Entrepreneurial Finance Is Different

1
Entrepreneurial Finance Is Different

• The domain of financial decision-making, in
  general, is resource allocation
• Investment decisions
• Financing decisions
• The domain of entrepreneurial finance is resource
  allocation in small and/or entrepreneurial
  entities or new ventures

2
Definitions

• Small Business
• on-going, lifestyle firm
• 95 of all small businesses
• Small Business Administration (SBA)
• Does not dominate its industry, capital is owned
  by a few individuals
• Defined further by number of employees or sales
  level

Osteryoung, Jerome S., Derek L. Newman, Leslie
George Davies, Small Firm Finance, an
Entrepreneurial Analysis, Dryden Press,1997, p.
6-7 Petty, W. J. and W.D. Bygrave, What Does
Finance Have to Say to the Entrepreneur, Journal
of Small Business Finance, 1993
3
Definitions , continued

• New Venture
• less than 5 years old
• 5 of all small businesses

4
Definitions, continued

• Entrepreneurial Person
• French, 1700s an undertaker, a bearer of risk
• J.B. Say, French economist, early 1800s shifter
  of resources from low to high productivity
• Frank Knight, 1921 manager of uncertainty
• Joseph Schumpeter, 1934 seeker of opportunities
  to innovate
• Peter Drucker, 1985 one who creates something
  new or different, who changes or transmutes values

5

• How is Entrepreneurial Finance Different from the
  Corporate Finance of FIN301?

6
Key DifferencesSeparation of Investment and
Financing Decision

• In Corporate
• Financing decisions are often made after
  investment decisions
• Financing decisions often made independently of
  wishes of firm owners
• Money raised is allocated among many projects
• OPPOSITE IS TRUE FOR MOST
• ENTREPRENEURIAL ENTITIES

7
Entrepreneur is the ultimate manager

• 87 have fewer than 20 employees
• Must handle strategy decisions in finance,
  marketing, accounting, employee relations,
  production
• More than 50 fail within 5 years

• Data source Adelman, Philip J., and Alan Marks,
  Entrepreneurial Finance for Small Business,
  Prentice-Hall, 2001, p. xiii

8
Key DifferencesNon-diversification of Risk

• Diversification More Difficult
• Owner often cannot diversify away from the firm
  too much personal assets tied into the firm
• Firm may have only a few projects, so risk of
  each cannot be diversified successfully

9
Key DifferencesManagerial Involvement by
Outsiders

• Corporate investors are passive
• get to vote for board members
• get to vote on acquisition offers
• Entrepreneurial entity investors are active
• protect their own investments by staying
  knowledgeable about the firm
• act as advisors to the firm
• provide safety net
• recommend professional service providers

10
Key DifferencesNecessity to Sell the Idea to
Outsiders

• Corporations use signaling to surreptitiously
  give information to the market to entice new
  investors
• dividend decisions, stock issues or repurchases,
  pre-announcement earnings statements
• Entrepreneurs have to take potential investors
  into their confidence
• no hidden agendas

11
Key DifferencesIncentive and Contract Issues

• Corporate entityalign interests of management
  with interests of owners
• managerial stock options and performance bonuses
• debt covenants pit creditors against management
  and owners
• Entrepreneurial entityowner IS the manager
• outside investors will demand protective
  contracts and active managerial role
• owners will want to maintain control of the
  firms equity
• More flexibility for mutually beneficial contracts

12
Importance of self-interest

• Owner goals usually a mix financial and
  non-financial

13
Key DifferencesReal Options Analysis

• Most investing involves a process of acquiring,
  retaining, exercising, and abandoning options
• Option value is a function of uncertainty
  surrounding investment in the underlying
  assetsee list, text p. 20-21
• In corporate setting, much less uncertainty
  because of diversification, hence less attention
• In entrepreneurial setting, maybe every decision
  concerns a real option valuesee examples, text
  p. 19-20

• Smith, Janet K., and Richard L. Smith,
  Entrepreneurial Finance, John Wiley and Sons,
  2000, p. 10.

14
Preeminence of cash

• Stock of cash needed
• To pay for goods and services
• To pay employees and owner
• To pay taxes
• Flow of cash needed
• To replenish cash balance when the things above
  happen
• To make new investments
• To support growth

15
Key DifferencesExit Strategies Needed

• Corporate Entity Owners
• investors have market liquidity
• can sell out whenever they choose
• Entrepreneurial Entity Owners
• no liquidity to sell out
• have to create liquidity events

16
Key DifferencesFocus on Entrepreneur as Ultimate
Investor

• Corporate setting
• management is the agent of the multitude of
  owners
• maximize shareholder value refers to market
  value of the assets and earnings of the firm
• Entrepreneurial setting
• management IS the owner
• maximize shareholder value may require many
  different dimensions to be measured

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ASK the Right Questions!

• Tools of finance help you identify the right
  questions to ask
• Tools of finance help narrow down the number of
  alternatives that must be evaluated
• Tools of finance provide input to the decision
  matrix

18
References

• Adelman, Philip J., and Alan Marks,
  Entrepreneurial Finance for Small Business,
  Prentice-Hall, 2001
• Osteryoung, Jerome S., Derek L. Newman, Leslie
  George Davies, Small Firm Finance, An
  Entrepreneurial Analysis, Dryden Press,1997
• Petty, W. J. and W.D. Bygrave, What Does Finance
  Have to Say to the Entrepreneur, Journal of
  Small Business Finance, 1993
• Smith, Janet K., and Richard L. Smith,
  Entrepreneurial Finance, John Wiley and Sons, 2000