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Launching New Ventures An Entrepreneurial Approach PDF
Launching New Ventures An Entrepreneurial Approach PDF
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LAUNCHING NEW VENTURES
An Entrepreneurial Approach
Kathleen Allen
University of Southern California
Neither the author nor the publisher of this book is engaged in rendering, by the sale of this
book, legal, accounting or other professional services. The reader is encouraged to employ the
services of a competent professional in such matters.
Index 463
List of Figures
Figure 1.1: Should You Start a Business? 9
Figure 1.2: The New Venture Process 11
Figure 1.3: Why Is Entrepreneurship So Important Today? 16
Figure 2.1: Generating Business Ideas 28
Figure 2.2: Feasibility Study Outline 33
Figure 2.3: Business Plan Outline 38
Figure 4.1: The Entrepreneurs Team 63
Figure 4.2: The 20-Point Test for Independent Contractors 72
Figure 4.3: The Virtual Entrepreneurial Company 72
Figure 5.1: Manufacturing Industrial Classifications 92
Figure 5.2: Categories of Data for Industrial Analysis 93
Figure 5.3: Sources of Field Data for Industry Analysis 94
Figure 6.1: Steps to Market Research 103
Figure 6.2: Sample Demographics of the Target Market 104
Figure 6.3: Market Analysis 111
Figure 7.1: Channels of Distribution 116
Figure 7.2: Industrial Channels of Distribution 119
Figure 7.3: The Value Chain 121
Figure 7.4: Channels of Distribution 123
Figure 8.1: Comparative Legal Structures 136
Figure 9.1: Regulations that Affect Business 150
Figure 11.1 The Product Development Cycle 198
Figure 11.2 The House of Quality 203
Figure 11.3 New Product Checklist 204
Table of Contents xv
List of Profiles
Profile 1.1: Turning Failure into Success 7
Profile 2.1: Making Creativity Work 24
Profile 2.2: A Creative Way to Generate Ideas 26
Profile 3.1: Making Pigs of Themselves: Inventors Turned Entrepreneurs 45
Profile 3.2: The Importance of Proprietary Rights 46
Profile 6.1: The Importance of Satisfying Customer Needs 102
Profile 6.2: The WaterBabies Prototype 110
Profile 7.1: CALYX & COROLLA Innovation in Distribution 120
Profile 9.1: Sub Pop Learns the Hard Way 152
xvi Table of Contents
Entrepreneurship is not about money, and its not just about starting businesses.
At the personal level it’s about passion—doing what you feel passionate about.
Talk to most of the truly successful entrepreneurs in this world, you will prob¬
ably find that the common denominator is that they are doing something they
really love. It has often been written that if you do what you love, money, and
success will follow. As trite as that phrase has become, it does appear to be true.
The logic makes sense. If you do what you love, you will probably be very good
at it; consequently you will establish a name for yourself. What you do will be in
demand, and people will pay handsomely for it. Of course, there are no guaran¬
tees that passion alone will bring success, but it is passion that drives the entre¬
preneur to succeed. Entrepreneurship is about passion, about doing what you love.
Every semester students attend my classes searching for the rules they need
to be successful in business. Everyone wants to learn the “keys to success,” but
sadly there are no keys—there are no rules. At least if there are, they change
from week to week and from situation to situation. You see, entrepreneurs
make their own rules. And thank goodness they do, because if they had all
followed the same rules when starting their businesses, we would never have
seen the stunning breakthroughs of the likes of Apple, Gentech, and Silicon
■ Graphics. It’s only what hasn’t been done before that excites the world—that
leap into the unknown that shakes us up and makes us take notice. It is often
said that “imitation is the sincerest form of flattery.” That may be true in public
relations, but it is the kiss of death for entrepreneurs. What worked last week
may not necessarily work this week. One change in any aspect of a business
environment can change the dynamics such that a product that was successful
one month cannot find customers the next. A technology that was “proven” one
year is obsolete the next. That is the excitement and challenge of entrepreneur-
ship today. Entrepreneurship is about innovation and change.
For the dynamic entrepreneur the path to success is not usually the path of
least resistance, for the path of least resistance does not return the most for the
effort. The opportunities that present the greatest challenge also bring the
greatest rewards, and so it is with entrepreneurs. They seek opportunities that
are innovative and show potential for growth. The challenge of turning such an
XVII
xviii Introduction
opportunity into a business is the passion of the entrepreneur. That passion leads
the entrepreneur forward with no thought of failure. Failure does not exist in
their vocabulary. What others judge as failure—a business that didn’t survive, a
product that didn’t find sufficient demand, the inability to secure growth
capital—is but a mere pause on the continual journey to success. For entrepre¬
neurs, success is not measured by how many times they fail but by how many
times they get up and try again. Each pause in their progress prepares them for
the next step ahead. Entrepreneurship is about challenge and persistence.
Often the students who come to my classes from other disciplines—engi¬
neering, cinema, English, international relations—feel intimidated by the fact
that they are sharing the class with business majors. It stems from the belief that
there must be some basic formula for business success, and if there is, business
students will certainly have learned it. Well, business students have learned
formulas, formulas that work fairly well for middle managers in large corpora¬
tions. But the mindset that business schools impose on students is actually the
antithesis of the mindset needed by someone starting a dynamic new venture.
Consequently, many business students come to entrepreneurship with precon¬
ceived notions about what the nature of business is. They have in essence lost
their innocence, their ability to creatively play with possibilities and do some¬
thing they weren’t taught to do. Business majors are starting from perhaps an
even more difficult position than those who are from other fields. They need to
regain some of their innocence by learning to look at everyday objects and
events from a different perspective so they can begin to recognize the opportu¬
nity that is all-round them. Entrepreneurship is about writing new formulas for how
things are done.
Entrepreneurship in the 1990s has taken on a new dimension. A global
economy, the tearing down of trade barriers, and the information superhighway
have created a competitive marketplace the likes of which has not been seen
before. Today large corporations are looking for ways to act small and flexible
so they too can be more competitive in the global marketplace. New ventures
will not succeed in this dynamic environment by doing business the way it has
always been done. Times have changed; circumstances have changed, and that
means the ventures that entrepreneurs create must change as well. Today it is
not enough to build a business around an innovative, quality product or
service—that’s expected. Today to sustain a competitive advantage in a global
marketplace means creating a world-class venture.
A world-class venture is one that is customer-driven, is lean and flexible, and
pursues excellence in all areas of the business. This book was written to help
Introduction xix
New Venture Checklists at the end of each chapter help organize the start-up
process.
Additional Sources of Information are listed at the end of each chapter for more
in-depth reading on the topic at-hand, including on-line resources for market
research.
Issues to Consider, questions at the end of each chapter, focus the thinking of
entrepreneurs and provoke meaningful discussion in the classroom.
Case Studies at the end of each of the seven parts of the book, are designed to
illustrate the key components of the section that precedes them, and include
discussion questions for classroom use.
XX
Features of this Book xxi
An index at the end of the book aids location of key topics, people and
companies covered in the text.
An Instructor’s Manual, featuring lecture outlines, overhead transparency
masters, discussion points for the case studies and end-of-chapter questions, as
well as worksheets and a test bank, is available upon adoption for classroom
use. To request a copy, cg.ll Upstart Publishing at (800) 235-8866.
Acknowledgments
Thanks first of all to my tireless faculty assistant, Nancy Frost, who has since
gone on to establish her career in financial services. Without her research work,
this book would have never been completed on time. Thanks to all my students
in the Entrepreneur Program at the University of Southern California who used
the manuscript in class and made very helpful suggestions. I am grateful to my
wonderful husband who kept me on track and edited every chapter of this
book. I also appreciate the excellent suggestions of my academic reviewers:
Candida Brush, Boston University; Bill Gartner, San Francisco State University;
Keith Cox, University of Houston; and Dewey Johnson, California State
University, Fresno. Candy and Bill also contributed three of their original case
studies to the book. My appreciation to Marianne Szymanski of Toy Tips, Inc.,
Steve Johnson of Simtek, Inc., Patricia Zinkowski of Flight Time International,
and Sandy Gooch of Sandy Gooch Enterprises, Inc. for allowing me to explore
their businesses and their entrepreneurial psyches in-depth for the case studies,
and to Dan Lauer of Tauer Toys for his help with the Waterbabies doll. Thanks
to Jack Savage, my editor, for his sense of humor and patience, and to Spencer,
Jean, Karen, Brad, Nancy, and all the great people at Upstart.
xxn
PART i
Overview
• The importance of entrepreneurship in a volatile world market
• Entrepreneurial characteristics and reasons for wanting to start a business
• The new venture creation process
• Entrepreneurial ventures versus small businesses
• Factors in the entrepreneurial environment that will affect the start-up
• Business trends of the 1990s that affect the search for a business idea
The old adage that the only sure things in life are death and taxes needs to be
updated for the 1990s to include change, for it is clearly evident that change has
become a way of life. Today there are no safe companies, no sure customers, no
secure jobs, and no such thing as an established market share. The global
economy has opened up heretofore unknown opportunities and with it a new
network of suppliers, distributors, and outsourcing resources that will compete
with and for American goods. Electronic highways like Internet have given
virtually anyone instant access to people and information throughout the entire
world, giving entrepreneurs the chance to compete with large companies on a
more level playing field. The price of money in the global marketplace is
changing daily, making it nothing short of a miracle to forecast costs, prices,
and interest rates into anything but the very immediate future. Many of the
3
4 Part 1 • The Entrepreneur and the Entrepreneurial Venture
products and services businesses will offer ten years from now cannot even be
conceived of today. Technology is constantly changing the business of business,
from manufacturing to distribution to customer service.
Tom Peters predicted the dynamic nature of the world today and the conse¬
quent need to redefine “excellence” in business in his prophetic 1987 book
titled Thriving on Chaos. Now more than eight years later, the truth of what he
said is being felt. “...Excellent firms of tomorrow will cherish impermanence—
and thrive on chaos,” or they will not survive. Peters’s study focused on
America’s big companies and demonstrated how failure to adjust to a changing
world threatens to destroy them. Change has not been part of the vocabulary of
many of America’s biggest companies. However, to those who have devoted
their lives and energy to entrepreneurship, the concept of change as a constant
is not entirely new. Uncertainty is the ubiquitous companion of any new
venture. Born into an uncertain environment, start-ups by nature must
Born into an uncer¬ be flexible, able to change in response to changing needs and require¬
tain environment, ments. Joseph Schumpeter, a classical economist who often took off
start-ups by nature that hat when he spoke of entrepreneurs, said the job of the entrepre¬
must be flexible, neur is “creative destruction.” Entrepreneurs disrupt the economic
able to change in equilibrium. Schumpeter’s concept of the entrepreneur does not,
response to however, fit easily into the economic models espoused by the followers
changing needs and of Keynes, Friedman, and supply-side economists, whose goals are to
requirements. optimize existing resources and arrive at economic equilibrium.
Consequently, they have a difficult time accepting Schumpeters model,
which contends that economic disequilibrium caused by entrepreneurial inno¬
vation is a sign of a healthy economy.
Nevertheless, the volatile world market cannot be ignored, and no one is
better prepared to face the dynamics of the 1990s and beyond than entrepre¬
neurs. Dealing with the new global and technological environment requires a
different vision and a different mindset today than it did even a decade ago.
Where in the past new businesses started with a narrow geographic focus,
purchased equipment and technology to last for the long term, designed prod¬
ucts and services before finding customers to purchase them, and built large
bureaucratic organizations, today the rules have changed. Today these intrepid
risk takers who start their high-growth ventures in this decade have the distinct
advantage of starting with flexible, dynamic organizations poised to respond to
change and to even create change as well. Certainly it is easier to start a venture
with the expectation of change than to attempt to downsize a monolithic giant
and re-educate employees to new ways of doing things.
Chapter 1 • Understanding World-Class Entrepreneurship 5
This then is the legacy of big corporations of the past—they have effectively
carved a new market niche for the dynamic entrepreneur of the future.
What Is an Entrepreneur?
The term entrepreneur has existed in our vocabulary for more than 250 years.
The United States was founded on the principle of free enterprise, which
encouraged entrepreneurs to freely assume the risk of developing businesses
that would make the economy strong. However, it wasn’t until the 1980s that
entrepreneur came into popular use in the United States and an almost folkloric
aura began to grow around men and women who started rapidly growing busi¬
nesses. These formerly quiet, low-profile people suddenly became legends in
their own time with the appeal and publicity typically accorded movie stars or
rock musicians. Extraordinarily creative and enterprising business people like
Bill Gates, who created Microsoft, Anita Roddick, who founded The Body Shop,
and Steven Jobs and Steven Wozmak, who started Apple Computers, suddenly
6 Part 1 • The Entrepreneur and the Entrepreneurial Venture
found that the whole world was interested not only in their businesses but in
their personal lives as well.
At the same time, academic researchers sought to define what made these
entrepreneurs so successful and to look at the new venture process as something
quite different from starting a small business or managing an established
company. In the early stages, researchers, with little success, attempted to identify
psychological characteristics or traits associated with entrepreneurs to differen¬
tiate them from managers. What they discovered was that many of the character¬
istics normally encountered in entrepreneurs also exist in some managers.
What are the characteristics typically found in entrepreneurs? Research
points to the entrepreneur’s ability to take calculated risks and to have an
achievement orientation, a sense of independence, an internal locus of control
and a tolerance for ambiguity.
Risk-Taking
The consensus of the research on risk-taking in entrepreneurs is that they are
not big risk-takers.1 They are, instead, calculated risk-takers who define the
risks inherent in any venture and attempt to minimize them while remaining
focused on opportunity. In fact, the real risk for the entrepreneur seems to
come from the fear of failure and the potential for damage to his or her reputa¬
tion. Consequently, it is in the best interest of the entrepreneur to analyze a
potential opportunity to reduce the risk associated with it.
A Sense of Independence
Entrepreneurs also seem to purposely seek independence—to be their own boss
in situations that allow them to assume a higher degree of personal responsibility
'Brockhaus, R.H. (1980). “Risk-laking Propensity of Entrepreneurs." Academy of Management Journal, 23,
509-520; Drucker, P.E (1985). Innovation and Entrepreneurship. New York: Harper and Row.
2McClelland, D.C. (1965). “N-achievement and Entrepreneurship: A Longitudinal Study.” Journal of
Personality and Social Psychology, 1, 389-392.
Chapter 1 • Understanding World-Class Entrepreneurship 7
PROFILE 1.1
for their decisions and achievements. This need for independence, however,
often makes it difficult for entrepreneurs to delegate authority to others.
3Greenberger & Sexton, D.L. (1988). “An Interactive Model of New Venture Initiation." Journal of Small
Business Management, 1-7.
8 Part 1 • The Entrepreneur and the Entrepreneurial Venture
4Gartner, WB. (1988). “Who is an Entrepreneur is the Wrong Question.” American Journal of Small Business,
11-31; Vesper, K.H. (1990). New Venture Strategies. Englewood Cliffs, NJ: Prentice Hall.
Chapter 1 • Understanding World-Class Entrepreneurship 9
met someone who gave him a contact with a Fortune 500 company. That
contact led to his starting Interfleet, Inc., now a successful business that services
the fleet vehicles of the Fortune 500 companies nationwide and consults to the
major auto makers.
No quiz can really tell you if you are the kind of person who should start a business. This little quiz
and its discussion at the end of the chapter will simply help you learn if you have some of the
typical characteristics found in many entrepreneurs. Answer the following questions without
spending a lot of time thinking about them. You are looking for a spontaneous reaction. There are
no right or wrong answers, but when you have finished, look at the end of the chapter to see what
research has found to be the typical responses made by entrepreneurs.
1. Are you
a. married c. widowed
b. single d. divorced
2. Are you
a. a man b. a woman
Others start businesses for very personal reasons. This was the case for Sandy
Gooch, who suffered from severe reactions to artificial additives in food. They
actually became toxins in her body. Learning that many others also suffered in
this way, she decided to become an expert on natural foods, and in 1977 she
founded her first Mrs. Goochs Natural Foods Market in the Los Angeles area.
By 1993 the company had seven stores, was doing about $80 million in annual
revenues, and had over 800 employees.
Still others simply want to own their own businesses. After World War II,
Masaru Ibuka started a company in a rented room of a bombed-out department
store in Tokyo with $1,600 of his own savings and seven employees, but no
idea as to what the business was. After weeks of brainstorming, they decided to
produce a rice cooker, which, unfortunately, didn’t work the way it was
supposed to. However, Ibuka and his team persisted in spite of failure, and they
are known today as Sony Corporation.
Whatever the reason, most entrepreneurs have the intense desire—the
passion—to start a business long before they know what that business will be.
It is that internal need to be independent and create something, “the burning
gut,” that drives entrepreneurs.
Entrepreneur Myths
Before leaving the topic of what defines entrepreneurs, some of the myths that
have surrounded them over the years need to be dispelled.
Entrepreneurs are horn, not made. Entrepreneurs come in all ages and back¬
grounds. Even though research has demonstrated links to role models of
previous generations within a family, the entrepreneurial drive has not been
shown to be hereditary. Almost anyone who has a vision for a new venture,
tremendous drive, and the willingness to risk failure can acquire the technical
skills to be an entrepreneur through education and experience. Entrepreneurial
drive, however, is one thing that must exist naturally in a person. It cannot be
learned.
Entrepreneurs are gamblers. Entrepreneurs are not gamblers! In fact, as stated
previously, entrepreneurs attempt to minimize the risk of an undertaking by
calculating the consequences of their decisions before they implement them.
For this reason, they conduct feasibility studies to determine an ideas potential
viability with some degree of accuracy before they expend a lot of time and
money on it.
Chapter 1 • Understanding World-Class Entrepreneurship 11
Money is the most important component of the start-up package. Researchers and
venture capitalists will tell you that while sufficiently capitalizing the new busi¬
ness is important to its survivability, the most important component is the
founding team. An excellent founding team can take an undercapitalized new
venture and make it a commercial success. On the other hand, a mediocre team
may have a difficult time making even a- sufficiently capitalized venture a
success. What constitutes an excellent management team is discussed in
Chapter 4.
Entrepreneurs are motivated solely by money. As you saw from the stories of
Talli Counsel, Ruth Owades, Sandy Gooch, and Masaru Ibuka, entrepreneurs
are motivated to start businesses for a variety of reasons, many of which are
personal and have nothing whatsoever to do with money. For people like Sandy
Gooch, for example, money is a means to an end, providing natural foods that
people can eat without worrying about toxic consequences.
