rie the t#pe o" "inan!in& ea!h /enture is %i2e%# to e see2in& an$
i$enti"# potentia% sour!es "or that "inan!in&.
A. .hi% =oun&+ "oun$er o" .e$a% .ushers+ has an i$ea "or a pe$a% rep%a!ement "or
!hi%$ren7s i!#!%es. ;he .e$a% .usher 'i%% rep%a!e e8istin& i!#!%e pe$a%s 'ith an eas#
re%ease stirrup to he%p sma%%er !hi%$ren ho%$ their "eet on the pe$a%s. ;he .e$a% .usher
'i%% a%so &%o' in the $ar2 an$ 'i%% pro/i$e a musi!a% soun$ as the i!#!%e is pe$a%e$.
.hi% is see2in& some "inan!ia% he%p in $e/e%opin& 'or2in& protot#pes.
8
(ince the venture is still in the idea stage and searching for prototype capital" the
venture would be classified in the development stage. While in this stage" the venture
will be ma$ing efforts to obtain seed financing" which typically comes from the
entrepreneur!s assets or from family and friends.
B. .eta% .ro/i$ers is a "irm that is tr#in& to mo$e% the ,.-. "%ora% in$ustr# a"ter its
European !ounterparts. European "%o'er mar2ets ten$ to ha/e %ar&er se%e!tions at
%o'er pri!es. >e/enues starte$ at ?1 mi%%ion %ast #ear 'hen the "irst )me&a* .eta%
.ro/i$ers "%ora% out%et 'as opene$. >e/enues are e8pe!te$ to e ?3 mi%%ion this #ear
an$ ?15 mi%%ion ne8t #ear a"ter t'o a$$itiona% stores are opene$.
(ince the venture has already established si;able revenue and is in the process of
growing its venture by opening new stores" the firm has just entered the rapid growth
stage.
2. ;he "o%%o'in& /entures ha/e supp%ie$ in"ormation on ho' the# are ein& "inan!e$. @in2
the t#pe an$ sour!es o" "inan!in& to 'here ea!h /enture is %i2e%# to e in its %i"e !#!%e.
A. Aoi!e >i/er pro/i$es me$ia3on3$eman$ ser/i!es /ia the 1nternet. Aoi!e >i/er
raise$ ?566+666 o" "oun$er7s !apita% in Apri% 2665 an$ )see$* "inan!in& o" ?1 mi%%ion in
-eptemer 2665 "rom the -entina2 Fun$. ;he "irm is !urrent%# see2in& ?6 mi%%ion "or a
&ro'th roun$ o" "inan!in&.
6oice &iver received development funds in the form of founders! capital and seed
financing. It is currently see$ing first round financing at the startup stage.
B. E%e!troni! .u%ishin& raise$ ?266+666 "rom three pri/ate in/estors an$ another
?266+666 "rom -BF;@E9D 0o%$in&s. ;he "inan!ia% !apita% is to e use$ to !omp%ete
so"t'are $e/e%opment o" e3mai% $e%i/er# an$ sus!ription mana&ement ser/i!es.
Electronic 'ublishing is still in the development stage. It has raised funds from angels
and an early stage venture capital firm.
3. 1$enti"# a su!!ess"u% entrepreneuria% /enture that has een in usiness at %east three
#ears. ,se histori!a% re/enues in"ormation to e8amine ho' this parti!u%ar /enture mo/e$
throu&h its %i"e !#!%e sta&es. Determine the %en&th o" the $e/e%opment sta&e+ the startup
sta&e+ an$ so "orth.
The Instructor might choose to use the capstone case C/oral (ystemsD at the end of the
textboo$ as an example.
4. For the entrepreneuria% /enture i$enti"ie$ in .ro%em 3+ $etermine the "inan!in& sour!es
use$ $urin& the /arious sta&es o" the /enture7s %i"e !#!%e.
The Instructor might choose to use the capstone case C/oral (ystemsD at the end of the
textboo$ as an example.