1. Type of Environment
• Uncertain
• Complex
• Volatile
2. Resource Availability
• Land
• Skilled labor
• Capital for start-up
3. Mechanisms for Realizing Value
• Favorable markets for new ventures
• Access to distribution channels
• Favorable tax structure
• Favorable governmental policies
4. Incentives for New Venture Creation
• Enterprise zones
• Small Business Administration grants
• Favorable capital gains laws
All these environmental characteristics affect the new venture concept that
the entrepreneur develops and will vary depending on the specific nature of the
industry in which the new business will operate. For example, entrepreneurs
who start high-technology businesses, such as computer and electronics busi¬
nesses, face an environment at once highly dynamic (^changing) and very
complex. In contrast, entrepreneurs who start restaurants face a more techno¬
logically stable and less complex environment. The more of these components
that are present in their favorable form in the environment when the entrepre¬
neur starts the business, the better the chance the new venture will grow and
become successful.
While the details of the list of environmental variables will be discussed in
their appropriate chapters, in general, the environment for starting new
ventures in the 1990s and beyond is characterized by:
Chapter 1 • Understanding World-Class Entrepreneurship 13
1. Global competition
2. Faster product development times
3. Rapidly changing technolog}7
4. Higher expected standards for quality and service
5. The need for strategic alliances
6. A decline in traditional financing sources
• innovative
• value-creating
• growth-oriented
By the early 1980s, business was in terrible shape. The Fortune 500 saw a
record 27 percent drop in profits.5 Large mills and factories were shutting
down; manufacturing employment was declining; yet, ironically, productivity
remained the same or increased. It was found that new, smaller manufacturers
were still generating jobs—and not only manufacturing jobs, but service jobs as
well. How was this possible? To become competitive, smaller, more flexible,
entrepreneurial manufacturers hired subcontractors who could perform tasks
such as bookkeeping and payroll more efficiently. These service firms developed
to support the needs of the product sector, but they too inspired the creation of
other service firms as well—people who work often need day-care service or
maid service, so even more jobs were created.
With the creation of all these jobs, it is no wonder that the 1980s have been
called the Decade of Entrepreneurship by many, including the dean of
management science, Peter Drucker, who was not alone in asserting that the
United States was rapidly and by necessity becoming an entrepre¬
All these events neurial economy.6
have moved this Responding to this entrepreneurial drive, big business in the 1980s
country in the 1990s found it necessary to downsize and reverse the trend of diversification
toward a period that it had promulgated for so long. If big companies were going to compete
requires the vision, with the dynamic, innovative, smaller firms and fend off the takeover
the resources, and bids so prevalent in the 1980s, they would have to restructure and
the motivation of the reorganize for a new way of doing business. This restructuring and
entrepreneur. reorganizing actually resulted in improved performance, increased
profits, and higher stock prices. It also meant, however, that many jobs
would no longer exist, people would receive fewer benefits, and the only
“secure” jobs left would be found in civil service.
All these events have moved this country in the 1990s toward a period that
requires the vision, the resources, and the motivation of the entrepreneur to
seek new opportunities and create new jobs in a vastly different global environ¬
ment. One measure of the awareness of this entrepreneurial trend is the
increasing number of schools worldwide that now offer entrepreneurship
courses. Today nearly 400 colleges and universities offer at least one course in
entrepreneurship. Community colleges and community-based programs are
also seeking to give aspiring entrepreneurs the tools they need to succeed.
5Case, J. (1992). From the Ground Up. New York: Simon & Schuster.
6Drucker, RF. (1985) Innovation and Entrepreneurship. New York: Harper & Row.
18 Part 1 • The Entrepreneur and the Entrepreneurial Venture
A Global Orientation
The old saying that the world is an increasingly smaller place seems to be true.
Technology has made access to other countries as easy as contacting the busi¬
ness in the next city. Exporting products and services to other countries has
almost become a necessity for a growing business to remain competitive. Today
it is just as likely you will purchase some of your supplies overseas as it is that
you will purchase them domestically. You may even, like Mattel Toy Company,
manufacture in another country.
Career Flexibility
Keeping the same job for 30 or more years is a thing of the past. Today adults
must be prepared for change, and they must constantly update their skills so
when change comes, they can adapt. Roe Hatlen found himself out of a job at
age 40. Fortunately, it was just the jump-start he needed to make the decision
to start his own company. He managed to build the very successful Old
Country Buffet chain of restaurants, offering home-style entrees.
Information is Power
You have no doubt heard the terms information age and information super¬
highway. With the advent of the computer revolution, information is more
readily available and in greater quantity than ever before. In fact, some would
say we are actually suffering from “information overload,” too much information
20 Part 1 • The Entrepreneur and the Entrepreneurial Venture
and too little time to process it all. Today a company’s power—or an individual’s
power for that matter—comes from staying on top of new information. We are
no longer a society that can educate people through age 21 and claim that they
are sufficiently educated. “Life-long learning” is the trend, and on just that
premise Jolme Godfrey founded Odysseum, Inc., an international learning
design company serving Fortune 500 companies.
Women in Business
Today women are starting businesses at a rate five times that of men. Moreover,
women now employ more people than the Fortune 500 worldwide. Why is
this? One reason is that women are no longer comfortable in a big business
culture dominated by men, which often prevents them from reaching the
highest levels of management. Women also start businesses so they can make
the major decisions and create a culture that reflects their different management
style. Emyre Robinson, for example, founded Barrios Technologies, an engi¬
neering contractor to NASA and major space contractors, to meet a need in the
industry but also for the opportunity to create a business culture based on the
nuclear family, where people come first. Her door is open to any employee of
the company, and all are encouraged to participate in its growth process and its
success.
The fact that more women are starting businesses is also important from an
economic standpoint; women now require the services they traditionally
supplied for their husbands: housecleaning, child care, cooking, and so on.
Consequently, some women are starting those very service businesses that help
other women move into economic sectors previously dominated by men. While
it is true that in general women start small businesses in the retail and service
sectors, we are now seeing a significant increase in the number of women who
start high-growth ventures in industries previously dominated by men.
Staying Home
Faith Popcorn, a noted market consultant to Fortune 500 companies, has
observed a trend she calls “cocooning.” Cocooning is simply staying home:
entertaining at home or working from home. What this means to entrepreneurs
is that people are demanding more delivery services for things such as restau¬
rant food, groceries, dry cleaning, and so forth. They want to entertain them¬
selves at home, so they are purchasing more in-home entertainment systems,
renting more videos, and shopping from home via computers.
Chapter 1 • Understanding World-Class Entrepreneurship 21
In the decade of the 1990s and beyond, entrepreneurial skills will be the key
not only to economic independence and success, but literally to survival as
well. The marketplace places a premium on creativity, initiative, independence,
and flexibility, characteristics present in dynamic entrepreneurs. Starting a new
venture is a process that begins long before the business ever opens its doors.
Consequently, this book takes a process approach to starting a world-class
venture. By using the framework of a business plan, it guides the reader
through the process, emphasizing the new “rules” for start-ups in the 1990s and
giving the reader a clear sense of how to create a world-class venture.
□ Determined how the trends for the 1990s will affect your search for a
business idea?
5. Entrepreneurs will need all of these factors. But note that entrepreneurs
believe they make their own luck.
6. Entrepreneurs are moderate risk takers. They calculate risk and take on risks
that have a good probability of producing adequate rewards.
7. Entrepreneurs often report having been fired, probably because they don’t
easily fit into traditional company molds.
8. Most entrepreneurs have started several ventures before age 20.
Recognizing and
Testing Opportunity
Overview
• Creativity exercises to enhance latent creative skills
• Techniques for generating new business ideas
• The issue of success and what it means to you
• A quick test of the business idea to determine if a feasibility study is
warranted
• Overview of the feasibility study and business plan
Recognizing Opportunity
Have you ever wondered where people get those great ideas that turn into
extraordinarily successful businesses? Is the ability to recognize opportunity
something you’re born with? Absolutely not! Certainly some people have an
easier time generating ideas than others, but that’s only because they have better
developed creative and awareness skills. This is good news, because even if you
have never thought of yourself as a creative person, you have the ability to
become one.
What does creativity have to do with entrepreneurship? Very simply,
creativity is a key ingredient to entrepreneurial success. Today’s entrepreneurs
face a very volatile, uncertain environment: a banking industry that is restruc¬
turing and moving away from lending to growing businesses; factories that are
downsizing or closing; local, state, and federal bureaucracies that have burden¬
some regulations; and an economic climate that is challenging at best for
starting and growing new businesses. Sounds grim.
23
24 Part 1 • The Entrepreneur and the Entrepreneurial Venture
But even in the worst of environments—in fact, especially in the worst envi¬
ronments—creative men and women find innovative ways of adapting to the
environment and making it work for them. It is no wonder then that the worst
of times often brings out the best in entrepreneurs. The case of John Wiley and
Alan Ackerman is a good example. (See Profile 2.1.) No matter what the envi¬
ronment throws at entrepreneurs, if they put their creative talents to work, they
can find a way to succeed.
PROFILE 2.1
1. Pick a simple item you have in your home, perhaps a box of granola, and see
how many uses you can find for it. There are at least 30! Remember, don’t
limit your thinking. For example, you could glue the granola to a backing,
spray it with shellac, and use it as jewelry! As silly as this sounds, you will
find that the more you do this exercise with different products, the easier it
gets and the more ideas you are able to generate. Some of them may actually
turn out to be sound business ideas.
2. The next time you say to yourself, “I wish there were a way to...” or “I wish 1
had something that could...” stop yourself and start thinking about how to
get from here to there. This is, by the way, how breakthrough products like
the fax machine were developed. The question that led to the fax machine
was, “Flow can I get a written document to people as quickly as I can phone
them?” For the solution the inventor didn’t limit himself by looking only at
what was obviously possible. Think of all the inventions and services that are
part of life today that wouldn’t be here if the inventors had limited them¬
selves to what was “possible.”
really was no precedent, are created. Even a simple product like Velcro was
inspired by going beyond human boundaries and observing the sticky hook
spine of the common burr in nature.
What sets off the creative process is a very personal thing. How many times
have you come up with an idea while listening to a dry lecture or a boring
sermon? Some people find their best ideas come while they are driving their
car, reading a book, or exercising. Do you get ideas through dreams or in the
shower? If you can identify where and when you seem to get most of your
creative thoughts, you might want, if possible, to do that activity or a similar
one more often and actually write down the ideas you get when you get them.
There are several ways you can use your newfound creativity to generate
some ideas that may lead to an opportunity and help turn you into an
entrepreneur.
PROFILE 2.2
Talk to People—Network
Dr. Naka Mats claims (see Profile 2.2) that networking with people wherever he
goes is a prime source of inspiration for new product ideas. In talking to people
you find out more about their needs, and an unmet need is an opportunity. Talk
to consumers, suppliers, your potential competition; there is something to be
learned from everyone you meet. When you talk to people, don’t just ask one
question, ask several, because it is not likely you will get the information you
need from the response to your first question. Many businesses like Toyota use
this technique with great success to uncover the root cause of problems. After
the first question, they ask at least three more. The technique might look some¬
thing like this:
If you had stopped after the first question, you. would have thought that
merely increasing cash flow by any means would correct the problem. By
continuing to ask questions, you arrived at the root of the problem, lack of
marketing experience, which is something quite different from solving a cash
flow problem. Insufficient cash flow was only a symptom of the real problem:
management deficiency
28 Part 1 • The Entrepreneur and the Entrepreneurial Venture
Read Voraciously
Read newspapers, business magazines, and trade journals from the industry
that interests you. Keep up with current trends in the marketplace, as well as
present and potential governmental policies that may affect your industry.
Remember, an idea can come from anywhere. The wealth of new environmental
businesses was spawned from the relatively recent awareness of what our busi¬
ness and life practices are doing to the world we live in and also from the regu¬
lations that ensued.
List some geographical areas that are not being serviced by a particular product/service.
1. _
2. _
3. _
1. _
2. ____
3. _
List some big or troublesome problems for which the solution could turn into a potential
business.
1. ______
2. _
3. _ _ _
back and a bubble saying “1 trusted you.” Most people send bills to the clients
office. He sent it to the home. Most people send the bill in a business envelope
by regular mail; Thompson sent it in a three-foot package by next day UPS. The
technique was extremely successful and even turned into a small business
because he thought about a problem from a different perspective; he did the
opposite of what everyone else did.
The free enterprise system is based on the profit motive; consequently, profits
are often used by those outside the business—bankers and investors—to
measure venture success. But you also need to consider what success means to
you. How will you know when your business is a success? For some entrepre¬
neurs it’s when they have created a certain number of jobs; for others, like Anita
Roddick and The Body Shop, it’s when she has established successful trade initia¬
tives with underdeveloped countries. Only you can define success for your busi¬
ness, and that definition reflects both your business goals and your lifestyle goals.
By studying the factors that seem to be associated with success, the factors
that contribute to failure also become readily apparent. Research has found that
the primary cause of failure is a poor management team. Most books and
Chapter 2 • Recognizing and Testing Opportunity 31
articles, however, shy away from talking about failure even though failure is an
important ingredient in success. It has been said that failure is just a rest stop
on the way to success. It was that way for Judy Sims who, with her husband,
started a games and educational retail software store that immediately failed.
Drawing on her successful experience with cold calling (making unsolicited
sales calls), she pulled herself up and began selling business software to local
businesses in Dallas. One of her first accounts was Ross Perots Electronic Data
Systems and the rest, as they say, is history. Today her company does over $160
million in sales. The point is that entrepreneurs don’t give up no matter how
many times an idea they have fails. Instead, they look at failure as a source of
opportunity, a wake-up call to listen more carefully to the customer and spend
more time observing what is going on in the marketplace.
1. Talk to some trusted friends and get initial feedback on the idea. But don’t be
discouraged or write off the idea if they tell you it’s crazy. People thought
Fred Smith was crazy when he said he could deliver a package anywhere in
the United States overnight—that is, until he founded Federal Express.
2. Do a quick checklist of the forces working for your idea and the forces
working against it. How does the idea stack up? Are there more forces
working in favor of the idea than against it?
3. Ask yourself three very important questions.
Am I really interested in this business opportunity? If you develop this concept,
it is going to take all the time and energy you can give it, so it’s impor¬
tant that vou like it.
j
Is anyone else interested? You can’t have a business without customers and
you may need investors, so you’d better be sure that others are inter¬
ested in what you have to offer.
Will people actually pay for what I am offering? Often when people hear about
a new product or service they express interest, even excitement, over it.
But what are they willing to pay for it? If they are not willing to pay what
you believe it’s worth, that’s a clue you may need to rethink the idea.
32 Part 1 • The Entrepreneur and the Entrepreneurial Venture
If your business idea can pass these tests, it is time for the next level of inves¬
tigation: the feasibility study. A feasibility study gives you an indication of
whether there is sufficient demand for your product or service. The estimation
of demand is a vital step in deciding if you have a viable business concept, for
there is no business without enough satisfied customers. Once you have
concluded there is adequate demand for the product or service, other issues
such as the operational and financial requirements can be undertaken and a
business plan completed. There is no need to spend considerable time and
effort on those issues if the feasibility study indicates insufficient interest in
your product or service.
Even though the feasibility study is a tool geared primarily toward providing
information to the entrepreneur, it’s often possible to attract outside interest in
your product/service at that point if the results are positive. That interest may
result in some funding to help you complete a comprehensive business plan,
conclude product development, and start the business. The feasibility study may
also assist in attracting quality people to the founding team. As stated in the
introduction, this book has a process organization. It follows the new venture
creation process from its inception through start-up and growth. The feasibility
study and the business plan are part of that process: They, in effect, document
the process for the entrepreneur and others who are interested in the business.
Product/Service Description
The first section of the feasibility study presents a complete description of the
product or service being offered, who the target customer is, the unique aspects
of the product/service, and the benefits to the customer. It is in this section that
the unique features of the product or service will be discussed, as well as possi¬
bilities for additional innovation in products, service, or distribution, called
spin-offs. If the product needs to be designed and built, this section describes
how this will be accomplished. Also note in this section any perceived or actual
environmental impact from your business and how to mitigate it.
Chapter 2 • Recognizing and Testing Opportunity 33
EXECUTIVE SUMMARY
I. PRODUCT/SERVICE DESCRIPTION
Purpose of the Business
Description and Uses
Design and Unique Features
The Primary Customer
Spin-Offs
Environmental Impact
Management Team
The management team, the second section, is a critical factor in determining
the potential feasibility of the new venture. This section of the study discusses
the key members of the founding team and the expertise they bring to the
venture. It also includes an analysis of any expertise that may be missing from
the team and how the entrepreneur intends to alleviate this weakness.
Market Analysis
The market analysis section of the feasibility study is a crucial section because it
presents support for the contention that there is a market and a demand for the
product or service. The section begins with a complete understanding of the
nature of the industry in which the business will operate. Industry knowledge
is enormously important, as it enhances your ability to find a niche market for
the product or service. The analysis in this third section of the study includes
such things as barriers to entry, stage of growth, competitors, market share, and
potential for growth. It also includes information on typical sales patterns and
gross margin percentages for the industry. A good understanding of the
industry facilitates zeroing in on your target market, the primary customer for
the product or service. An in-depth analysis of the customer includes the size,
location, buying habits, and needs of the customer base.
Also accomplished in this section is a comprehensive analysis of both direct
and indirect competitors. A description of emerging competitors and substitute
products demonstrates that the entrepreneur has considered all possible
competition. Finally, this section defines those unique competitive advantages
the business enjoys.
• Investors
• Bankers
• Potential management
• Strategic partners
Each of these groups looks at the business plan from a different perspective.
36 Part 1 • The Entrepreneur and the Entrepreneurial Venture
Investors. Investors review closely both the factors that predict growth and the
qualifications and track record of the management team. This is because they
want to ensure their investment increases in value over the period of time they
are involved in the business and that it is in capable and experienced hands.
They look at the deal structure, that is, what their investment will buy them in
terms of an equity interest and subsequent ownership rights in the company.
They also want to know how they will be able to liquidate their investment at
some future date.
partner may get. They are also interested in the new ventures ability to pay
them for their work. Knowing in advance what these third parties are looking
for will prompt you to address their specific needs in your business plan, facili¬
tating your ability to achieve the goals of the business.
Having considered the value of doing a business plan, it should be noted
that some successful businesses were started without one—Crate and Barrel,
Pizza Hut, and Reebok, to name just a few. It is certainly possible to start a
business without a business plan—people do it every day; however, entre¬
preneurs today operate in an intensely competitive, complex, and
A business plan is dynamic environment. Unless you are starting a very simple, small
one way to compen¬ business or buying an established firm, you will probably not want to
rely solely on your talent or luck. A business plan is one way to
sate for knowledge
compensate for knowledge you don’t have and gives you credibility in
you don't have and
the eyes of others.
gives you credibility
What the business plan is not is a guarantee of success. Businesses
in the eyes of others.
have succeeded in spite of poorly done business plans and have failed
even when the plan was carefully crafted. The business plan is a tool
entrepreneurs use to enhance their chances of success. That is why it is important
that both the entrepreneur and the founding team be fully involved in the
development of the business plan. There are companies that will write your
business plan and do research for you, but you know the business better than
anyone. And you will understand it that much better if you and your team do
the work necessary to put together a business plan.
Figure 2.3, pp. 38-39, presents an outline of the business plan. The first
three sections of the business plan are identical to those in the feasibility study.
Operational Analysis
In this section of the business plan, a detailed description of the product/service
is presented, including engineering specifications and a description of the proto¬
type. The status of product development is addressed, as well as additional steps
that must be taken before having a product that is ready to sell to the public. The
time and cost requirements of completing the development tasks are also
included. In addition, this section contains a discussion of the distribution chan¬
nels used to move the product or service from the producer to the end user. A
major portion of this section is devoted to a description of how the business will
operate, where it will get its raw materials, how they will be manufactured
and/or assembled, and what type and quantity of labor is required to operate the
38 Part 1 • The Entrepreneur and the Entrepreneurial Venture
EXECUTIVE SUMMARY
I. PRODUCT/SERVICE DESCRIPTION
Purpose of the business
Description and uses
Design and unique features
The primary customer
Spin-offs
Environmental impact
Distribution Channels
Status of Development and Related Costs
Current status of development
Tasks to be completed, time and cost to complete
Potential difficulties, resolution
Government approvals
Manufacturing or Operating Requirements and Associated Costs
Manufacturing cycle
Materials requirements
Inventory requirements (also retail/wholesale business)
Production requirements (also retail/wholesale or service)
Labor requirements (all businesses)
Maintenance and quality control requirements (all businesses)
Financial requirements (all businesses)
V. MARKETING PLAN
Pricing
Venture versus competitors
Value chain
Purpose of Marketing Plan
Target market
Unique market niche
Business identity
Marketing Tools
Advertising & promotion
Media Plan
Uses and costs of specific marketing tools
Marketing Budget
Individual costs and total costs as a percentage of sales
business. The outline of the business plan notes where businesses other than
manufacturing have the same information requirements as manufacturing.
Financial Plan
The financial plan presents the entrepreneurs forecasts for the future of the
business. Generally these forecasts are in the form of financial statements
broken out by month in the first year or two, and then annually for the next
two to five years. This section demonstrates the financial viability of the venture
and the assumptions made by the entrepreneur in doing the forecasts. It is
designed to show that all the claims about the product, sales, marketing
strategy, and operational strategy can work financially to create a business that
can survive and grow over the long term.
□ Made a list of the information you will need to start collecting to complete the
feasibility study and business plan for the new venture?
ijjl . Pick a business in your community and find a creative way to change either
the product/service or the way it is delivered to the customers.
. What is the value of the feasibility study to the entrepreneur?
. Consider two types of new ventures: a service business and a manufacturing
firm. In what ways would the business plans for these two ventures differ?
. If you already had sufficient capital to start your new venture, would you still
do a feasibility study and business plan? Why or why not?
. What information does a business plan provide that the feasibility study does
not?
CHAPTER 3
Developing the
Business Concept
Overview
• Turning an idea into a business
43
44 Part 1 • The Entrepreneur and the Entrepreneurial Venture
Proprietary Issues
If the new venture opportunity involves a product, it is especially important
that the inventor and/or entrepreneur investigate the potential for acquiring
intellectual property rights—that is, determine if there are legal ways to protect
the product idea from competitor duplication until after it goes to market. (See
Profile 3.2, p. 46.)
The issue of who owns an idea is a crucial one as it could mean the difference
between having a successful business and not having one. The primary legal
means to protecting an original idea is through a patent. Other methods of
protection include trademarks, copyrights, and contracts to protect trade secrets.
Chapter 3 • Developing the Business Concept 45
PROFILE 3.1
Patents
The U.S. patent system was designed 200 years ago by Thomas Jefferson to
protect the inventions of the independent inventor. Today, although most
inventors work in the research departments of large corporations, the basic
legal tenets of patent law still remain true to the independent inventor. In fact,
the number of patents issued to independent inventors increased 37 percent in
the last half of the 1980s. Since the first patent was issued in 1790, more than
five million U.S. patents have been granted.
A patent grants an inventor the exclusive right to an invention for a period
of years, depending on the type of patent. It also prevents others from
46 Part 1 • The Entrepreneur and the Entrepreneurial Venture
PROFILE 3.2
Bob Kearns was tired of windshield wipers that operated either too slowly or too fast.
He wondered why they couldn’t function like an eyelid and literally blink. Kearns had
a damaged eye, the result of being hit with a champagne cork on his wedding night,
and had great difficulty seeing while driving one night in a severe rainstorm. That’s
when the inspiration for intermittent windshield wipers came to him.
For Kearns, generating ideas for products that solved problems was a way of life.
His first invention was a comb that distributed hair tonic, then came an amplifier for
people who had undergone laryngectomies, followed by an innovative type of
weather balloon. Most of the ideas never went beyond the model stage, which is not
atypical for inventors. Kearns, who had a masters degree in mechanical engineering,
began working on the prototype of the intermittent wiper blade in 1963. When he had
a working prototype, which he installed in his car, he arranged to show it to engineers
at Ford. They encouraged him to field test it to see if it would achieve three million
cycles. When it did, he again contacted Ford which suddenly didn’t seem interested
any more. He then went to a friend who owned a mid-sized manufacturing firm that
supplied parts to the auto industry. Kearns assigned the rights to the patent to his
friend in exchange for his friend paying the costs of getting the patents and paying
Kearns royalties plus $1,000 a month to continue research and development.
Then, surprisingly, in 1969, Ford came out with an intermittent wiper blade that
used the Kearns design. GM followed suit in 1974 and Chrysler in 1977, along with
several foreign car companies. Kearns, who by that time had reacquired his patent
rights, filed suit against Ford in 1978 for patent infringement and later against
Chrysler. It took 12 years of intense work (Kearns represented himself) for the first
case to come to trial. In the first suit, Ford agreed to settle for $30 million after the jury
found in Kearns’ favor, but he turned them down (he was seeking $1.6 billion). In a
second trial, Kearns was awarded $5.2 million. Ultimately Ford and Kearns settled for
$10.2 million. The Chrysler case, which concluded in June 1992, gave Kearns an
additional $11.5 million, but he was still unhappy because the jury didn’t find that the
automaker had been willful in the infringement. Still, Kearns stands as a role model to
other inventors who regularly face patent infringement by large corporations.
Chapter 3 • Developing the Business Concept 47
manufacturing and selling the invention during the period of the patent. At the
end of this time, the patent is placed in public domain. Two types of patents
concern most inventors: utility and design patents. Utility patents are the most
common type. They protect the functional part of machines or processes, in
addition to computer programs associated with hardware. Some examples are
toys, film processing, protective coatings, tools, and cleaning implements. A
utility patent is valid for 17 years from the date of issuance. Design patents
protect new, original ornamental designs for manufactured articles. The design
must be nonfunctional and part of the tangible item for which it is designed.
Some examples are a gilding, an item of apparel, or jewelry. Design patents are
valid for 14 years from date of issuance.
Ever vigilant to changing technology, in 1980 the Patent Office created a new
category of protection: life forms. It covers such controversial things as altered
human genes and microbes that break down crude oil. Another special category
is the plant patent, which protects any new variety of a sexually or asexually
reproduced plant.
Computer programs present some special problems requiring several
methods of protection. For example, they may be protected by a trade secret
contract if the developer/owner merely licenses the program for distribution by
someone else to a narrow market. If wide dissemination is the goal, a patent
offers more protection and is available if the program contains at least one
unique algorithm that is part of the machine or physical process. Copyrights are
commonly used for programs that don't qualify for a patent. In addition, the
name of the program can be trademarked and the instructions copyrighted.
Many inventions can be classified into more than one category. That does not
present a problem, however, since the inventor does not have to choose into
which category the invention fits.
2. It must have utility, in other words, be useful. This is not usually a problem
unless you have invented something like an unsafe drug or something purely
“whimsical.” The Patent Trademark Office (PTO) has been known to issue
patents on some fairly strange inventions, such as a male chastity device
(#587,994).
3. It must not contain prior art. Prior art is knowledge that is publicly available
or published prior to the date of the inventions—that is, a date before the
filing of the patent application. Accordingly, it is important to document
everything that is done in the creation of the invention. Also you must follow
the “one-year rule,” which says the invention must not become public or
available for sale more than one year prior to filing the patent application.
This rule is meant to ensure that the invention is still novel at the time of
application. Novelty consists of physical differences, new combinations of
components, or new uses.
4. It must be unobvious. The invention must not be obvious to someone with
ordinary skills in the field. This is a tricky definition but has been further
explained by the PTO as an invention that contains “new and unexpected
results.” If your invention is rejected on the first pass as not being “unob¬
vious,” it probably means the patent examiner wants you to demonstrate its
unobviousness.
Once the application is received, the Patent Office will conduct a search of its
patent records. During this period the invention is said to be “patent applied
for,” which establishes the inventors claim and dates relative to prior art. An
invention can stay in the patent-applied-for stage for up to two years, the
primary advantage of this being that the public does not have access to the
patent application and drawings, which might allow someone else the chance
to design around the patent.
The Patent Office contacts the inventor and states that they either accept the
claims in the application or deny the application and give the inventor a period
of time to appeal and/or modify the claims. It is not uncommon for the original
claims to be rejected in their entirety by the PTO, usually because of prior art. If
and when the Patent Office accepts the modified claims, the invention is in the
“patent pending” stage, that is, awaiting the issuance of the patent. The
The entrepreneur inventor may market and sell the product during this period, but must
clearly label it “patent pending.” Once the patent is issued, however, it
does not have to
becomes public record.
own a patent to
If the patent examiner rejects the modified claims, the inventor has
benefit from it. the right to appeal to a Board of Patent Appeals within the Patent
Office. Failing to find agreement at this point, the inventor may appeal
to the U.S. Court of Appeals for the Federal Circuit. This appeals process may
take years.
The entrepreneur does not have to own a patent to benefit from it. In some
cases it may be possible to license the right to use a patent from the inventor.
For example, an inventor may license the entrepreneur to manufacture and
distribute the invention and receive a royalty on sales. Alternatively, it may also
be possible for the entrepreneur to purchase an assignment of a patent from
the inventor, transferring ownership rights to the entrepreneur. Be aware,
however, that the patent, once issued, is a powerful document that gives the
holder the right to enforce the patent against infringers in a court of law.
Under the law, the patent holder is entitled to a reasonable royalty from the
infringer and if the infringer refuses to pay, the patent holder can enjoin or
close down the operation of the infringer. If the entrepreneur is planning to
export products, patent applications should be filed in the countries in which
the product will be sold. This can be a costly process if the entrepreneur is
dealing with a number of countries. Furthermore, entrepreneurs have often
found their patents violated in countries that do not have as stringent patent
laws as the United States.
Chapter 3 • Developing the Business Concept 51
1. If the mark has already been in use, the applicant can file a use application
requesting registration and ownership of the mark. You will also have to
submit three specimens showing actual use of the mark.
2. If the mark has not yet been in use, you can file an mtent-to-use application.
After the mark is in use, you must submit the three specimens showing
actual use before receiving registration.
3. Depending on international agreements with a specific country, an applicant
can file based on having a trademark in another country.
To apply, you need to submit PTO Form 1478 with a drawing of the mark
and the appropriate fee. The PTO does not require a search for potentially
conflicting marks prior to filing the application. However, it is probably wise to
do so since it isn’t difficult. You can conduct a search in the PTO public search
library or a patent and depository library, or hire a specialist to search for you.
The PTO determines whether the mark may be registered and notifies you. If
the PTO rejects the application, you have six months to respond.
Marks that cannot be trademarked include:
Trade Secrets. Trade secrets are those aspects of the business that you wish to
protect from disclosure by employees or others involved with the business. The
52 Part 1 • The Entrepreneur and the Entrepreneurial Venture
only way to protect trade secrets is through an employment contract that specif¬
ically details any trade secrets. Then, should a former employee use a specified
trade secret, the company can use legal remedies, such as an injunction or
suing for damages.
Aspects of the business that may be considered trade secrets are recipes or
ingredients (Mrs. Fields Cookies), source codes for computer chips, customer
discounts, manufacturer costs, and so forth.
creating. Suppose you have developed a new computer program that will revo¬
lutionize the way manufacturers control inventory. You have a product; now
what is the business? There are actually several options.
The choice of the kind of business to start is a function of your life goals and
how much time and money you have to devote to the business. Obviously,
opening a computer store is more time consuming, costly, and risky than
licensing, for example. It is important to consider all options and their associ¬
ated risks, costs, advantages, and disadvantages before settling on the type of
business you will create.
Buying a Business
Buying a business has several advantages:
• It is less risky than starting from scratch because facilities, employees, and
customers are likely to be in place.
• It is an easier route to owning a business if the entrepreneur has limited busi¬
ness experience.
• The chances for success are increased, particularly if the business has a good
reputation.
• The business may have established trade credit, which is crucial because
relationships with suppliers and others take a long time to develop.
54 Part 1 • The Entrepreneur and the Entrepreneurial Venture
• The owner may be willing to stay on board for a time to help the entrepre¬
neur learn the business.
The owner is more likely to say the business is being sold because the owner
wants to retire or is suffering from some illness. With this in mind, there are
several questions to ask prior to purchasing a business.
Buying a business will take the same kind of research as starting one. In fact,
although this book is geared toward starting a business from scratch, many of
the same skills apply to buying an existing business and making it grow. You
will need to:
• Understand the industry and the market niche in which the business will
operate
• Examine the records of the business
• Talk to employees, suppliers, and customers
• Examine equipment and facilities
• Examine all contracts
Chapter 3 • Developing the Business Concept 55
• Verify the value of the business based on industry statistics (See Chapter 17
for suggestions on valuing the business.)
The New Pig Corporation in this chapter. Don Beaver and Ben Stapelfeld saw
the business in a much broader sense than just a product business. They actu¬
ally viewed it as a business that provided a service by solving people’s clean-up
problems. In that way their product offering increased substantially over the
initial product, the PIG.
The Product/Service Plan is the first section of both the feasibility study
and the business plan. Some of the things you should consider when
constructing this section include:
characters and the artist’s humorous quotes makes the artwork and prod¬
ucts attractive and one-of-a-kind.
Unique Features
Today, even if you are selling a commodity a standard item like hand soap that
people use in their everyday lives, you won’t get consumers to purchase your
product over the many others in the market if you can’t tell them why they
should. Consumers want to know the unique features your product or service
offers. These features will ultimately form the basis of the marketing strategy. In
the case of Image Designs, the entrepreneur was able to identify several unique
features, including “one-stop” shopping for all design needs and a management
team with a working knowledge of manufacturing, R&D, and high technology
company operations.
Proprietary Rights
It is important to note any ways in which the product/service concept can be
legally protected, whether it be through patents, copyrights, trademarks, or
trade secrets. Intellectual property rights add value to the product or service;
therefore they are an important consideration in new venture creation.
Spin-Offs
Including any related products or services that can derive from the initial one
adds more value to the business concept, as it points to directions for future
growth. For example, Image Designs could move into mixed-media arts,
animation, and 3-D or video production—in other words, expand its services
within the same target market. The New Pig Corporation identified many
58 Part 1 • The Entrepreneur and the Entrepreneurial Venture
Environmental Impact
Today businesses must be concerned with the impact they may have on the
environment either from their products or from the processes that produce
those products. Specifying what, if any, impact the new venture will have and
how it will mitigate any potential negative impact will go a long way toward
establishing a positive image for the company. Potential negative effects are
easier to identify in a product-oriented business; however, even a service busi¬
ness can demonstrate a concern for the environment. For example, Image
Designs intends to create environmental products using the licensed designs,
using recycled materials for all paper and packaging, and supporting local
efforts to clean up and protect the environment.
In sum, the detailed description of the business provides the entrepreneur
with a focus as he or she begins to study the potential market for the product or
service. Understanding the purpose and goals of the business makes the work
of determining feasibility more manageable.
□ Considered if you will start the new business from the ground up or buy an
existing business?
Issues to 1. Compare and contrast buying a business with starting a business in terms of
Consider the advantages and disadvantages of each.
2. What is the difference between a disclosure document and a patent applica¬
tion?
3. Suppose you have an idea for a new type of “sunless” tanning lotion. What
procedures would you follow to protect your idea?
4. You have succeeded in protecting your new idea for sunless tanning lotion.
Name four types of businesses you could start using this idea.
5. What information will you need to have if you decide to consider buying a
business?
6. Using the sunless tanning lotion as your product, describe the essential
ingredients of the Product/Service Plan.
’;
CHAPTER 4
Overview
• The value of a team approach for starting the venture
• Criteria for professional advisors to the new venture
• The benefits and legalities of using independent contractors for any or all
aspects of the business
• Outsourcing new venture functions
• The initial management team for the new venture and a gap analysis
61
62 Part 1 • The Entrepreneur and the Entrepreneurial Venture
team effort will provide a better chance for success than a solo effort.1 There are
several other important reasons for using a founding team.
'Van de Ven, A.H., Hudson, R. &r Schroeder, D.M. “Designing New Business Start-Ups.’’ Journal of
Management, Vol. 10 (1984).
Chapter 4 • The Founding Team 63
Professional
Advisors
Consultants
Attorneys
Management
Accountants
Sales
Bankers
Market Research
Insurance Agents
Training
Board of Directors
Advisory Board
Sales Support
Manufacturing
Manufacturer Reps
Support
Sales Agencies
Sub-contractors
Distributors
Design Engineers
Foreign Reps
the entrepreneur and the venture will benefit greatly from a team composed of
a variety of strengths and disciplines. Another advantage to forming a quality
team is that the founding team has a vested interest in the new venture. They
invest not only their time but often their money as well. Thus the burden of
raising the resources necessary to start the venture is distributed among the
team members, giving the lead entrepreneur access to the network of contacts
of the other members in addition to his or her own. This vastly increases the
information and resources available to the new venture and allows the venture
to grow more rapidly.
Of course, it isn’t always possible to put together the “perfect” team from the
start. You may not have yet found the right person to fill a particular need, or
you may have found the right person, but he or she is too expensive to bring on
board during start-up. No matter. Talk to that person anyway about joining the
team at a later date and keep that person up-to-date on what the company is
doing. You would be surprised at how many times an aggressive start-up
company can woo an experienced person away from a major corporation.
64 Part 1 • The Entrepreneur and the Entrepreneurial Venture
Professional Advisors
When a new venture is in the infancy stage, it generally doesn’t have the
resources to hire in-house professional help such as an attorney or accountant.
Instead it must rely on building relationships with professionals on an “as-
needed” basis. These professionals provide information and services not
normally within the scope of expertise of most entrepreneurs, and they can play
devils advocate for the entrepreneur, pointing out potential flaws in the busi¬
ness concept.