:
5. For the entrepreneuria% /enture i$enti"ie$ in .ro%em 3+ i$enti"# the /enture7s eCuit# o'ners
an$ ho' shares ha/e een $istriute$ amon& the o'ners. What portion o" o'nership has
een a%%o!ate$ to mana&ement team memers? What+ i" an#+ a&en!# !on"%i!ts !an #ou
i$enti"#?
The Instructor might choose to use the capstone case C/oral (ystemsD at the end of the
textboo$ as an example.
6. Explain how you would choose between the following situations. Develop your answers
from the perspective of the principles of entrepreneurial finance presented earlier in the
chapter. 3ou may develop your answers with or without ma$ing actual calculations.
A. =ou ha/e ?1+666 to in/est "or one #ear Dthis 'ou%$ e a %u8ur# "or most entrepreneursE.
=ou !an a 4F interest rate "or one #ear at the ;hir$ First an2 or a 5F interest rate at
the First Fourth an2. Whi!h sa/in&s a!!ount in/estment 'ou%$ #ou !hoose an$ 'h#?
Third *irst ban$B G%"AAA x %.A5 H G%"A5A
*irst *ourth ban$B G%"AAA x %.A7 H G%"A7A
The *irst *ourth ban$ loan would be preferred because you would receive G%A more
?G%"A7A versus G%"A5A@ at the end of one year. This example illustrates the principleB
Creal" human" and financial capital must be rented from owners.D The time value of
money is an important component of the rent one pays for using someone else!s
financial capital.

B. A )"rien$* o" #ours 'i%% %en$ #ou ?16+666 "or one #ear i" #ou a&ree to repa# him
?1+666 interest p%us returnin& the ?16+666 in/estment. A se!on$ )"rien$+* has on%#
?5+666 to %en$ to #ou ut 'ants tota% "un$s o" ?5+466 in repa#ment at the en$ o" one
#ear. Whi!h %oan 'ou%$ #ou !hoose an$ 'h#?
*irst friendB G%"AAAIG%A"AAA H %AJ interest rate
(econd friendB G5AAIG7"AAA H =J interest rate
The second friend is offering you a lower interest rate ?=J versus %AJ@ which would
be preferred" other things being e<ual. This example illustrates the principleD real"
human" and financial capital must be rented from owners.D The time value of money is
an important component of the rent one pays for using someone else!s financial capital.
)owever" the dollar amount of financial that is needed also must be considered. *or
example" if you CneedD G%A"AAA then the lower interest rate G7"AAA loan is not a viable
option. The only viable choice might be to borrow G%A"AAA at the %A percent rate of
interest.
C. =ou ha/e the opportunit# to in/est ?3+666 in one o" t'o in/estments. ;he "irst
in/estment 'ou%$ pa# #ou either ?2+766 or ?3+366 at the en$ o" one #ear $epen$in& on
=
the su!!ess o" the /enture. ;he se!on$ in/estment 'ou%$ pa# #ou either ?2+666 or
?4+666 at the en$ o" one #ear $epen$in& on the su!!ess o" the /enture. Whi!h
in/estment 'ou%$ #ou !hoose an$ 'h#? 9o'+ 'ou%$ #our ans'er !han&e i" #our
in/estment 'ere on%# ?1?
ow &esult )igh &esult Expected 6alue
*irst investmentB G1":AA G2"2AA ?G1":AA K G2"2AA@I1 H G2"AAA
(econd investmentB G1"AAA G5"AAA ?G1"AAA K G5"AAA@I1 H G2"AAA
+ second principle of entrepreneurial finance isB Cris$ and expected reward go hand in
hand.D C&is$D is reflected in the dispersion or range of outcomes. Each investment
amount is G2"AAA and the expected return on average is G2"AAA for each investment.
)owever" the second investment is considered to be ris$ier in that you might actually
receive only G1"AAA or two4thirds of your investment at the end of one year. (ince the
investment amounts and expected values are the same" ris$4averse investors would
prefer the first investment because it has less dispersion ris$.