Attorneys. The first thing an entrepreneur should realize when dealing with
attorneys is that, for the most part, they are not business people. They are pro¬
fessionals who specialize in one area of the law: tax, real estate, business, patents.
Therefore, it is important to select an attorney who specializes in the particular
area needed by the entrepreneur. Attorneys can provide a wealth of support for
the new venture. Within their particular area of expertise attorneys can:
Choosing a good attorney is a time consuming but vital task that should occur
prior to start-up. Decisions made at inception may affect the venture for years to
come, hence, the need for good legal advice. A few tips may facilitate the search.
The accountant can assist in all these areas. Once the new venture is beyond
the start-up phase and growing consistently, an annual audit is needed to deter¬
mine if the accounting and control procedures are adequate. Additionally, the
auditors may also require a physical inventory. If everything is in order, they
will issue a certified statement, which is important should the entrepreneur ever
decide to take the company public on one of the stock exchanges. Accountants
are also a rich networking source in the entrepreneurs search for additional
members of the new venture team. Much like attorneys, accountants tend to
specialize, so finding one who is used to working with young, growing busi¬
nesses will be an advantage. It is highly likely that the accountant who takes
your business through start-up and early growth may not be the same person to
take care of the company’s needs when it reaches the next level of growth. As
the financial and recordkeeping needs of the business increase and become
more complex, the entrepreneur may need to consider a larger firm with exper¬
tise in several areas.
Bankers There is a saying that all banks are alike until you need a loan. Today
that phrase is even more true. Having a qualified banker on the advisory team
66 Part 1 • The Entrepreneur and the Entrepreneurial Venture
of the new venture is an issue not only when you need a line of credit for oper¬
ating capital or to purchase equipment but from the moment you open the
business account. An entrepreneur should think of a banker as a business
partner who can:
Major insurance firms can often handle all types of insurance vehicles, but
many times the entrepreneur will need to seek specialists for certain kinds of
protection like bonding (which is common in the construction industry to
Chapter 4 • The Founding Team 67
the actions of the firm, and for arbitrating differences. These activities are not as
crucial in the start-up phase when the entrepreneurial team is gathering
resources and raising capital. However, a board of directors can assist the entre¬
preneurial team in those functions and can network with key people who can
help the new venture. At this juncture in the new venture some poten¬
The board members tial directors will ask to be included on the board so they can monitor
can offer the strug¬ their investment in the company. This is common with large private
gling team an objec¬ investors, bankers, and even accountants. To ensure that you get only
the best people on the board, standards should be set in advance and
tive point of view
strictly adhered to.
and the benefit of During the growth period of the new venture, the entrepreneurial
their considerable team is normally buried with operational details, the need to generate
experience. sales, and the problem of maintaining a positive cash flow. Dealing with
a board of directors is not something they will want to do. But the
board members can offer the struggling team an objective point of view and the
benefit of their considerable experience.
When choosing people to serve on the board of directors, you should
consider those who have:
If the entrepreneurial team is not careful, they may learn too late that a
director they have appointed to the board considers the position an appoint¬
ment for life, much like being appointed to the Supreme Court. To avoid a situ¬
ation—you’ll want new directors at times in order to bring new life to the
board—ask directors to serve on a rotating basis for a specified period of time.
The board is headed by the Chairman, who, in a new venture, is typically the
lead entrepreneur. The entrepreneur will also, most probably, be the President
and Chief Executive Officer (CEO). The additional positions of secretary and
treasurer may be held by a single person, often another member of the
founding team.
Chapter 4 • The Founding Team 69
Boards normally meet an average of five times a year, depending on the type
of business. How often the board meets will largely be a function of how active
it is at any point in time. Directors typically spend about nine to 10 days a year
on duties related to the business and are usually paid a retainer plus a per-
meeting fee with their expenses also reimbursed. The compensation can take
the form of cash, stock, or other perquisites.
Today it is more difficult to get people to serve as directors because in some
cases they can be held personally liable for the actions of the firm, and the
frequency with which boards are being sued is increasing. For this reason,
potential directors may require that the business carry directors and officers’
(D & O) liability insurance on them; however, the expense of this insurance is
often prohibitive for a growing company. Additional expenses related to the
development of a board of directors include meeting rooms, travel, and food.
Advisory Board. The advisory board is an informal panel of experts and people
who are interested in seeing the new venture succeed. They are generally
unpaid and may meet once or twice a year to advise the entrepreneur. Advisory
boards are often used when a board of directors is not required or in the start¬
up phase when the board of directors consists of the founders only. It can
provide the new venture with the needed expertise without the significant costs
and loss of control associated with a board of directors. In a wholly owned
corporation there really is no distinction between the functions of a board of
directors and a board of advisors, as control remains in the hands of the entre¬
preneurial team.
Mistakes to Avoid
Putting together the extended founding team is a serious undertaking that, if
unsuccessful, could have severe ramifications for the future of the business.
Several common mistakes in forming the team should be avoided.
• Using family members or friends as attorney and accountant for the busi¬
ness. As these professional advisors must remain objective at all times to best
represent and assist the entrepreneur, choosing relatives can cause unneces¬
sary problems.
• Giving the founding team all stock in lieu of salary. The lead entrepreneur
does not want significant shares of stock in the hands of people who may
later leave the company. Furthermore, loose stock can land in the hands of
the firm’s competitors. In a later chapter, the issue of a buy-sell agreement to
prevent this problem will be discussed.
• Hiring as few employees as possible (employees are usually the single largest
expense of a business).
• Leasing rather than buying so as not to tie up limited funds in equipment
and facilities. With a lease, there is often no down payment and the cost is
spread over time.
• Arranging longer terms with suppliers.
• Where possible, getting customers to pay in advance.
The first rule of thumb above is relevant to this chapter. How does a new
venture survive with as few employees as possible and still grow? One solution
is to hire employees from a temporary service; another is to use independent
contractors, a process known as outsourcing. Independent contractors own
their own businesses and are hired by the entrepreneur to do a specific job.
They are under the control of the entrepreneur only for the result of the work
they do and not in the means by which that result is accomplished. There are
several advantages to the entrepreneur in using independent contractors.
If, however, the entrepreneur does not follow the rules regulating classifica¬
tion of workers as independent contractors, the entrepreneur can be held liable
for all back taxes plus penalties and interest, which can result in a substantial
sum. Entrepreneurs using independent contractors should:
• Consult an attorney.
• Draw up a contract with each independent contractor that specifies that the
contractor will not be treated as an employee for state and federal tax
purposes.
• Be careful not to indicate the time or manner in which the work will be
performed.
• Verify that the independent contractor carries workers compensation
insurance.
• Verify that the independent contractor possesses the necessary licenses.
More specifically, the IRS uses a 20-point test for classifying workers. (See
Figure 4.2 on p. 72.) Even if you follow all the IRS rules, however, there is no
guarantee the IRS won’t challenge your position. Therefore it is important to
document the relationship with an independent contractor through a legal
agreement that explicitly demonstrates that the independent contractor owns
his or her own business. The IRS can decide that a worker is an employee if
even one of the 20 points is true.
If all the IRS rules are followed, independent contractors can make the very
small start-up venture look like an established corporation to anyone on the
outside. A large corporation will generally have vice presidents for departments
of operations, sales, marketing, and finance. It is possible for the entrepreneur to
replicate the corporate bureaucracy using independent contractors thereby
lowering costs and remaining more flexible. Figure 4.3 on p. 72 shows how a
growing entrepreneurial venture can imitate the strength, stability, and expertise
of a much larger, more established company through the use of independent
contractors. The concept is called the “virtual corporation” and will be discussed
at length in Chapter 10.
72 Part 1 • The Entrepreneur and the Entrepreneurial Venture
Traditional Corporation
Chapter 4 • The Founding Team 73
Since they tend to be fairly expensive, consultants are best used for critical
one-time advice or problem solving. However, this is a matter of perspective, as
a quality consultant can accomplish a mission or job more efficiently and effec¬
tively than an employee because their greatest strengths are usually problem
solving and working quickly within a strict budget.
Sales Support. Hiring a sales staff can be an expensive proposition for any new
venture, not only from the standpoint of benefits but because they must be
trained as well. As new, high growth ventures seek a geographically broad
market, even global, it is vital to consider manufacturers representatives (reps)
and foreign reps who know those markets and can act as the entrepreneurs
representative. Using distributors allows the entrepreneur to reach the target
74 Part 1 • The Entrepreneur and the Entrepreneurial Venture
market without having to deal with the complex retail market. In addition, sales
agencies can provide fully trained sales persons to the new venture in much the
same manner as temporary services supply clerical help. Some can also provide
advertising and public relations.
Governmental Agencies. There are many agencies at the federal, state, and
local levels that offer various services to new ventures. Notable among them are
the Small Business Administration, which provides education, loans, and grants
to small business; the Department of Commerce, which can assist the entrepre¬
neur on issues of trade; and state and local economic development corporations.
By taking advantage of the many services available, the entrepreneur can
literally start a business from home to reduce start-up capital requirements, yet
still operate like a major corporation. This was the route Talli Counsel of
Interfleet took (see Chapter 1). He now handles over $14 million worth of fleet
Leasing your staff, outsourcing as it is called, is a way for a new business to enjoy the advantages
of major corporations without incurring the expense. The way it works is that a leasing company
assumes the payroll and human resource functions for the business for a fee that generally
ranges from three to five percent of gross payroll. Each pay period the new venture pays the
leasing company a lump sum to cover payroll plus the fee. The National Staff Leasing Association
reports that there are about one million leased employees in the U.S. and the industry is growing
at an annual rate of 30 percent.
Chapter 4 • The Founding Team 75
vehicles, and he and his wife are still the only employees of the company. This
is not to suggest that a company can always avoid hiring employees and still
grow. That will depend on the type of business started. However, it does
suggest that in the start-up, bootstrapping phase of a new venture the use of
independent contractors can help ensure that the business survives long
enough and generates enough revenues to hire employees.
Baty, G.B. (1990). Entrepreneurship for the Nineties. Englewood Cliffs, NJ:
Prentice Hall. Chapter 5.
Covey, S.R. (1989). The 7 Habits of Highly Effective People. New York: Simon
and Schuster Trade.
Ford, R.H. (1992). Boards of Directors and the Privately Owned Firm. New
York: Quorum Books.
Timmons, J.A. (1990). New Venture Creation. Homewood, IL: Richard D.
Irwin, Inc., Chapter 7.
Ward, J. (1991). Creating Effective Boards for Private Enterprise. San
Francisco: Jossey-Bass.
Chapter 4 • The Founding Team 77
Issues to 1. What are the advantages of starting a new venture with a team versus as a
/( Case StudTn
Armed with a wealth of nutritional knowledge, Sandy realized that all the
knowledge in the world about food could not compensate for a lack of experi¬
ence in business. She would need to take on a partner. Fortunately, she had a
friend who was managing a health food store in the San Fernando Valley, and
she succeeded in convincing him to help.
They had to find a store location that was accessible and in a good area of
town. After much driving around and consulting newspapers, they found a
market on the west side of Los Angeles that had gone out of
business. It was obvious that the owners had run it into the
ground, but to Sandy it couldn't be more perfect. Using her
teacher retirement money and all of her savings, she opened
her first natural foods market on this site in 1977. The store
was an overnight success in spite of the fact that she had
done no location studies or psychographic studies. She was
not simply lucky, however. She had correctly determined that
there were a lot of people who shared her problems with unnatural foods. In
other words, she had innocently and intuitively found a niche in the market.
Customers lined up and kept her at the register for six hours straight without a
break.
High demand for what you have to offer has its obvious pluses and its not-
so-obvious minuses. One of the problems they faced early on was a shortage of
cash. Often cash flow problems are the result of poor management, but in
Sandy’s case, it was caused by the need to stock sufficient inventory to meet
demand. And that required a lot of capital, which they didn’t have. By keeping
overhead costs down and scrimping anywhere that it didn’t affect the customer,
they were able to keep up with demand pretty well.
Sandy’s passion for her business and her need to help people, coupled with
the tremendous demand for what she had to offer, led to the opening of a
second store within a year. To finance this store, Sandy offered limited partner¬
ships to raise $125,000. From then on, using internal cash flows, five more
stores followed over a period of 15 years, with each store reflecting Sandy
Gooch’s philosophy and mission for the business:
The mission statement guided all of the decisions she made about the stores.
Accordingly, Sandy required that her suppliers guarantee the quality of their
products and be able to furnish laboratory analyses or signed affidavits if
requested. The products she carried could not contain chemicals, white flour,
sugar, preservatives, artificial colors or flavors, caffeine, chocolate, hydrogenated
vegetable oil, or irradiated food. The mission statement also gave her a way to
expand the product line to include, in addition to food, nutritional supple¬
ments and body care products. To increase efficiency as the company grew, she
opened a produce/grocery distribution center, a food commissary for the prepa¬
ration of deli and bakery foods, a design studio to create store
decor and a construction shop to build the displays.
A former teacher, Sandy Goochs love of education found its
way into her business. To help achieve her mission, her 800
employees were carefully trained to be knowledgeable about
the products she carried. Sandy believed strongly that their
product was really knowledge and information. That belief
formed the basis of her marketing strategy. She knew that an
informed consumer would be an advocate for the type of nutritional lifestyle
she was proposing. As advocates they would return again and again to purchase
those products and gain more knowledge. She promoted health awareness by
offering seminars, producing a newsletter, and giving her customers free
brochures on nutrition. A mini-bookstore in each store contained all the latest
research on foods and their relationship to the body Even the ads that appeared
in newspapers were educational in nature.
Sandy incorporated the business early in its development and set up a Board
of Directors, which included herself, her partner, the general manager, and their
attorney. As this privately held company began to grow, Sandy wondered if she
had made the correct decision putting all “insiders” on the board. Would they
continue to share her mission for the business?
Finding, Analyzing,
and Testing Opportunity
Overview
• Identifying the industry in which the new venture will operate
• Industry carrying capacity, dynamism, and complexity
• Sources of secondary industry information
• Sources of field data on the industry
• Effective field interviews
• Presenting the industry profile in the feasibility study or business plan
83
84 Part 2 • Finding, Analyzing, and Testing Opportunity
Carrying Capacity
Capacity is the extent to which the industry can support growth. Entrepreneurs
will typically seek out an industry that can support expansion, thus allowing
the new venture to grow and obtain the resources it needs. Difficulty in entering
a specific industry suggests that the industry may be approaching its carrying
capacity—that is, the production capability of the existing firms equals or
exceeds the demand for industry products. The only way to enter such an
industry then is through the introduction of new technology or by discovering
a niche where a need has not been met. The was the strategy of Gentech
Corporation in introducing new technology in a niche market of the large and
very mature generator and compressor industries.
Dynamism
Dynamism is the degree of certainty or uncertainty in the industry, as well as
stability or instability; in other words, a dynamic environment is one that is
difficult to predict because it is in constant flux. Industries that operate in
volatile environments, like the computer industry, contain higher degrees of
uncertainty or risk. Consequently, the rewards are usually higher as well.
Complexity
Complexity is the number and diversity of inputs and outputs facing an organi¬
zation. Firms that operate in complex industries usually have to deal with more
suppliers, customers, and competitors than other industries, and they usually
produce a greater number of dissimilar products for global markets. Industries
with a high degree of complexity by their very nature make it difficult for new
'N.C. Churchill, J.A. Hornaday, B.A. Kirchhoff, O.J. Krasner & K.H. Vesper. “Venture Survivability.” Frontiers
of Entrepreneurship Research, Wellesley, MA: Babson Center for Entrepreneurial Studies. (1987).
2Starbuck. WH. “Organizations and Their Environments." (1976). In M.D. Dunnette (Ed.) Handbook of
Industrial and Organization Psychology. Chicago: Rand McNally. Pfeffer, J. & Salancik, G.R. (1978). The
External Control of Organizations. New York: Random House.
Chapter 5 • Understanding the Industry: Prelude to Success 85
Industry Structure
In studying the industry in which the new venture will operate, develop a
broad picture of how the industry works, how friendly it is to new entrants,
and where it is going in the future. Michael Porter asserts that there are five
forces in any industry that affect the ultimate profit potential of a venture in
terms of long run return on investment. They are:
These are the forces that drive competition and affect the long run prof¬
itability of the new venture as well as other firms in the industry. Short run
profitability, by contrast, is affected by such things as economic forces, changes
in demand, material shortages, and so forth.
3Porter, Michael E. (1980). Competitive Strategy: Techniques for Analyzing Industries and Competitors. New
York: The Free Press, p. 3.
86 Part 2 • Finding, Analyzing, and Testing Opportunity
mature industries where growth has slowed, so rivalry for market share
intensifies as profits decline. Weaker firms ultimately exit the industry.
Competitive Strategies
The new venture’s entr-y strategy will largely be a function of the structure of
the industry into which it seeks entry. In general, three broad strategies are
available to the new venture: cost superiority, product/process/service differ¬
entiation, and niche.
Cost Superiority
Essentially, cost superiority entails entering the industry with an organizational
structure that is “lean and mean,’’ with tight controls on costs. To accomplish
this usually requires designing the production process and distribution mecha¬
nisms to operate under strict controls, meeting stringent quantity targets. This
strategy is very difficult for a new venture to achieve in that it most often results
from being further along on the experience curve and from producing in high
volumes. It is rare that a new venture will have the infrastructure and resources
in place, and sufficient product/service demand from the beginning to allow it
to use cost superiority as an entry strategy.
Differentiation
Differentiation is a strategy that involves distinguishing the new venture from
others in the industry through product/process innovation, or a unique
marketing or distribution strategy. Differentiation often creates brand loyalty
among customers, thereby making the product or service less sensitive to price.
Consequently, margins are usually increased, which better insulates the
company against supplier and buyer bargaining power, and moves the focus
away from the cost to produce. Additionally, substitute products are less likely
to be a threat where differentiation is the strategy.
Niche Strategy
The third strategy is often referred to as a niche strategy, which simply means
that the new venture focuses on a particular customer group or specific
geographic region not currently served by the industry effectively. Many a new
venture has entered an established industry via a niche. This strategy may
include either a cost leader or differentiation strategy as well, with the key
90 Part 2 • Finding, Analyzing, and Testing Opportunity
distinction being that the niche strategy tackles only a segment of the industry
rather than the industry as a whole. Where competition is weak and exposure
to substitute products is a minor issue, the niche strategy offers a safer route to
establishing a foothold in the industry. Gentech, whose PowerSource industrial
machine competes in the generator/compressor industries, is focusing on a
niche market in equipment rental outlets as a strategy to enter a large industry
with established firms.