)owever" when investments are very small ?or are perceived to be small by a specific
investor@" some investors might ma$e the ris$ier investment in the ChopeD the highest
return will occur. This is sometimes called the ClotteryD effect in that investors $now
there is a high probability that they will lose all of their investment but they are willing
to underta$e the investment in the hope they will receive the high payoff even those the
odds of doing so are very" very small.
.an$ruptcy or failure situations may also cause the investor ?entrepreneur@ to choose
the ris$ier investment. *or example" let!s assume that you will need G2"7AA in order to
$eep your business afloat. (ince only the ris$ier second investment has the possibility
of paying at least G2"7AA" the second investment might be selected.
D. An outsi$e /enture in/estor is !onsi$erin& in/estin& ?166+666 in either #our ne'
/enture or in another /enture+ or in/est ?56+666 in ea!h /enture. At the en$ o" one
#ear+ the /a%ue o" the /enture mi&ht e either ?6 or ?1+666+666. ;he other /enture is
e8pe!te$ to e 'orth either ?56+666 or ?566+666 at the en$ o" one #ear. Whi!h
in/estment !hoi!e D#ours+ the other /enture+ or ha%"3an$3ha%"E $o #ou thin2 the /enture
in/estor 'ou%$ !hoose to in/est in? Wh#?
ow &esult )igh &esult Expected 6alue
=our /entureB GA G%"AAA"AAA ?GA K G%"AAA"AAA@I1 H G7AA"AAA
0ther ventureB G7A"AAA G7AA"AAA ?G7A"AAA K G7AA"AAA@I1 H G1:7"AAA
)alf4and4halfB G17"AAA G:7A"AAA ?G17"AAA K G:7A"AAA@I1 H G2=:"7AA
#nder the half4and4half alternative" G7A"AAA is invested in each venture. The low result
outcome is G17"AAA ?GA K G17"AAA@ and the high result outcome is G:7A"AAA ?G17A"AAA
K G7AA"AAA@.
In actuality there are two more possible outcomes under the half4and4half alternative.
They areB G17A"AAA ?GA K G17A"AAA@ and G717"AAA ?G17"AAA K G7AA"AAA@. Thus" the
>
more complete half4and4half calculation would beB ?G17"AAA K G17A"AAA K G717"AAA K
G:7>"AAA@I5 H G2=:"7AA.
+ venture investor who is not very ris$ averse might choose your venture to invest in
since there is a possibility of receiving G%"AAA"AAA in return for putting up G%AA"AAA.
0f course" such an investor could lose all of hisIher investment if the low result occurs.
+ more ris$ averse venture investor might choose to invest in only the other venture
where heIshe could lose only G7A"AAA of the G%AA"AAA investment if the low result
occurs with the possibility of receiving a maximum of G7AA"AAA if the high result
possibility occurs.
.y combining the two venture investments in a Cportfolio"D the result is often less
dispersion ris$. In the above example" the lowest amount returned would be G17"AAA
?instead of ;ero for just your venture@. )owever" the highest amount returned also
would be lower at G:7A"AAA ?instead of the possibility of G%"AAA"AAA for your venture@.
The final decision will depend on the venture investor!s willingness to trade off a lower
expected return for less dispersion ris$.

7. Assume that #ou ha/e een 'or2in& on a "irst3&eneration )protot#pe* "or a ne' pro$u!t.
An an&e% in/estor is 'aitin& in the )'in&s* 'antin& to in/est in a se!on$3&eneration mo$e%
or protot#pe. ,n"ortunate%# #ou ha/e run out o" mone# an$ aren7t a%e to "inish the initia%
protot#pe. ;he usiness an&e% has pre/ious%# sai$ that she 'ou%$ )'a%2* i" #ou !annot
pro$u!e a 'or2in& "irst &eneration protot#pe.