Competitive Analysis
Within any industry, it is important to hypothesize about the competitive
strategy of the competition—in other words, to know the competition as well
as you know your own business. Studying the history and management style of
your major competitors will give insight into what motivates them and how
they may potentially react to your strategy. You need to identify their current
Chapter 5 • Understanding the Industry: Prelude to Success 91
strategy to learn how they have positioned themselves in the industry. In the
same way that you would analyze your strategy’s strengths, weaknesses, oppor¬
tunities and threats, you should also study theirs.
Not all of your competitors will exhibit the same strategy, so it is useful to
categorize them to get a handle on what the new venture is facing. Once the
competitors have been categorized, you will more readily see into what strategic
grouping the new venture lies, that is, who your key competitors are. From
there the new ventures position in that group will be determined as well as the
strategic group’s position in the industry as a whole. To have the best chance for
success, the new venture should be positioned in the strategic group that offers
the best profit potential, yet a reasonable cost of entry.
Industry Evolution
Industries do not remain static or stable over time. In fact, they are in an almost
constant state of evolution. Like a business, an industry moves through a life
cycle that includes birth, growth, maturity, and ultimately decline. Of course, for
every industry the life cycle stages occur at different rates and last for varying
lengths of time. Some industries like the auto industry avoid decline by con¬
stantly innovating to meet market demand and satisfy governmental regulations.
As an industry grows, it sees demographic shifts, changes in costs of materials
and labor, product and process innovations, and changes in its customer
markets. Industry products tend to become commodities over time, so the com¬
petitive tendency to differentiate products is enhanced. With time, uncertainty is
reduced and proprietary rights become less exclusive, which may result in larger,
risk-averse firms entering the industry. These larger firms have the resources to
integrate vertically, gaining control of suppliers and distribution channels, and
instituting product and process innovations that can result in larger volumes of
goods being produced and sold. These actions can cause a change in the cost
structure of the industry and the exit of firms unable to compete in the new
industry structure. A few firms will finally dominate the industry.
Industry Analysis
The importance of understanding the industry in which the new venture will
operate cannot be overstated because the industry environment has a direct
impact on how the new venture does business and on its potential for success.
The nature of the industry certainly must be taken into consideration when
establishing the competitive strategy for accomplishing the goals of the venture.
92 Part 2 • Finding, Analyzing, and Testing Opportunity
a 10 to 15 year period, can often help the entrepreneur spot trends, cycles,
and seasonal variations in the industry. Trade magazines provide a good sense
of who the key firms are and the directions the industry may be taking.
Figure 5.2 provides a listing of some of the essential raw data on the industry
that should be collected. Some of this information will also be useful later for
the market analysis.
After the secondary data are collected, they must be organized and analyzed.
In general, the key questions about the industry that should be answered are:
• Industry observers, those who study particular industries and regularly report
on them in newspapers, newsletters, or through the media.
94 Part 2 • Finding, Analyzing, and Testing Opportunity
• Where possible, secure an introduction from someone who knows the inter¬
viewee. You will find that once you talk to the first person, that person will
recommend someone else, and you’ll be on your way to gathering more
information than you could ever use.
• Seek out individuals who regularly deal with the media since they are easier
to approach; however, be aware that they are also used to being very careful
about what they say
• Allow sufficient lead time for the meeting since you are probably dealing
with very busy people on tight schedules.
• Offer something that might be of value to them such as a summary of the
results of the industry analysis or to take them to lunch.
• Be honest about your affiliation, either with a university or business.
Interviewees want to know you understand the value of their time.
• To give yourself credibility, demonstrate your knowledge of the interviewee’s
business. Of course, to do this you will have had to research the business
before the meeting.
• If possible, take a colleague or business partner along to ensure that you
obtain all the needed information and catch all the visual cues. This is partic¬
ularly true when talking to potential competitors.
• Carefully observe the surroundings. Physical clues and non-verbal commu¬
nication are often excellent indicators of the nature of the industry.
• Be sure your opening questions are easy and non-threatening and show a
genuine interest in the interviewee’s business.
While no industry is perfect, an industry comprised of the following features offers more opportu¬
nity for a new venture.
• An industry with over $50 billion in sales will probably have niche markets of sufficient size to
allow for the attainment of an adequate market share.
• An industry that is generally growing at a rate greater than the GNP offers more potential for
growth of the new venture.
• An industry that allows for after-tax profits of greater than five percent of sales within three to
five years will enhance the new venture’s chances for success.
• An industry that is socially and environmentally responsible will be one that is compatible with
current societal and political trends and, consequently, may be eligible for special grants and
other types of funding.
New ventures entering an emerging industry will not have the luxury of a history and information
that can indicate potential for growth and profits. They can, however, look to the experiences of other
recently formed industries that are similar to theirs to predict patterns and potential market demand.
These characteristics are merely benchmarks. With so many variables involved, no one can
guarantee a new venture will survive or become a success even if the industry possesses all
these characteristics. However, as with anything, the more information the entrepreneur has, the
better chance there is of not making costly mistakes.
96 Part 2 • Finding, Analyzing, and Testing Opportunity
• The current size of the industry as measured by total sales volume, total
number of firms, and total number of employees.
• The growth potential, based on historical trends in size. Is the industry
growing, shrinking, or remaining stable?
• Geographic location, where the industry seems to cluster (i.e. semiconductors
in Silicon Valley, California; Route 128 in Massachusetts, and so forth).
• Industry trends in terms of products, services, innovation, and technology.
• Seasonality of demand for products and services, based on days of week,
months, or seasons of the year.
• Profit potential, based on performance of existing firms in the industry.
• Sales patterns as measured by frequency and quantity of purchase.
• Gross margins on products as an indicator of how easy or difficult it will be to
cover overhead.
• Technology, both process and product as an indicator of barriers to entry and
potential for innovation.
• Government regulation of aspects of the industry that may affect the new
ventures growth potential.
Both the entrepreneur and other interested parties will want to know that the
industry is healthy, growing, and provides an excellent window of opportunity
for the new venture.
Chapter 5 • Understanding the Industry: Prelude to Success 97
□ Identified the SIC code for the industry in which your new venture will
operate?
□ Developed an industry profile that will tell you and others if the industry is
growing, who the major competitors are, and what the profit potential is?
£jx 3. What kinds of information can suppliers and distributors give you?
4. What information about the industry can trade shows provide7
5. How should tables and graphs be used in the industry profile?
_
CHAPTER 6
Overview
• Defining and describing the target market
• Direct, indirect, and emerging competitors
• Competitive advantage
• Secondary sources of data on the target market
• Techniques for estimating demand for the product or service
• Presenting the market analysis in the feasibility study or business plan
• Determining initial feasibility
99
100 Part 2 • Finding, Analyzing, and Testing Opportunity
'Hills, G.E. "Market Analysis and Marketing in New Ventures: Venture Capitalist Perceptions” in Frontiers of
Entrepreneurship Research. Babson Center for Entrepreneurial Studies, (1984), p.43.
Chapter 6 • Evaluating the Target Market 101
really means describing the primary customer for your product or service—that
customer who will help your business grow and succeed.
In the beginning stages of market analysis, you will probably have a fairly
loose description of the target market. This description will be refined and may
even change as you talk to the target customers during the field research. The
key questions you will be attempting to answer are:
• Who is my customer?
• What do they typically buy and how do they hear about it?
• How often do they buy?
• How can my new venture meet the customers’ needs?
Direct Competitors
Those businesses that supply products or services that are the same or similar to
yours, or are a reasonably good substitute for yours, are direct competitors to
the new venture. However, be careful: the term competition is not quite that
simple. Suppose you are going to open an entertainment center that incorporates
virtual reality computer games in a shopping mall. One possible direct com¬
petitor that comes to mind is a video arcade. But if you consider your venture to
be in the entertainment business, you will see that other direct competitors for
the consumer dollars you are seeking are movie theaters, miniature golf courses,
bowling alleys, and video rental stores. That certainly complicates the picture,
and it’s not the only source of competition for the new venture.
Indirect Competitors
Indirect competitors may not even be in the same industry as the new
venture but who compete alongside it for consumer dollars. Using the example
above, consumers may choose to spend their limited dollars at restaurants
102 Part 2 • Finding, Analyzing, and Testing Opportunity
Emerging Competitors
When entering a market as a new business, it is vital not only to assess the
existing competition but also the potential for new competition—emerging
competitors—at some time in the future. In many industries today, technology
and information are changing at such a rapid pace that the window of opportu¬
nity to successfully start a new venture has been closing. Consequently the
entrepreneur must be ever-vigilant to new trends and new technology in both
the industry in general and in the specific target market.
Competitive Advantage
Understanding who your competitors are is one step in learning what the new
venture’s competitive advantages are. If your product or service has intellectual
property rights—patent, trademark, copyright—that is a significant competitive
advantage. Other advantages may be found in the market strategy, the distribu¬
tion strategy, and the operations strategy. The bottom line in competitive advan¬
tage is innovation in all aspects of the business. What this suggests is that
knowing your competitors as well as you know your new venture allows you to
seek more ways in which the new venture can innovate, can distinguish itself
from its competitors, and can attain an important level of competitive advan¬
tage in the marketplace.
PROFILE 6.1
possible), you would not gather data or design a questionnaire that would give
you “yes-no” answers. Fortunately, the market research most entrepreneurs do
involves simple, descriptive statistics as seen in Figure 6.2 above.
Recall that the entrepreneur collects both primary and secondary market
data. It is important, however, to gather the secondary data first so you have a
better understanding of the market prior to designing a sampling plan and
doing the field research.
2 Hall, J.A. (1991) Bringing New Products to Market. New York: AMACOM.
Chapter 6 • Evaluating the Target Market 105
within any geographic area, those who meet the particular demographic
requirements of the product/service can be segmented out.
Most communities have economic development departments or Chambers of
Commerce that keep statistics on local population trends and other economic
issues. Some communities have Small Business Development Centers (SBDCs),
branches of the Small Business Administration that contain a wealth of useful
information, as well as services, for small and growing businesses. Other
sources available in the library are reference books and trade journals on all
types of industries. Apart from the library, useful information can be found
from trade associations like the National Association of Manufacturers,
commercial research firms, and financial institutions. These resources will assist
you in determining the size and characteristics of the target market.
• Keep the questionnaire short with lots of white space so the respondent is
not intimidated at the outset.
• Be careful not to ask leading, biased questions.
• Ask easy questions first, leading up to the more complex ones.
• Ask demographic questions (age, sex, income) last when the respondents
attention span has waned. These questions can be answered very quickly.
• For questions people generally hesitate to answer (age, income), group
possible responses in ranges (25-35 for age, $35,000-$45,000 for income) so
the respondent doesn't feel he or she is giving away very private information.
• Keep in mind that people generally increase their income classification one
class and decrease their age one class.
106 Part 2 • Finding, Analyzing, and Testing Opportunity
Mail surveys are a relatively easy way to reach a lot of people in the target
market and take less time than many other methods. However, mail surveys do
have a few weaknesses.
• The response rate is generally very low, usually around 15 percent, which
means that about 85 of every 100 persons sampled do not respond.
Consequently, the potential for non-response bias makes it difficult for the
entrepreneur to feel very comfortable about the reliability of the results.
• The entrepreneur does not have the benefit of non-verbal communication as
would be the case with an interview. This is significant when you consider at
least 85 percent of all communication is non-verbal.
• The entrepreneur has no way of questioning or clarifying a response.
• There is no control over the accuracy of the information given.
• Normally, a second, follow-up mailing is necessary to achieve the desired
response rate.
Phone Surveys. Like mail surveys, phone surveys also use questionnaires so
consistency in the questions asked can be achieved. Phone surveys have two
particular advantages over mail surveys. They allow for explanation and clarifica¬
tion of questions and responses, and the response rate is higher. However phone
surveys take more time to accomplish and are more prone to surveyor bias; that
is, there is more opportunity for the person conducting the survey to bias the
results by the tone in his or her voice or by unscripted comments. In addition,
phone surveys lack the benefits of observing non-verbal communication.
Interviews. Although more costly and time consuming than mail or phone
surveys, interviews have many advantages.
Where time and money permit, interviews are probably the best source of
valuable information from customers, suppliers, distributors, and anyone else
Chapter 6 • Evaluating the Target Market 107
who can help the new venture. It is also possible, however, to use a combina¬
tion of techniques. For example, the entrepreneur may start with phone surveys
to obtain basic information and follow up with interviews with the most useful
sources.
Choosing the Sample. All three techniques described above require the selection
of a sample from the target market. This step in measuring the market should be
done with great care for it will determine the validity of the results achieved. In
general, you want to attempt to choose a random sample, that is, one in which
you have as little control as possible over who will be selected to participate in
the sample. Most entrepreneurs, because of cost and time, choose to use what is
called a convenience sample. This means that not everyone in the defined
target market has a chance of being chosen to participate. Instead, the entrepre¬
neur may, for example, choose to select the sample from people who happen to
be at a particular shopping mall on a particular day. Clearly, the entre¬
The credibility preneur will not be reaching all possible customers at that mall, but if
the target customer typically shops at malls, there’s a good chance of
of your market
achieving at least a representative sample from which results can be
research results derived fairly confidently.
will be measured by Even if a convenience sample is used, there are ways to ensure the
randomness of selection of the participants. Using the mall example,
the quality of the
the entrepreneur can decide in advance to survey every fifth person
sample you select.
who walks by. In this way, the person is not chosen based on their
attractiveness or lack of it, or any other reason for that matter. A
random number generator on a computer can select names from a telephone
book. Whatever system is employed, the key point is to make an effort not to
bias the selection.
Often you will hear potential entrepreneurs say they took a sample of friends
and relatives who loved the new product idea. Friends and relatives may be
able to give you some initial feedback, but they are not the best source of unbi¬
ased information. Remember, one of the reasons you are doing a feasibility
study and, ultimately, a business plan is to convince others about the viability of
the new venture concept. The credibility of your market research results will be
measured by the quality of the sample you select.
Focus Groups. One more efficient way to gain valuable information before
investing substantial capital in production and marketing is to conduct a focus
group. The entrepreneur brings together a representative sample of potential
108 Part 2 • Finding, Analyzing, and Testing Opportunity
customers for a presentation and discussion session. Assuming the new venture
involves a consumer product, the entrepreneur may choose to introduce the
new product in concert with other products to test the unsolicited response to
the product when presented with its competition. For example, suppose your
product is a new type of non-alcoholic beverage. You might serve the new
beverage along with several competitors’ beverages in glasses labeled with
numbers, and then solicit feedback on taste, aftertaste, and so on.
Some products and services do not easily lend themselves to blind studies
like the one just described. In those instances, the product can simply be
presented to the focus group and their opinions and feedback can be solicited.
It is important that the person leading the focus group have some knowledge of
group dynamics and be able to keep the group on track. Many times these
focus group sessions are videotaped so the entrepreneur can spend more time
analyzing the nuances of what occurred. Thus, in many ways, focus groups can
often prevent the entrepreneur from making the costly error of offering a
product or service for which there is little or no interest.
Clinical Studies. Clinical studies are one of the more expensive routes to gath¬
ering market data, and, in general, are used by large corporations introducing
new products. A clinical study takes place in a controlled setting and is most
often used for consumer products. Consumers are asked to visit a test center,
which may be set up as a small store. They are given a certain amount of money
and asked to choose among a variety of new products available in the test store,
which helps the company learn which products are most attractive to
customers. In another type of study, consumers may be asked to do blind
testing of products such as shampoos or food products to compare tastes and
preferences.
PROFILE 6.2
the audiences reactions and make changes based on them before releasing the
film on a national basis. Major product companies like Procter and Gamble will
put a new product into certain geographical test markets like Denver, Colorado
to get feedback from customers. Many a new product has met an untimely
death as a result of these test market studies.
can result in losing a window of opportunity for entering the market. Some
basic market research techniques can provide excellent information at very little
cost and relatively quickly.
Target Market
Primary target markets
Secondary markets
Demographics
Customer needs analysis
Product/Service Differentiation
Unique features
Potential for innovation
Competitors
Direct and Indirect
Market share
Strengths and weaknesses
Emerging
Substitute products
Competitive Advantage
Proprietary protection
Other competitive advantages
112 Part 2 • Finding, Analyzing, and Testing Opportunity
If the entrepreneur has personally conducted the research and done all the
work to this point, he or she will not only have important information to help
make the decision but will also have an intuitive or “gut feeling” as to whether
the new venture concept is viable or not. If market indicators are positive, it is
time to consider other aspects of feasibility and proceed to test the business
concept further.
On the other hand, many entrepreneurs will find it difficult to abandon an
idea with which they have “fallen in love,” even in the face of market data indi¬
cating demand for the new product/service is weak. When this happens, it is
important to remember that without customers there is no business. It is far
better to abandon a business concept at this point than to venture ahead to the
more costly aspects of a business start-up and ultimately fail.
□ Determined the most effective method for gathering primary data on your
target market?
D Organized, analyzed, and presented the data to answer the key question: Is
there sufficient demand for the product or service?
Chapter 6 • Evaluating the Target Market 113
fr— ' ^ Andreason, A.R. (1988). Cheap But Good Marketing Research. Burr Ridge, IL:
Irwin.
Breen G. &r Blankenship A.B. (1989). Do-It-Yourself Marketing Research. New
York: McGraw-Hill, Inc.
Crispell, Diane. (1990). The Insider’s Guide to Demographic Know-How.
Chicago: Probus.
Findex: The Directory of Market Research Reports, Studies and Surveys. (1990).
Gaithersburg, MD: Cambridge Information Group Directories.
Levinson J.C. (1984). Guerrilla Marketing. Boston: Houghton Mifflin.
Overview
• Consumer versus industrial distribution channels
• The role of the distributor in the marketing of a product
• The role of manufacturers’ reps
• Adding value through distribution channels
• Distribution channel information in the feasibility study and business plan
115
116 Part 2 • Finding, Analyzing, and Testing Opportunity
There are two types of distribution channels: direct and indirect. In a direct
channel of distribution, the product or service moves from the manufacturer or
producer directly to the customer. Service businesses generally operate in this
fashion. For example, when you call a plumber to fix a pipe or call your
accountant to do your taxes, the work is handled directly by the company you
called with no one else involved. Selling through mail order is another way of
using a direct channel. When manufacturers sell to the customer through one
of their manufacturer’s outlets, they are also using a direct channel.
An indirect channel of distribution involves one or more intermediaries,
people who move products from the manufacturer or producer to the end user.
They include wholesalers, retailers, distributors, and agents. For example,
suppose you are producing paper products such as cups and plates, etc. When
the product leaves the production facility, it may go to a wholesaler who will
then secure retailers. The retailers job is to advertise and find customers who
will buy the product. Depending on the kind of business the entrepreneur
plans to start, he or she will be dealing either with consumer channels or indus¬
trial channels of distribution.
Direct Selling
The most direct channel in the consumer market is to sell to the customer
using no intermediaries. As discussed earlier, service businesses usually fall
into this category. However, in the past few years a number of manufacturers
have also begun bypassing intermediaries and selling directly to their
customers. Clothing, household, and furniture manufacturers, to name a few,
have opened “outlets” in special factory outlet malls located away from major
metropolitan areas. Generally manufacturers sell direct after they have an
established following through their normal channels so name recognition is
present and little marketing effort is necessary. The outlets are a good way to
get rid of excess inventory and slightly defective merchandise that can’t be sold
in their normal retail outlets. The substantial discounts attract customers from
considerable distances.
Retailers
The most common way for manufacturers to get their products to customers is
through retail stores, which are responsible for sales and advertising of the
product. Using this channel, the manufacturer does not have to incur the
expense of maintaining a sales staff or stores. However, without a distributor,
the manufacturer needs manufacturer’s reps or in-house sales people to locate
potential retail customers and arrange for distribution of the product.
Wholesalers/Distributors
Wholesalers or distributors (the terms are interchangeable in common usage)
buy products in bulk from manufacturers and then seek retail outlets to reach
the consumer. The wholesaler removes from the manufacturer the responsi¬
bility of finding suitable retail outlets for the products. A distributor can mean
the difference between success and failure for a business. When you realize
you are entrusting your most valuable assets—your customers—to the distrib¬
utor, it becomes clear that selecting a distributor is a crucial part of the start¬
up process. Not only will good distributors contribute to increased sales, but
they will help with product planning for the future.. The specifics of what a
distributor may do depend on the distributor. Some of the tasks performed by
them are:
• Warehousing products
• Advertising and promotion
118 Part 2 • Finding, Analyzing, and Testing Opportunity
The key to finding a good distributor is knowing whom to ask. Some of the
sources of information on distributors are:
• Customers
• Suppliers
• Lawyers
• Business consultants
• Bankers (they have knowledge of a distributor’s payment record)
Logistics Firms
It takes a long time before a new venture can justify having its own distribution
center. Consequently many growing companies are outsourcing their pack¬
aging, warehousing, inventory control, and trucking requirements to third-
party logistics firms. In distribution terminology, logistics is the timely
movement of goods from the producer to the consumer. In addition to other
services, logistics firms can negotiate the best deals and the most efficient
carriers, potentially saving the growing venture thousands of dollars.
Agents/Manufacturers’ Reps
Often manufacturers/producers retain agents, brokers, or manufacturers’ reps to
find suitable outlets for their products. These agents arrange agreements with
wholesalers and retailers for the manufacturer. Agents usually do not buy or
hold an inventory of goods from the manufacturer; instead, they bring together
manufacturers and distributors or retailers to establish the most efficient
Chapter 7 • Distribution Channels: Getting the Product or Service to the Customer 119
distriution channel. The manufacturer or producer shares the cost with other
manufacturers represented by the agent and pays a commission only on what
the agent sells.
Manufacturers’ representatives are essentially independent salespeople who
handle the manufacturers business in specific territories and are paid on
commission. Unlike agents who bring buyers and sellers together for indi¬
vidual transactions, manufacturers’ reps work with a specific manufacturer on
a continuing basis, receiving a commission per product sold. Reps may also
provide warehousing in a territory and handle shipping the product to the
retailer.
PROFILE 7:1
All these factors are a function of the distribution channel chosen. Suppose
you are manufacturing a consumer product in the sporting goods industry.
Here is how you might compare the distribution options available to you. The
most common route to the consumer is:
At each stage the channel member adds value to the product by performing a
service that increases the chances the product will reach its intended customer
(see Figure 7.3). The wholesaler seeks appropriate retail outlets, and the retailer
advertises and promotes the product to its customers. This value created allows
each channel member to increase the price of the product to the next channel
member. For example, the manufacturer charges the wholesaler a price that
covers the costs of producing the product plus an amount for overhead and
profit. The wholesaler, in turn, adds an amount to cover the cost of the goods
Manuf acturer
Cost = $3
Sells at $6
Wholesaler / Distributor
Cost = $6
Sells at $10
Retailer
Cost = $10
Sells at $19.95
122 Part 2 • Finding, Analyzing, and Testing Opportunity
purchased and his or her overhead and profit. The retailer does the same and
charges the final price to the customer. That price can typically be 4-5 times
what it cost to manufacture the product (labor and materials).
Suppose you decide to bypass the wholesaler and sell directly to retailers:
Manufacturer —» Retailer
It appears on the surface that the final retail price could be substantially
lower, perhaps even priced at the rate the wholesaler sold to the retailer in the
first example. However, there is a flaw in this reasoning. The wholesaler
It is important for performed a valuable service. He or she made it possible for the manu¬
the entrepreneur to
facturer to focus on producing the product and not incur the cost of
consider all the
maintaining a larger marketing department, a sales force, additional
costs, advantages,
warehouses, and a more complex shipping department. All these activi¬
disadvantages, and
ties now become a cost to the manufacturer of doing business with
consequences of
choosing a retailers and must be factored into the decision to choose this distribu¬
particular market tion channel. This is not to say it never makes sense for manufacturers
channel to reach to sell direct to retailers. However, it is important for the entrepreneur
the customer. to consider all the costs, advantages, disadvantages, and consequences
of choosing a particular market channel to reach the customer.
Other aspects of starting the new venture can also be examined by studying
the distribution channel options. For example, location and transportation
decisions will be affected by the method chosen to reach the customer. Suppose
you have chosen the following channel:
□ Planned how you will get information on the members of your distribution
channel so you can choose the best people to serve your business?
□ Figured the costs associated with the distribution channel you have chosen?
□ Determined the length of time it will take to get your product to the customer?
1. How does direct selling in the consumer and industrial channels of distribu¬
Issues to
tion differ?
Consider
2. Is it possible to prepare a market plan for the new venture without identi¬
iji fying a distribution channel to reach the customer? Why or why not?
3. What kinds of companies may be involved in both consumer and industrial
channels?
4. What are the advantages of using distributors/wholesalers?
5. How does a distribution channel affect the price of the product or service?
126 Part 2 • Finding, Analyzing, and Testing Opportunity
I n 1988, John Allen was doing commercial real estate development in the San
Joaquin Valley in California. Allen had a group of subcontractors whom he
regularly hired to do various construction tasks. One of these subcontractors was
a man named Bill Nelson, a finish carpenter with a penchant for tinkering and
inventing things. Through prior conversation, Nelson had learned that Allen had
advanced degrees in engineering and had been previously employed as an engi¬
neer by an aerospace firm. Nelson had invented a portable machine to provide a
single source of power for electric and pneumatic tools. On the job, Nelson had
seen the need for such a product but felt that he didn’t have the skills to
commercialize the product. Consequently, Nelson approached Allen with his
invention to explore the possibility of retaining Allen for technical and financial
advice and support. He believed that Allens unique knowledge of engineering,
finance, and construction would result in a good match for his invention.
The original invention was a generator and compressor sitting on twin four-
gallon air tanks, and coupled to a small gasoline-drive engine. The concept was
quite simple: when the user started a power tool, a signal was sent to the
compressor head to open a valve and vent the compressor to the atmosphere,
thus reducing the demand on the drive motor and allowing full power to go to
the generator. This feature allowed the unit to be powered by a smaller, less
costly, lighter-drive motor. Prior attempts by other manufacturers to make a
combined unit resulted in heavy, bulky, and expensive products. Nelson felt he
had discovered the answer to this with his invention and had applied for a
patent to protect his idea.
Allen was intrigued by the concept but lukewarm on getting involved. As a
favor to Nelson, Allen made several inquiries to engineering and business asso¬
ciates but received very little encouragement for Nelsons invention. The topic
was dropped.
In 1989, Nelson came back to Allen and claimed that he had invented an
improvement to his original machine that would make it much more
marketable, unique, and innovative than his first attempt; however, he couldn’t
divulge his new invention until he had completed the prototype and had a non¬
disclosure statement signed by Allen. He then asked Allen for financial assis-
Chapter 7 • Distribution Channels: Getting the Product or Service to the Customer 127
tance in patenting and developing this new invention without disclosing what
the invention was. Allen was naturally hesitant; however, he agreed to consider
getting involved after a demonstration of the working prototype.
Several months later, Nelson called Allen to ask if he could come over to
demonstrate his new invention. Nelson showed up in a dilapidated old Toyota
pick-up with the machine in the back, along with several other tools, electrical
cords, air hoses, and general clutter. The invention matched the general appear¬
ance of the vehicle and its cargo. It looked like it was put
together in a blacksmith’s shop from spare parts. Nelson
removed the unit from his truck and plugged an electrical cord
into one of the household receptacles attached to a piece of
wood, which was attached to his machine. The other end was
plugged into a power tool. He proceeded to walk away from
the unit with the power tool in his hand. At approximately
100 feet from the unit he pulled the trigger of the power tool
and the drive motor of the unit started up, and then the power tool started
working instantaneously. When he lay the tool down, the motor stopped. He
repeated this process several times. Needless to say, Allen was impressed.
Nelson had a modified air starter (small air drill) coupled to the drive motor
that would start the motor with a signal sent from the power tool. He was using
compressed air in the tanks (storage from the compressor) as a “battery” for the
air starter. It was ingenious. Allen agreed to get involved and assist in the finan¬
cial needs to file the patent and construct an engineered, functional prototype.
About this time, Allen formed Gentech Corporation to manufacture, sell, and
distribute the product. Through five years of engineering and prototype
building, the invention was improved to incorporate a solid state, program¬
mable controller which, with its additional features, has made the functions of
the machine more efficient and intelligent.
The Corporation
Gentech Corporation, a privately held California corporation, was established to
manufacture and distribute portable power equipment incorporating patented,
state-of-the-art technology and satisfying a need for efficient, energy-saving, and
environmentally friendly power equipment. PowerSource, the first product to be
offered by Gentech Corporation, is a combination air compressor and generator
unit mounted on a typical twin-tank, wheelbarrow-style frame. Driven by a
single gasoline engine, the dual purpose PowerSource provides both AC electric
128 Part 2 • Finding, Analyzing, and Testing Opportunity
power and air power from one portable, lightweight unit. When operating as a
generator, it supplies electrical power to 110-volt outlets. When an electrical
tool is in use, an electronic switching unit automatically sends a signal to open
a valve to vent the compressor piston to the atmosphere, thus significantly
reducing the demand on the engine. As long as there is air stored in the tanks,
air tools and power tools can be used simultaneously. A powerful AC generator
and a high output air compressor, the PowerSource eliminates the need to trans¬
port both a generator and compressor to the work site.
The benefits to the user are that PowerSource:
Industry Profile
Gentech Corporation and its product PowerSource will operate in the motors and
generators (SIC 3621) and air and gas compressors (SIC 3563) industries,
which are mature industries with many companies. The industries and leading
75 companies in each industry in the United States are summarized as follows:
power plant is unique and will result in a competitive advantage during the
market entry and roll-out program.
Target Market
Initially the target market is the niche market of the small building contractor or
subcontractor. During the first year of operation, the marketing effort will be
limited territorially to California and the western states, with the initial entry
through construction equipment rental outlets. There are over 12,000 equipment
rental outlets nationally and over 2,000 in California alone. Equipment rental
outlets typically replace their equipment annually, selling the used equipment.
This practice allows Gentech Corporation the ability to generate clients who will
have a need to purchase PowerSource on a regular basis. Using a preproduction
quality prototype, demonstrations to potential distributors, end-users, and
investors were conducted. The response indicated that there is a need for this
product, and the special features make it competitive with existing single
purpose units. The consensus has been that this niche market product could
have a significant customer base; those participating in the demonstrations were
extremely enthusiastic about the product potential. Based on these findings
Gentech Corporation is conservatively estimating demand at 1,800 units in the
first year, 3,600 in the second year in the western United States.
As the market and product mix are expanded, additional users will be identi¬
fied and targeted. Other classes of users may include farmer, mechanics,
commercial fishermen, domestic do-it-yourselfers, the military, utility compa¬
nies, and federal, state, and local government services and agencies.
At this time, the founding team is not certain what the post start-up strategy
should be.
Overview
• The legal structure options for new ventures
• The pros and cons of incorporating
• The requirements, advantages, and disadvantages of a sub-chapter S election
• Forming a 501 (c)(3) non-profit corporation
135
136 Part 3 • The New Venture and the Law
4. Are you willing and able to assume personal liability for any claims against
your business?
5. Do you wish to have complete control over the operation of the business?
If you answer “yes” to all these questions, you may be able to use the sole
proprietor form of organization for the new venture.
Typically, issues arise when setting up your company. Figure 8.1 compares
the various legal forms of ownership.
Sole
Issues Proprietorship Partnership C-Corporation
Number of Owners One No limit No limit on
shareholders
Start-Up Costs Filing fees for DBA Filing fees for DBA. Attorney fees for
and business license Attorney fees for incorporation
partnership agreement documents,
filing fees
Liability Owner liable for all General partners liable Shareholders liable
claims against for all claims. Limited to amount invested.
business only to amount of Officers may be
investment personally liable
Transfer of Interest Owner free to sell General partner requires Shareholders free to
consent of other sell unless restricted
generals to sell interest. by agreement
Limiteds’ ability subject
to agreement
Management Control Owner has full control Shared by general Rests with the board
partners according to of directors who are
partnership agreement appointed by the
shareholders
Chapter 8 • The Legal Structure of the Business 137
Sole Proprietorship
Nearly 76 percent of all businesses in the United States are sole proprietor¬
ships, most probably because it is the easiest form to create. In a sole propri¬
etorship, the owner is the only person responsible for the activities of the
business. Likewise, the owner is the only one to enjoy the profits and suffer
the losses.
To operate as a sole proprietor requires nothing more than a DBA if the
entrepreneur does not use his or her name as the name for the business. A
DBA is a “Certificate of Doing Business Under An Assumed Name” and can be
obtained by filing an application with the appropriate local government
agency. The certificate, sometimes referred to as a “fictitious business name
statement,” ensures that yours is the only business in the area (usually a
county) using the name you have chosen and provides a public record of busi¬
ness ownership for liability purposes. For example, Anthony Jackson and
Associates does not require a DBA if the entrepreneurs name is Anthony
Jackson, but Corporate Consultants does.
Sole proprietorships have several advantages.
• The sole proprietor has unlimited liability for all claims against the business;
that is, any debts incurred must be paid from the owners assets. Therefore,
the sole proprietor puts at risk his or her home, bank accounts, and any
other assets. In the current litigious environment, exposure to lawsuits is
substantial. To help mitigate this liability, a sole proprietor should obtain
business liability insurance, including errors and omissions coverage.
• It is more difficult to raise debt capital because the owners financial state¬
ment alone often may not qualify for the amount needed.
• The sole proprietor usually relies on his or her skills alone to manage the
business. Of course, employees with specific skills can be hired to comple¬
ment the skills of the owner.
• The business’s ability to survive is dependent on the owner and, therefore,
the death or incapacitation of the owner can be catastrophic for the business.
138 Part 3 • The New Venture and the Law
Often small businesses such as shoe repair shops and boutiques are run as
sole proprietorships. This is not to say that a high-growth venture cannot be
started as a sole proprietorship; it just will in all likelihood not remain a sole
proprietorship for long as the entrepreneur will typically want the protections
and prestige a corporation afford.
Partnership
When two or more people share the assets, liabilities, and profits of a business,
the legal structure is termed a partnership. The partnership form is an
improvement over the sole proprietorship from the standpoint that the business
can draw on the skills, knowledge, and financial resources of more than one
person. Like the sole proprietorship, however, the partnership requires a DBA
when the last names of the partners are not used in naming the business.
Professionals like lawyers, doctors, and accountants frequently employ this
legal structure.
A partnership is essentially a sole proprietorship involving more than one
person in terms of its advantages and its treatment of income, expenses, and
taxes. However, where liability is concerned, there is a significant difference. In a
partnership, each partner is liable for the obligations another partner incurs in
the course of doing business. For example, if one partner signs a contract with a
supplier in the name of the partnership, the other partners are also bound by the
terms of the contract. However, creditors of an individual partner can only attach
the assets of that individual partner, including their interest in the partnership.
Partners also have specific property rights. For example, each partner owns
and has use of the property acquired by the partnership unless otherwise stated
in the Partnership Agreement. Each partner has a right to share in the profits
and losses, and each may participate in the management of the partnership.
Furthermore, all elections such as depreciation and accounting methods are
made at the partnership level and apply to all partners.
Though the law does not require it, it is wise for a partnership to draw up a
written partnership agreement, based on the Uniform Partnership Act, that
spells out business responsibilities, profit sharing, and transfer of interest. This
is because partnerships are inherently fraught with problems that arise from the
different personalities and goals of the people involved. A written document
executed at the beginning of the partnership will reduce the eventual disagree¬
ments and provide for an orderly dissolution should irreconcilable differences
arise. Partnerships are burdened by the same disadvantages as sole proprietor¬
ships with the additional encumbrance of personal conflicts, usually over
Chapter 8 • The Legal Structure of the Business 139
power and authority, that can result in the dissolution of the partnership. Many
partnerships have solved much of this problem by assigning specific responsi¬
bilities to each of the partners.
There are two types of partnerships: general and limited. In a general part¬
nership, all the partners assume unlimited personal liability and responsibility
for the management of the business. In a limited partnership, by contrast, the
general partners seek investors whose liability is limited to their monetary
investment; that is, if a limited partner invests $25,000 in the business, the
most he or she can lose if the business fails is $25,000. It is important to note,
however, that limited partners have no say in the management of the business.
In fact, they are restricted by law from imposing their will on the business. The
penalty for participating in the management of the business is the loss of their
limited liability status.
Corporation
A corporation is different from the preceding two forms in that it is a legal
entity in and of itself. The U.S. Supreme Court has defined the corporation as
“an artificial being, invisible, intangible, and existing only in contemplation of
the law.” It is chartered or registered by a state and can survive the death or
separation of the owner(s) from the business. The owners of the corporation are
its stockholders who invest capital in the corporation in exchange for shares of
ownership. Like limited partners, stockholders are not liable for the debts of the
corporation and can only lose the money they have invested.
Most businesses form what is known as a closely held corporation; that is,
the corporate stock is owned privately by a few individuals and is not traded
publicly on a securities exchange such as the New York Stock Exchange. This
chapter will focus on private corporations. The issue of “going public” typically
arises after the business is established and desires to raise substantial capital for
growth by issuing stock through an initial public offering (IPO). The IPO and
public corporations in general are the subject of Chapter 17.
A corporation is created by filing a Certificate of Incorporation with the state
in which the company will do business and issue stock. It also requires the
establishment of a board of directors, which meets periodically to make
strategic policy decisions for the business. The regular documentation of these
meetings is crucial to maintaining the corporations limited liability status. The
board also hires the officers who will run the business on a day-to-day basis.