A. What 'ou%$ #ou attempt to $o to )sa/e* #our entrepreneuria% /enture?
,any entrepreneurs state that high ethical standards are one of a venture!s most
important assets and are critical to long4term success and value. Ta$ing the time and
money to invest in the venture!s character will help ensure that it is an asset rather than
a liability. ,ost would agree that the proper course of action would be one of being
honest up front. That is" inform the business angel that you are out of money and thus
can!t finish the initial prototype. If this causes the business angel to Cwal$"D so be it.
0f course" the first order of business is to secure necessary financing to complete the
initial prototype.
B. 9o' %et7s assume that the an&e% in/estor 'i%% a$/an!e #ou the "inan!in& nee$e$ "or the
se!on$3&eneration protot#pe ase$ on #our )'or$* that the "irst3&eneration protot#pe
has een !omp%ete$ an$ is 'or2in&? What 'ou%$ #ou $o?
The situation has not changed from the suggested actions noted in 'art +. Inform the
business angel that the initial prototype has not yet been completed because you are out
of money. .eing honest up front is li$ely to be in the best interests of the venture ?and
entrepreneur@ in the long4run. /onfidence and trust in you ?the entrepreneur@ by the
business angel will be in the best interests of a successful wor$ing relationship over
time.
%A
SUPPLEMENTAL EXERCISES/PROBLEMS AND ANSWERS
LNoteB These activities are for readers who have an understanding of financial statements.M
8. .hi% =oun&+ "oun$er o" .e$a% .ushers+ e8pe!ts to spen$ the ne8t one3ha%" #ear $e/e%opin& an$
testin& protot#pes "or a pe$a% rep%a!ement "or !hi%$ren7s i!#!%es. D-ee .art A o" .ro%em 1
"or a $es!ription o" the propose$ pro$u!t.E .hi% anti!ipates pa#in& month%# rent o" ?766 "or
spa!e in a %o!a% 'arehouse 'here the .e$a% .usher pro$u!t 'i%% e $esi&ne$+ $e/e%ope$+ an$
teste$. ,ti%it# e8penses "or po'er an$ heat are estimate$ at ?156 per month. .hi% p%ans to
)$ra' $o'n* a sa%ar# o" ?1+666 per month. Gateria%s nee$e$ to ui%$ an$ test an initia%
protot#pe pro$u!t are e8pe!te$ to !ost ?5+566. 1n a$$ition+ ea!h re$esi&n an$ ne' protot#pe
'i%% reCuire an a$$itiona% ?4+566 in/estment. .hi% anti!ipates that e"ore the "ina% .e$a%
.usher is rea$# "or mar2et at the en$ o" si8 months+ the initia% p%us t'o more protot#pes 'i%%
nee$e$ to e ui%t an$ teste$. Costs asso!iate$ 'ith test mar2etin& the .e$a% .usher are
estimate$ at ?7+666.
A. Determine the amount o" "inan!ia% !apita% that .hi% =oun& 'i%% nee$ $urin& the si83
months it 'i%% ta2e to $e/e%op an$ test mar2et the .e$a% .usher.
,onthly ExpensesB
&ent 8 months x G:AAH G5"1AA
#tilities 8 months x G%7AH G >AA
(alaryN 8 months x G%"AAAH G8"AAA
0ne4Time ExpensesB
0riginal 'rototype G>"7AA
&edesign 'rototypes 1 x G5"7AAH G>"AAA
Test ,ar$eting G:"AAA
Total Expenses ?&e<uired /apital@ G28"8AA
B. What t#pe o" "inan!ia% !apita% is nee$e$ an$ 'hat are the %i2e%# sour!es o" that !apita% "or
.hi% =oun&?
The venture is in the development stage since it is still developing the product via
prototypes. Therefore" it would be searching for seed financing as its source of capital"
which will most li$ely be obtained through the entrepreneur!s assets" family" or friends.
C. What 'ou%$ e #our estimate o" the amount o" "inan!ia% !apita% nee$e$ i" the pro$u!t
$e/e%opment perio$ %aste$ nine months?