The C-corporate form (a variation of this most common form, the S-corp.,
will be discussed later) has several important advantages.
140 Part 3 • The New Venture and the Law
• It enjoys limited liability in that its owners are liable for its debts and obliga¬
tions only to the limit of their investment. The only exception to this protec¬
tion is payroll taxes that may have been withheld from employees’ paychecks
but not paid to the Internal Revenue Service.
• Capital can be raised through the sale of stock up to the amount authorized
in the corporate charter; however, the sale of stock is heavily regulated by
federal and state governments. A corporation can create different classes of
stock to meet the various needs of its investors. For example, it may issue
non-voting preferred stock to conservative investors who, in the event
A corporation can
the corporation must liquidate its assets, will be first in line to recoup
create different
their investment. Common stock is more risky because holders of it are
classes of stock to
paid only after the preferred stockholders. Common stockholders are
meet the various
entitled to vote at stockholders’ meetings and divide the profits
needs of its
investors. remaining after the preferred holders are paid their dividends, assuming
these profits are not retained by the corporation to fund growth.
• Ownership is easily transferred. This is at once an advantage and a disadvan¬
tage as the entrepreneur will want to be careful, particularly in the start-up
phase, that stock does not land in the hands of undesirable parties such as
competitors. This problem is normally handled through a buy-sell clause in
the stockholders’ agreement that states that stock must first be offered to the
corporation at a specified price before being offered to someone outside the
corporation.
• The corporation can enter into contracts, sue, and be sued without the signa¬
ture of the owners. In a start-up or young company, bankers, creditors, and
such will likely require that majority stockholders or officers personally guar¬
antee loans. This is because often a new corporation will be wholly owned
by the entrepreneur; that is, the entrepreneur or the founding team holds all
the issued stock. As the company does not have a track record and is in a
high-risk phase of development, creditors protect themselves against the
potential failure of the corporation by requiring the signatures, thus giving
them the ability to pursue the assets of the owners.
• Corporations often enjoy more status and deference than do other legal
forms, principally because they are a legal entity that cannot be destroyed by
the death of one or all of the principal shareholders. Moreover, to enter the
public equity markets, a business must be incorporated. Also, the perception
is that corporations probably keep better records than other forms of owner¬
ship because they tend to be under greater scrutiny from governmental agen¬
cies. The reason for this scrutiny is the fact that the assets of the corporation
are separate from the assets of the individual owner/shareholders.
Chapter 8 • The Legal Structure of the Business 141
A corporation must endeavor in all ways to act as an entity separate from its
owners. It must keep personal finances completely separate from corporate
finances, hold directors meetings, maintain minutes, and not take on any finan¬
cial liability without sufficient resources to back it up. Failing to do any of the
above can result in what is known as “piercing the corporate veil,” which leaves
the officers and owners open to personal liability.
Apart from legal considerations, where to incorporate is also an important
issue. It is normally advantageous to incorporate in the state in which the entre¬
preneur intends to locate the business so that it is not under the regulatory
powers of two states (the state in which it is incorporated and the state in which
it must file an application to do business as an out-of-state corporation.)
Normally, however, a corporation will not have to qualify as a “foreign” corpo¬
ration doing business in another state if it is simply holding directors/share¬
holders meetings in the state, or holding bank accounts, using independent
contractors, or marketing to potential customers whose transactions will be
completed in the corporations home state. It has often been said that you should
incorporate in Delaware because it has laws favorable toward corporations. If
you don’t intend to do a substantial amount of business in Delaware, however,
Incorporation Checklist
the cost and hassle of qualifying in another state may overcome the benefit of a
Delaware incorporation. The entrepreneur should also consider the favorable¬
ness of the laws governing corporations in the state chosen. Some states, like
California, have a required, minimum annual corporate income tax whether or
not the business has a taxable income.
The S-Corporation
An S-corporation, unlike the C-corporation, is not a tax-paying entity. It is
merely a financial vehicle that passes the profits and losses of the corporation to
the stockholders. It is treated much like the sole proprietorship and the part¬
nership in the sense that if the business earns a profit, that profit becomes the
income of the owners/stockholders, and it is the owners who pay the tax on
that profit at their individual tax rates.
The rules for election of the S-corporation option are very specific.
• If the entrepreneur sells the assets of the business, the shareholder pays a tax
on the amount of appreciation. With a C-corporation, the gain is taxable to
the corporation and the balance paid to the stockholder is also taxed.
The businesses that benefit most from an S-corporation structure are those
that don't have a need to retain earnings. In an S-corporation, if the entrepre¬
neur decides to retain, say, $100,000 of profit to invest in new equip¬
The businesses that ment, the stockholders must still pay taxes on that profit as if it had
benefit most from an been distributed. Furthermore, while most deductions and expenses
are allowed, S-corporations cannot take advantage of deductions based
S-corporation struc¬
on medical reimbursements or health insurance plans. Another consid¬
ture are those that
eration is that unless the business has regular positive cash flow, it
don’t have a need to
could face a situation where the business makes a profit which is
retain earnings.
passed through to the owners to be taxed at their personal rate, but
generates insufficient cash to pay those taxes.
The S-corporation was a valuable financial tool under the 1986 Tax Reform
Act because personal tax rates were significantly lower than corporate rates.
However, there is some question about the tax advantages under the 1993 Tax
Code, as top personal rates have increased and surcharges have been imposed
so that a C-corporation might be preferable at higher profit levels. For some
small businesses, however, the S-Corporation may still be less costly in the long
run because it avoids double taxation of income. A good tax attorney or CPA
should advise the entrepreneur on the best course of action.
Ventures that typically benefit from election of the S-corporation status
include service businesses with low capital asset requirements, real estate
investment firms during times when property values are increasing, and start¬
ups that are projecting a loss in the early years. Entrepreneurs should probably
not elect the S-corporation option if they want to retain earnings for expansion
or diversification or if there are significant passive losses from investments such
as real estate.
Only privately held companies can become LLCs and they must be formed
following very strict guidelines.
• The owners of an LLC are called “members” and their interests are known as
“interests.”
• An LLC will have two or more members and is formed via filing articles of
organization, which resembles a limited partnership agreement.
• The management of the company can be undertaken by the members or by
people they have elected to do so.
• The members create an “operating agreement,” which is very similar to a
partnership agreement that spells out rights and obligations of the members.
• Managers, officers, and members are not personally liable for the company’s
debts or liabilities except as they have personally guaranteed these debts or
liabilities.
• Most LLCs will be organized for tax purposes like partnerships so that
income tax benefits and liabilities will pass through to the members. In New
York and California, however, the LLCs will be subject to state franchise
taxes or fees. To avoid being taxed like a corporation, the LLC must not have
at least two of the four corporate characteristics: limited liability, continuity
of life, centralization of management, and free transferability of interests. The
two that are least likely to be eliminated to meet the test are continuity of life
and free transferability of interests. In fact, several states have “bulletproof’
statutes that insure that LLCs will always be classified as partnerships for
federal income tax purposes.
• Transfer of ownership is with the consent of members who in the aggregate
own at least a majority of the company.
• Unless the members owning the majority interest in the aggregate deem
otherwise, the LLC will dissolve upon the death, resignation, expulsion or
bankruptcy of a member.
• Interests in LLCs where members participate in the management and control
of the company are considered securities for federal and most state securities
laws, very much like limited partnership interests. This means that the
offering or sale of interests must be registered, which then exposes the orga¬
nizing members to potential liability for material omissions and misrepresen¬
tations of fact under securities laws.
The LLC is most often compared to the limited partnership and the
S-corporation. There are, however, differences. In a limited partnership, one or
more people (the general partners) agrees to assume personal liability for the
146 Part 3 • The New Venture and the Law
actions of the partnership; this is not the case with an LLC. Unlike a limited
partnership, in an LLC a member does not have to forfeit the right to participate
in the management of the organization to retain his or her limited liability status.
In an LLC, unlike in an S-corporation, there are no limitations on the
number of members or their status, such as corporation, pension plans, or non¬
resident aliens. Also, while S-corporations can’t own 80 percent or more of the
stock of another corporation, an LLC may actually have wholly owned
subsidiary corporations. LLCs are not limited to one class of stock and in some
ways they receive more favorable tax treatment. For example, unlike an S-
corporation shareholder, the LLC member can deduct losses in amounts that
reflect the members allocable share of the debt of the company.
If at a later date, the entrepreneur decides to go public, the LLC can become
a C-corporation by transferring the LLC assets to the new corporation. It is,
however, a bit more difficult to go the other way, as you must pay capital gains
tax on the appreciation.
LLCs are also becoming a popular vehicle for companies that may have
global investors, as the S-corporation does not permit foreign ownership. As
this is still a fairly new legal structure, an attorney should be consulted to find
out if this form is available in the entrepreneurs state and to help the entrepre¬
neur understand and abide by the requirements associated with it.
□ Answered the questions that will determine if you can operate as a sole
proprietor?
□ Examined the advantages and disadvantages of the corporate structure for the
new venture?
Bangs, D.H. (1994). The Start-Up Guide, 2nd edition. Dover, NH: Upstart
Publishing Co.
Barlett, J.W (1988). Venture Capital—Law, Business Strategies and Investment
Planning. New York: John Wiley & Sons.
Friedman, R. (1993). The Complete Small Business Legal Guide. Chicago:
Dearborn Enterprise.
Mancuso, J.R. (1988). Mancuso’s Small Business Resource Guide. New York:
Center for Entrepreneurial Management.
Nicholas, T. (1993). The Complete Guide to “S” Corporations. Chicago:
Dearborn Publishing Group, Inc.
Whitmyer, C., S. Rasberry & M. Phillips. (1988). Running a One-Person
Business. Berkeley, CA: Ten Speed Press.
1. What are three important issues the entrepreneur should consider prior to
Issues to
electing to operate the new venture as a sole proprietorship?
Consider
2. What advantages does a partnership have over a sole proprietorship?
ijx Disadvantages?
3. Assuming you had a successful business being run as a sole proprietorship,
what would induce you to change the legal form to a corporation?
4. Why would an entrepreneur elect S-corporation status over C-corporation?
5. What types of organizations qualify as nonprofit corporations and 501(c)(3)
tax-exempt status?
CHAPTER 9
Regulations Affecting
New Businesses
Overview
• The importance of laws and regulations on all aspects of a new venture
• The requirements for a valid contract
• Laws and rules that will affect the choice of a site for the business
• Laws related to the hiring and firing of employees
• Laws that regulate dealings with consumers
• Taxes for which the business is responsible
149
150 Part 3 • The New Venture and the Law
The Idea
• Patents
• Copyrights Trade Issues
• Trademarks • Price Discrimination
Start-up • Consumer Protection
• Permits • UCC
• Licenses • Truth in Lending
• Contracts • Truth in Advertising
X
BUSINESS
Gordon Roddick of The Body Shop, to be the most regulated country in the
world. Roddick believes that compliance with regulations adds at least five
percent to the cost of doing business, reducing the number of businesses that
are able to start1 because a new venture must often spend its scarce resources
on attorneys and accountants to ensure compliance with the law.
This chapter looks at the process of starting a business from a regulatory
point of view, considering which regulations affect which aspects of the new
venture. As can already be observed from Figure 9.1, a young business—any
business for that matter—is affected in every arena of its existence by laws and
regulations.
^‘Regulation Time: 60 Seconds with...Gordon Roddick.” Inc. magazine, June, 1993, p. 16.
Chapter 9 • Regulations Affecting New Businesses 151
One of the first areas where the entrepreneur is affected by laws and regulations
occurs at the idea stage before the new venture even begins. Laws determine
whether or not an invention or design can be protected by intellectual property
rights, and whether a symbol or logo that represents the business can be trade-
marked so no one else can use it. These legal protections can give the business a
significant competitive advantage.
In all likelihood, you will enter into several contracts before the business is
up and running. These may include agreements with suppliers, a lease for the
business site, a partnership agreement, independent contractor agreements,
employment contracts, and so forth. If you have established a relationship with
a business attorney, he or she will probably be able to create standard contract
forms reflecting the specific needs of your business that can be used over and
over again in similar situations. On the other hand, when presented with a
contract created by a third party (your suppliers attorney, for example), you
should ask your attorney to review the document to make sure you are
protected and are not agreeing to something that could ultimately harm the
business. In general, contracts should be drawn in such a way as to be legally
binding so you will have legal remedies should the other party not comply with
the terms of the contract.
To be a legally binding contract, there must be an agreement, which is an
offer or promise to do something or refrain from doing something. For
example, a vendor may offer to sell you a copy machine, which constitutes an
offer to do something. For the agreement to be valid, however, there must also
be consideration, which is your promise to supply or give up something in
return—a check or purchase order, for example. Furthermore, to be legally
binding, the parties to the contract must have capacity; that is, they must be
legally able to enter into a contract. Contracts cannot be entered into legally by
intoxicated persons, persons who are not of sound mind and body, or minors.
If these people do enter into an agreement, the contract may be contested and
ruled to be void, as never having existed.
A lawyers time is normally very expensive, but lawsuits can be devastating to
a growing business, not to mention time-consuming. It may, however, be
possible to save money by taking advantage of some of the new self-help legal
software and books now available. While they should not be used as a substitute
for sound legal advice on complex issues, they are excellent for basic legal issues
such as simple agreements. Both software and books usually provide standard
152 Part 3 • The New Venture and the Law
PROFILE 9.1
forms with blanks to fill in. Some interactive programs even guide the entrepre¬
neur through a series of questions that lead to a customized document. When
using these programs, be aware that the deletion or addition of even one word
can change the meaning of a sentence with potentially disastrous consequences.
cial, but no manufacturing. Light industrial zoning allows for distribution and
warehousing, while heavy industrial includes major manufacturing and assem¬
bling of products. In general, as you move from commercial zoning to heavy
industrial, the cost per square foot of the land declines. Consequently, manu¬
facturing facilities that normally require considerably more square footage of
buildable space enjoy less expensive land and rent costs. This is because as
you move from commercial to industrial zoning, the importance of the specific
location for business success decreases. Therefore, you are more likely to find
commercial zoning in the vicinity of residential zoning than you are to find
industrial. This subject is treated more fully in Chapter 10. You can learn more
about city and county zoning ordinances from the planning department or
building and safety department of the city in which the business will be
located. Unincorporated areas normally have their own county planning
department.
Not only will the business have to abide by zoning ordinances, but
Most municipalities also by building codes. Whether you build the facility or buy an
existing facility, you have to ensure that the building meets local and
require that a
state building standards. Such things as structural codes for earth¬
business have a quake safety, fire codes, and electrical codes are all mandated by these
license to operate standards. If you are building, you should hire an experienced,
licensed general contractor who will see that all requirements and
within the limits of
inspections are met. If you are buying an existing building, you can
the city or town. hire a professional contractor or inspector to verify that the building
meets all codes. If you are renting, make sure the landlord can provide
proof that the building meets all code requirements so you don’t face having to
move when a building inspector condemns the building after your business is
already there.
Most municipalities require that a business have a license to operate within
the limits of the city or town. If the business is located within the unincorpo¬
rated areas of a county, it may also be required to obtain a license. License
requirements vary from city to city, but you can find out your city’s require¬
ments by going to the business license division, usually located in the city hall
or planning department. Depending on the nature of the business, you may
also be required to hold a permit, which can be obtained m the same location
as the license. Some typical permits that may be required are building, health,
electrical, fire, and sign permits.
More recent environmental regulations affect the choice of site. Most states
now have environmental quality regulations that protect against businesses
154 Part 3 • The New Venture and the Law
emitting pollutants into the ground, air, or water. They also define who can
handle toxic wastes and how they must be disposed of. Check with local
government agencies to determine if any permits are required for your business
(this is normally for manufacturing or extraction businesses). Also contact
federal and state agencies like the Environmental Protection Agency, the Office
of Health and Emergency Planning, and the Occupational Safety and Health
Administration (OSHA) for information. Some states like California have
Environmental Business Resources Assistance Centers that provide access to the
latest environmental regulatory compliance resources for small and medium¬
sized businesses by phone, fax, or electronic bulletin board as well as through a
personal visit to the center.
Hiring Employees
Several laws exist related to hiring, firing, and compensating employees, so the
entrepreneur must be aware of his or her obligations under the law before hiring
anyone to avoid any future problems. An employer’s obligation begins with the
language used in advertising for positions in the company and extends to the
interviews conducted with potential hires. The Equal Employment Opportunity
Commission (EEOC) is charged with protecting the rights of employees. It
mandates that you cannot refuse to hire someone based on age, race, national
origin, religion, gender, or physical challenge. The only time sex or race can be
a valid consideration for a job is when it is a bona fide occupational qualifica¬
tion, for example, an acting job calling for an Asian male over the age of 40.
This also means written job descriptions must be accurate and defensible and
contain clear language that differentiates essential tasks of the job from non-
essential ones. It is only on the basis of the essential tasks that you can seek
someone who is of a certain gender, who has no physical disability, or who can
speak a certain foreign language.
If you have written a good ad, you will probably receive several resumes. With
jobs being generally more difficult to find, applicants are likely to embellish their
resumes somewhat to be more competitive in the marketplace. You, however,
must protect yourself against hiring someone whom you may later have to fire,
because firing someone is no longer as easy as it used to be. The laws protecting
the employee, combined with a litigious society in general, make for a very deli¬
cate situation for any employer attempting to fire an employee. It is, therefore,
probably dangerous to take any resume on face value. A few phone calls to refer¬
ences can give you a sense of the veracity of the resume.
Chapter 9 • Regulations Affecting New Businesses 155
1. Don’t feel that just because the person has experience in only one arena, he or she is not qual¬
ified to do what you want them to do. Look for core skills like writing, speaking, organizing,
leading, and so forth. These basic abilities can be put to use in a variety of scenarios.
2. Consider promoting from within—training current employees so that they can move up when
the time comes.
3. Look for people with successful experience in the general field in which you are interested.
5. Look for demonstrable success, not just statements like, “I was a successful salesperson for
ABC,” but rather statements like, “Over the past five years I have increased my sales volume
by 20 percent per year."
6. Look for people who have stayed with a company for a reasonable length of time.
At the interview stage, certain questions are not permitted by the EEOC.
These include questions about
• Health
• Disabilities (You may ask, “Do you have any conditions that would preclude
your doing this job?”)
• Age (To protect those under 21 and over 40)
• Medical history
• Living arrangements
• Religious preference
• Type of military discharge
• Pregnancy plans
• Arrest record (You may ask: “Have you ever been convicted of a felony
crime?”)