The total expenses would be the G28"8AA as in ?+@ plus an additional three months of
expensesB
+dditional ExpensesB
%%
&ent 2 months x G:AAH G1"%AA
#tilities 2 months x G%7AH G 57A
(alary 2 months x G%"AAAH G2"AAA
G7"77A
Total Nine4,onth Expenses ?/apital Needed@B G28"8AA K G7"77A H G5%"17A
D. What compensation arrangements would you recommend as he hires additional members
of the management team-
Typically he would want to provide some base salary to provide normal living expenses
plus an incentive compensation pac$age in options or stoc$ ownership that would be tied
to the venture!s progress and profitability.
5. @et7s assume that .hi% =oun& $oes in$ee$ $e/e%op an$ su!!ess"u%%# mar2et the .e$a%
.usher pro$u!t $is!usse$ in .ro%em 5. .hi%7s /enture 'i%% pur!hase materia%s "or
ma2in& the pro$u!t "rom others+ assem%e the pro$u!ts at the .e$a% .usher /enture7s
"a!i%ities+ an$ hire pro$u!t sa%es representati/es to se%% the .e$a% .ushers throu&h %o!a%
retai% an$ $is!ount stores that se%% !hi%$ren i!#!%es. ;he !osts o" p%asti! pe$a%s an$
e8tensionsH o%ts+ 'ashers+ an$ nutsH re"%e!ti/e materia%H an$ a )mi!ro3!hip* to pro/i$e
the )musi!* 'hen the i!#!%e is pe$a%e$ are e8pe!te$ to e ?2.33 per pair o" .e$a%
.ushers. Assem%# !osts are pro(e!te$ at ?1.56 per pair. -hippin& an$ $e%i/er# !osts are
estimate$ at ?.26 per pair or set an$ .hi% =oun& 'i%% ha/e to pa# !ommissions o" ?.36 per
pair o" pe$a%s so%$ to the sa%es representati/es.
A. What 'i%% it !ost to pro$u!e an$ se%% a pair o" .e$a% .ushers?
#nit /ostsB
,aterials G1.22
+ssembly G%.7A
(hipping GA.1A
/ommission GA.2A
Total #nit /osts G5.22
B. What pri!e 'i%% .hi% =oun& ha/e to !har&e "or a pair o" .e$a% .ushers i" he 'ants a
)mar2up* o" 56 per!ent on ea!h sa%e? 9o'+ 'hat 'ou%$ the retai%ers ha/e to u%timate%#
se%% a pair o" .e$a% .ushers "or i" the#+ in turn+ $esire$ a mar23up e"ore their e8penses
o" 46 per!ent?
'hil 3oung!s sale price to achieve a 7AJ mar$up would need to be G8.7A because
G5.22 x %.7A H G8.5>7 and prices are <uoted in dollars and cents ?not fractions of cents@.
The retailers sale price to ma$e a 5AJ mar$up is ?G8.7A@ x ?%.5A) = G>.%A.
C. 9o' that .e$a% .ushers is up an$ operatin&+ .hi% =oun& "ee%s he shou%$ e pai$ a sa%ar#
o" ?5+666 per month. Bther a$ministrati/e e8penses 'i%% e ?2+566 per month. 0o'
%1
man# units DpairsE o" .e$a% .ushers 'i%% the /enture ha/e to se%% to !o/er a%% operatin&
an$ a$ministrati/e !osts $urin& the "irst #ear o" operation?
#nit contribution before additional expenses H G8.7A E G5.22 H G1.%:
*ixed ExpensesB
(alary %1 months x G7"AAA G8A"AAA
+dministrative %1 months x G1"7AA G2A"AAA
G>A"AAA
#nits needed to be sold to reach brea$evenB
H?*ixed Expenses@I?/ontribution 'er #nit@
H?G>A"AAA@I?G1.%:@
H 5%"5:7 units ?after rounding up to the next highest unit@
To chec$ that this is brea$even" note that
&evenue E 6ariable /ost E *ixed /ost H 'rofit. In this problem" we haveB
5%"5:7 x G8.7A E 5%"5:7 x G5.22 4 G>A"AAA H G.:7. This is the smallest amount of units
that does not result in a loss.
MINI CASE: INTERACT SYSTEMS, INC
Interact (ystems" Inc. has developed software tools that help hotel chains solve application
integration problems. Interact!s +pplication Integration (erver ?+I(@ provides a two4way
interface between central reservations systems ?/&(@ and property management systems ?',(@.
+t least two important trends in the hotel industry are relevant. *irst" hotels are shifting away
from the manual boo$ing of room reservations and electronic boo$ings will continue to increase
as more boo$ings are made over the Internet. (econd" competitive pressures are forcing hotels to
implement yield management programs and to increase customer service. .y integrating the
/&( and ',( through Interact!s +I(" inventories can be better managed" yields improved" and
customer service enhanced.
+ll reservation traffic is routed from the /&( to individual hotel properties. This allows
Interact (ystems to create a database that can be used to trac$ customers and to facilitate
mar$eting programs" such as fre<uent stay or 6I' programs" as a way of increasing customer
satisfaction. Interact forecasts application integration expenditures in the hospitality industry to
exceed G% billion by 1AA:.
9reg Thomas founded Interact (ystems in 1AA% and developed the firm!s middleware
software and hospitality applications. )e has twelve years of systems applications experience
and currently is Interact!s /hief Technology 0fficer. Eric Wests$ow joined Interact in early 1AA5
as 'resident and /E0. 'rior to that time" he wor$ed in sales and mar$eting in the software
industry for more than twenty years.
Interact (ystems! +I( software development which began in 1AA% went through several
design changes in 1AA1. The first product was sold and installed in 1AA2. (ales were only
%2
G7AA"AAA in 1AA5. )owever" now that the firm has dependable mar$et4tested +I( products ready
to be shipped" revenues are expected to reach G1A.= million in 1AA:.
9reg Thomas founded Interact (ystems with G7A"AAA of his own savings plus G7A"AAA
from friends. Two private investors provided an additional G1AA"AAA in 1AA1. In addition" G%
million was obtained from a venture capital firm" Oatile /apital 'artners" in early 1AA5 in
exchange for an e<uity position in Interact. The firm currently is see$ing an additional G7
million to finance sales growth.
A. Aeri"# the t'o important tren$s that are $e/e%opin& in the hote% in$ustr#.
%. )otels are shifting away from the manual boo$ing of room reservations to electronic
boo$ings. This trend will continue to increase as more boo$ings are made over the
Internet.
1. /ompetitive pressures are forcing hotels to implement yield management programs and
to increase customer service.
B. Des!rie ho' 1ntera!t -#stems7 A1- so"t'are pro$u!ts are to ene"it the hote% in$ustr# "rom a
pro"itai%it# stan$point.
Interact!s +pplication Integration (erver ?+I(@ provides a two4way interface between central
reservations systems ?/&(@ and property management systems ?',(@. .y integrating the
/&( and ',( through Interact!s +I(" inventories can be better managed" yields improved"
and customer service enhanced.
C. Des!rie ho' 1ntera!t -#stems7 A1- so"t'are is to he%p hote%s impro/e !ustomer satis"a!tion.
+ll reservation traffic is routed from the /&( to individual hotel properties. This allows
Interact (ystems to create a database that can be used to trac$ customers and to facilitate
mar$eting programs" such as fre<uent stay or 6I' programs" as a way of increasing customer
satisfaction.

D. Des!rie the %i"e !#!%e sta&es that 1ntera!t -#stems has pro&resse$ throu&h to $ate.
Interact (ystems! +I( software development which began in 1AA%" went through several
design changes in 1AA1 ?development stage@. The first product was sold and installed in
1AA2 and sales were G7AA"AAA in 1AA5 ?startup stage@. )owever" now that the firm has
dependable mar$et tested +I( products ready to be shipped" revenues are expected to reach
G1A.= million in 1AA: ?survival stage and possibly rapid growth stage@.
E. What t#pes o" /enture "inan!in& ha/e een otaine$+ or are ein& sou&ht+ # 1ntera!t?
(eed *inancingB 9reg Thomas founded Interact (ystems in 1AA% with G7A"AAA of his own
savings plus G7A"AAA from friends. Two private investors provided G1AA"AAA in 1AA1.

(tartup *inancingB G% million was obtained from a venture capital firm" Oatile /apital
'artners" in early 1AA5 in exchange for an e<uity position in Interact.
%5

*irst4&ound *inancingB The firm currently is see$ing an additional G7 million to finance sales
growth.
F. >e%ate ma(or sour!es or p%a#ers 'ith the /enture "inan!in& $es!rie$ in .art E.
,ajor sources or players includeB
266%B Entrepreneur!s assets ?G7A"AAA@ and friends! assets ?G7A"AAA@.
1AA1B Two private investors ?business angels@ provided G1AA"AAA.
1AA5B 6enture capitals ?Oatile /apital 'artners@ provided G% million.
G. What t#pes o" a&en!# pro%ems or !on"%i!ts shou%$ the "oun$in& entrepreneur ha/e
anti!ipate$?
+gency relationships arise when principals hire agents to perform specified activities or
services. .usinesses are involved in two potentially conflicting relationshipsB ?%@ owner4
manager conflicts and ?1@ manager4debtholder conflicts. +t this time" the founding
entrepreneur" 9reg Thomas" does not have to worry about manager4debtholder conflicts. )e"
or the other e<uity investors" could possibly have a possible owner4manager conflict with
Eric Wests$ow who joined Interact in 1AA5 as president and /E0. 9reg Thomas also could
have possible conflicts with some or all three groups of investors ?friends" business angels"
and venture capitalists@ if they believe he is not managing the venture in their best interests as
investors.

0. What+ i" an#thin&+ shou%$ the "oun$in& entrepreneur ha/e $one in anti!ipation o" a&en!#
!on"%i!ts?
In order to minimi;e a possible owner4manager conflict" the president and /E0" Eric$
Wests$ow" when hired in 1AA5 should have been given an e<uity sta$e in Interact so as to
align his personal goals with the financial goal of maximi;ing the value of the venture.
1. Assumin& the /enture su!!ee$s+ 'hat are the potentia% a$/anta&es to other sta2eho%$ers
D!ustomers+ emp%o#ees+ an$ so!iet# more roa$%#E?
The goal of maximi;ing the entrepreneurial venture!s value is not inconsistent with ethical
behavior in business practices. +ctions by entrepreneurs to increase the value of their
ventures also can be consistent with the good of society. /ustomers benefit from the
development of new ideas" products" and services. Employees benefit through stable
employment" salary increases" and possibly from increased insurance" medical" and
retirement benefits. (ociety benefits from higher employment levels and higher gross
national product" as well as possibly through charitable contributions and other forms of
venture philanthropy.
I. 1" interna% sa%es &ro'th pro(e!tions are re/ise$ $o'n'ar$ a"ter the !urrent "inan!in& roun$+
'hat+ i" an#+ $is!%osure to sta2eho%$ers Din/estors+ emp%o#ees+ !ustomers+ et!.E shou%$ o!!ur?
Wh#?
%7
The entrepreneur4manager has the responsibility to inform investors in a timely and
transparent manner about changing conditions or other factors ?such as lower sales growth
projections@ that will lead to lower valuations. 0ther sta$eholders should also be informed in
a timely fashion if and when they may be affected. *or example" if slower sales growth is
expected to result in layoffs or fewer wor$ing hours" it is important to notify affected
employees in a timely fashion. /ustomers should also be notified in a timely manner if and
when product or service support is li$ely to be affected from a slow down in sales growth.
%8