• Ancestry
In general, the rule is to keep all questions related to the job requirements,
including skills, experience, and attitudes. One last point on this issue: It is
illegal to request a photo with a job application or resume unless the job is
specifically known to be predicated on appearance, such as a modeling job.
co-worker. A year later you fire her, and she files a federal wage-and-hour claim
for back pay for the extra hour each day she spent during the year. It is likely
she will win her claim. Why? Because even salaried employees are entitled to
protection under the Department of Labors Fair Labor Standards Act, which
establishes minimum wage. There are a disparately large number of claims
against small businesses as opposed to large organizations. This is because small
businesses rarely have personnel departments with people whose responsibility
is to make sure the hiring and firing of employees is handled correctly so as to
avoid claims.
In general, four types of job categories are exempt from minimum wage and
hour laws: executive, administrative, professional, and outside sales. This is
only true, however, if strict guidelines are followed. The Department of Labors
basic criteria for establishing an employee as exempt are:
growing and most vexing claims are those for repetitive motion injury (such as
carpal tunnel syndrome) and stress-related disabilities.
The high cost of workers’ compensation premiums has led many small busi¬
nesses to join consortiums to self insure. While this is a complex process, there
are many consultants who are able to help businesses through it. In some
instances, trade associations have formed a consortium for self-insuring busi¬
nesses in the same industry and facing the same potential injury claims.
Fortunately, the bright spot in all this is that a business can control its costs
through active accident prevention and education programs. The issue of safe
and healthy work environments is the purview of the Occupational Safety and
Health Act of 1970 (OSHA) and its administrative unit. OSHA requires that
employers eliminate hazardous areas in the workplace and maintain health and
safety records on all employees. OSHA inspectors regularly target businesses
that have certain hazards inherent in the nature of the business, such as
asbestos, and conduct rigorous inspections, liberally dispensing fines and
penalties where violations have occurred (the basic fine is $7,000).
Before the new business is faced with an OSHA audit, call OSHA and ask to
receive some of their helpful pamphlets (See Additional Sources of Information on
p. 165) or ask an OSHA consultant to conduct a free, confidential, on-site test
of your business and give you compliance advice. Also local colleges usually
offer seminars in safety management.
PROFILE 9.2
Several tips will help you avoid high premiums and the stress of OSHA
audits.
while the employment rules are regulated by the EEOC. As the law is stated in
broad terms such as “undue burden” and “reasonable accommodations,” many
business owners are concerned that this ambiguity translates into more litigation
for them. The laws related to disability will evolve over time, so it is important
that the entrepreneur maintain an awareness of the status of ADA.
Sexual Harassment
The rulings regarding unwanted attention and harassment on the job began to
get very tough in the 1980s. The courts have expanded the definition of sexual
harassment, and businesses are now developing policies in an effort to ward off
embarrassing and expensive lawsuits. The EEOC reports that sexual harassment
complaints grew from 4,400 in 1986 to 5,600 in 1990. In its first ruling on the
subject, the Supreme Court held that sexual harassment violates Title VII of the
1964 Civil Rights Act when the act is unwelcome and represents an abuse of
power in the workplace. Generally, harassment can be divided into two cate¬
gories: quid pro quo where advancement on the job or a raise is conditional on
certain sexual favors, and hostile working environment cases where the employee
is subjected to a sexually offensive environment against his or her will. Harass¬
ment includes but is not limited to verbal and non-verbal assaults of a sexual
nature, and physical harassment. As a result, business owners should establish
policies that educate and make clear to employees what conduct is not acceptable
in the workplace. In doing so, entrepreneurs can solicit guidance from the EEOC.
Trade Issues
In the United States great value is placed on the free marketplace, and generally
any attempts by government to interfere in the free market process are
shunned. Nevertheless, since the 1800s the government has imposed certain
laws specifically designed to preserve competition and the free market. The
Sherman Antitrust Act of 1890, one of the first, prohibited any restraint of free
trade. Other regulations followed, and they are discussed in several categories.
Price Discrimination
The Clayton Act of 1914 and the even stricter Robinson-Patman Act of 1936,
enforced by the Federal Trade Commission, assert that businesses cannot sell
the same product to different customers at different prices without justifica¬
tion. In other words, they must demonstrate that the lower price was based
on a quantity-sold discount, quality of the product (seconds or slightly
160 Part 3 • The New Venture and the Law
Consumer Protection
The greatest number of laws affecting trade come under the heading of
consumer protection. They include:
• Unscrupulous sellers
• Unreasonable credit terms
• Unsafe products
• Mislabeling of products
One of the largest federal agencies monitoring product safety is the Food and
Drug Administration (FDA), which is responsible for research, new product
testing, and inspection of the operations of food and drug manufacturers. If your
new product is a cosmetic, a drug, a food item, or anything applied to the skin,
like suntan lotion, you will need FDA approval before marketing the product.
The Consumer Product Safety Commission was established in 1972 as the
watchdog for consumers over products considered hazardous. Additionally, it is
charged with setting standards for such things as toys for children under the age
of five. If your product falls into one of these categories, you will need to be aware
of the standards and requirements for marketing and producing that product.
The Fair Packaging and Labeling Act was designed to provide consumers
with information so they could shop more wisely. The act mandates that manu¬
facturers truthfully list all raw materials used in the production of the product
on a clearly marked label. This is in addition to the size and weight of the pack¬
aging. If your product is a food product, the percentages of nutrients, vitamins,
carbohydrates, calories, and fat contained in one normal size serving of the
product must be displayed. By becoming aware of the regulations affecting
products manufactured for public consumption, you can avoid both the
possible recall of your product and potential lawsuits.
if you are a merchant, you must also abide by the laws of the UCC, which can be
different. To use a simple example, suppose you have ordered some supplies
from a manufacturer under a contract that contains the tenns of place, delivery
date, and quantity, but you have failed to ask the price. The supplies arrive and
the price is higher than expected. Under the regulations of the UCC, a price that
is reasonable at the time of delivery is assigned, based on the fact that both you
and the manufacturer are professionals who understand how the business oper¬
ates. You can’t claim lack of knowledge the way a lay person can; you are
presumed to know the rules of the game since you are in business.
The UCC also deals with product liability issues. Historically, the philosophy
of the marketplace in the United States has been caveat emptor or “let the buyer
beware.” In contemporary times, the burden of that philosophy has shifted to
“let the seller beware” as consumer groups and advocates like Ralph Nader have
forced businesses to take responsibility for the quality and safety of what they
produce. Whenever you sell goods, you also sell a warrant of merchantability,
which is an implied warranty that the product is of at least average quality and
suitable for the purpose for which it was intended. Consequently, the shift in
the burden of responsibility has resulted in numerous lawsuits by consumers
and higher premiums for product liability insurance. For example, it is esti¬
mated that about 25 percent of the cost of a football helmet pays for product
liability insurance. Any entrepreneur who intends to manufacture and sell a
consumer product should be careful to include clear instructions on its use and
warnings about the consequences of misuse.
Consumer Credit
Like consumer protection laws, the laws regulating consumer lending are
pervasive in an effort to protect consumer rights. The Equal Credit Opportunity
Act (ECOA) provides for fair and equitable treatment of all borrowers without
regard for marital status, source of income, race, color, or national origin. It also
requires prompt disclosure of the reasons for any denial of credit. It applies to
all banks, credit unions, retailers, and business creditors. Before any credit
granting can be completed, the Truth-in-Lending Act (Regulation Z) mandates
detailed disclosures concerning the cost of credit. It also requires disclosures on
the method of billing on open-ended contracts, personal property leases, and
credit card accounts as well as the number and amount of payments required,
and the type of collateral given to secure the loan. It applies to anyone who
regularly extends credit, imposes a finance charge, or permits an obligation to
be repaid over more than four installments.
162 Part 3 • The New Venture and the Law
The Fair Credit Billing Act (FCBA) provides procedures for dispute resolu¬
tion, and the Fair Credit Reporting Act (FCRA) mandates standards for
reporting information on credit recipients to credit reporting agencies. If you
intend to grant credit to your customers, you must make yourself aware of all of
the applicable regulations. The bottom line is: merchant lender beware!
Truth in Advertising
The Federal Trade Commission is charged with protecting the rights of
consumers against false or misleading advertising. It has come down hard on
many businesses for misleading customers about what a product can do,
offering a reduced (sale) price on an item that was never advertised at a higher
price, using list price as a comparison if the business has never sold the item at
list, and using bait-and-switch techniques to lure customers into the store only
to switch them to a higher-priced item.
Taxes
As a business owner, you are also legally responsible for paying certain taxes in a
timely fashion. Since no one wants to pay more taxes than required, business
owners must understand which transactions qualify as tax-free and what the tax
consequences are of any transaction. For example, a $2,000 transaction is worth
$2,000 to the business if it is tax-free; however, if it is taxable it may only be
worth $1,400—a sizable difference. In general, the following are tax-free receipts:
• Compensation from accident and health plans for injuries or illness and life
insurance benefits
• Contributions by the employer to a qualified accident and health plan
• Workers’ compensation benefits
• Meals and lodging provided for the convenience of the employer, as in busi¬
ness trips
• Interest on municipal bonds.
• Income from the discharge of indebtedness if the taxpayer is insolvent or
bankrupt
Payroll Taxes
One of the payroll taxes you will deduct from an employees paycheck is F1CA
(social security tax). The deduction is based on a percentage of the employees
income and as of 1994 was 7.65% on wages up to $60,600 (this includes
Chapter 9 • Regulations Affecting New Businesses 163
1.45% for Medicare). Beyond the $60,600, 1.45% for Medicare must still be
deducted as there is now no limit on wages for this deduction. In addition, the
employer contributes an amount equal to the FICA deduction from the
employees pay, hence the fact that it costs more to employ a person than the
mere face value of the paycheck. State and federal income taxes must be with¬
held according to the current tax law and the employees W-4 form. This
amount is a percentage of taxable gross pay after allowable deductions.
You as the employer are also required to make contributions under the
Federal Unemployment Tax Act (FUTA), which provides compensation to
workers who are temporarily unemployed. This tax amounts to 6.2% of the
first $7,000 of gross pay. If you pay your state unemployment tax in a timely
fashion, it is credited against the federal unemployment taxes paid. For
example, in California the unemployment tax rate is 5.4%. Subtracting that
from the federal rate of 6.2% leaves a net federal tax rate of .8%. Some states
like Pennsylvania, Alabama, Alaska, and New Jersey also collect FUTA from
employees.
In some states you may be required to pay state disability insurance. In
California, for example, this amounts to 1.30% on wages not to exceed
$31,767.00 and paid by the employee.
If your business accumulates $100,000 or more of FICA and federal income
tax withholdings during any pay period, you are required to deposit that
amount in an approved depository by the close of the next business day or face
a penalty of 2 to 15 percent of the amount. Consequently it is very important to
monitor payroll taxes carefully, particularly if you have a labor-intensive busi¬
ness. Don’t assume all banks have the same rules for date-of-deposit. You
should either deposit withholding tax on the same day you pay employees or
by the end of the banks next business day, and deposit in a commercial bank
rather than a Federal Reserve bank, which always credits deposits to the next
day. A one-day error can cost your business a lot of money.
□ Protected aspects of your business concept that fall into the intellectual prop¬
erty rights categories?
□ Found an attorney who can review any contracts you enter into?
□ Identified all the taxes for which you are responsible and set up a plan for
meeting payment deadlines?
Chapter' 9 • Regulations Affecting New Businesses 165
Issues to 1. How will you know when you have a legally binding agreement?
I n September of 1991, 23 years old and only two years out of college,
Marianne Szymanski left her job and started Toy Tips®, Inc., a toy research
and consulting firm. For most people this would have been a very frightening
thing to do, but Marianne had no doubts her new business would succeed.
Having graduated from Marquette University with a bachelor of arts degree in
psychology and marketing, she had been working for a toy manufacturer selling
toys to retailers and sometimes stocking shelves. Naturally customers would
come up to her and ask questions. Often they were grandparents who didn’t
recognize any of the new toys and consequently had no idea what to purchase.
As a result, Marianne decided to find out if there was any information out
there on the best toys to buy for kids of various ages. Consulting the major
magazines related to children, she found they all seemed to have their own
version of the “Top Ten” list of toys. Upon closer inspection, however, she
discovered that invariably the toys on the lists were made by the manufacturers
who had purchased advertising space in the magazine. Moreover, she found
that the self-proclaimed “experts” in the field were actually paid by the manu¬
facturers to review their products. This was certainly not a very unbiased way to
judge these toys. Marianne, who hadn’t yet decided what she wanted to do with
her life, immediately saw an opportunity to provide a much needed service and
create a career opportunity for herself.
The Start-Up
Marianne puzzled about the best way to start this business so that she could
reach the most people. At the time, 900 telephone numbers were becoming a
popular business venture that could be started quickly and with relatively little
capital. Marianne decided to try this avenue. So Toy Tips began as the National
Toy Information Hotline, a 900 number, that people could call to receive the
latest information on toy safety, product recalls, and tips on age-appropriate
Chapter 9 • Regulations Affecting New Businesses 167
toys. To start the business, Marianne drained her savings account and then took
her business plan to nearly every banker in Milwaukee. She was turned down
time and time again with “This is great; this is wonderful—-good luck.” But no
money.
Tortuitously, two days before actually starting the business, she was asked
by a local talk show to appear. That free publicity was worth more than any
bank loan. From that point on, the media picked up on what she was doing,
and her business grew much more quickly than she expected. By the end of
the first year, little town gazettes all over Wisconsin had picked up on the
hotline; but when the AP and USA Today got hold of it the
business exploded. She started receiving phone calls from all
over the United States.
At the same time she had also sent some information about
her hotline to the Toy Manufacturers of America in New York,
which is the voice of the toy industry, and they published her
information in their monthly PR release to toy manufac¬
turers. All of a sudden she was inundated with information
and hundreds of samples from toy companies. Still working out of her home
testing toys on the living room floor with neighborhood children, she decided
she needed to look for another site for the business because the toys were taking
over her home. She went to a pediatrician she knew and worked out a barter
arrangement that allowed her to fill up four rooms of his office with toys for his
patients to “test.” That worked for a while, but soon she had overgrown the
space and needed to move again. By now her ability to convince people of her
credibility was well honed, so she went to the President of Marquette University,
Father D1U1I0, who helped to come up with the idea of working out of the child
care center at Marquette. The arrangement was that the children would test the
toys, she would observe them, and the toys would be donated to the university.
And so it was that Toy Tips, Inc. moved into the child care center, a series of
rooms bursting with primary colors, bustling with activity, and alive with the
sounds of children.
By the end of 1991, she was working with 50 manufacturers. By the end of
1992, that number had swelled to 140, and her revenues had doubled. She had
also created a magazine to carry her message and publish the notices of toy
recalls. The magazine also contains Mariannes “Top Ten” lists: “The Top Ten
Travel Toys,” “The Top Ten Educational Toys,” and even “The Top Ten
Environmental Toys.”
168 Part 3 • The New Venture and the Law
Bootstrapping Genius
Even though the company was growing, Marianne did not have enough money
to hire the employees she needed to help her handle the ever increasing load of
work. But Marianne, who is the essence of the bootstrapping entrepreneur, knew
that there must be a way to get help by bartering, the way she had done for her
office space. Once again she went to the university and suggested that they offer
an internship program with Marquette students who would work for university
credit in her research center. The university agreed and “Toy Tips 101” was born.
Engineering students tested the toys and even designed a “toy crusher” for her.
Working with one of the engineering professors, she was able to develop new
tests for toys, such as tests for flammability and toxicity Journalism students
helped her do fact checking and gather information for articles, while a public
relations student helped her with her media tour. Psychology and education
majors were involved in the focus groups and testing. She also used marketing
students to develop questionnaires and research on the needs of parents. Until
just recently, Marianne had no “employees” in the traditional sense. She has now
hired two assistants to help her carry the load.
With all the media attention she was receiving, Marianne had to travel, but
she didn’t have an appropriate wardrobe, and since all her money was going
into the business, she didn’t have the money to go out and buy one. So
Marianne again demonstrated her bootstrapping creativity when she went to JH
Collectibles clothing company and bartered for a new wardrobe for her media
tour. In exchange for the wardrobe, JH Collectables was given a page of adver¬
tising in her magazine, which was handed out during the tour.
Marianne used a similar technique to “buy” time with an attorney. She
happened to attend a seminar on “Global Marketing in Europe” given by the
Wisconsin trade center. Being the only woman at the seminar became an advan¬
tage, because when she later called the attorney who led the seminar, he
remembered her. She arranged for an appointment ostensibly to talk to him
about trademarks, but actually this was just an excuse to approach him about
becoming the attorney for her small, but growing, business. She asked if he
would consider working with her at a reduced rate with the understanding that
when she got bigger and had the money, she would pay his regular rate. He
laughed appreciatively at her assertiveness and agreed to work with her. He
continues to do so, always charging for his time but being flexible in billing
depending on her business’s financial situation.
Chapter 9 • Regulations Affecting New Businesses 169
or warrant any toy that it reviews.” It considers itself an independent source for
informed decision-making on the purchase of toys. With this mission in mind
Marianne must decide where she should take the business from here. She has
considered forming a non-profit corporation for research purposes as this
would give her access to foundation grants. But establishing a non-profit
corporation is more complicated and has more rules and regulations than a
C-corporation. At this point, she is not sure what the advantages and disadvan¬
tages would be.
■
CHAPTER 10
Overview
• The nature of a virtual enterprise
• The steps in seeking a site for the new venture
• Characteristics of retail, service, and manufacturing sites
• The advantages and disadvantages of building, buying, or leasing a building
173
174 Part 4 • The Operating Structure of a New Venture
Doing this section of the business plan will also force the entrepreneur to
seriously consider how the business will work. It’s one thing to come up with a
great idea that people love. It’s quite another to turn that idea into an operating
business.
PROFILE 10.1
CEO
Entrepreneur
Then begin making lists of tasks, equipment, and people needed to run the
business. This information will also be useful when you need to figure expenses
for financial projections later on.
the best site becomes one of the most crucial decisions to make, one that will
need to be justified to the readers of the business plan.
Site decisions begin at a macro level with the state or region of the country
and work their way down to the parcel on which the facility is located. That is
the process followed in the discussion of the site.
Choosing a Community
The community in which you currently reside may not necessarily be the best
place in which to start the business. Certainly it is always easier to deal with
something you know well, particularly when starting something as risky as a
new business, but don’t assume the location factor applies only to decisions
within your own neighborhood. Many potentially successful new ventures have
failed because they were not located in a region or community that supported
that type of business.
180 Part 4 • The Operating Structure of a New Venture
Financial Incentives. Most community governments are faced with cash needs
that go well beyond the tax tolerance level of its citizens; consequently, they
work diligently with economic development agencies to attract new businesses
and the accompanying tax revenues into the community. One of the ways they
attract business is to offer incentives such as lower taxes, cheaper land, and
employee training programs. Some communities have enterprise zones, which
give the businesses that locate in them favorable tax treatment from the state
based on the number of jobs created, as well as lower land costs and rental
Chapter 10 • The Big Picture 181
rates. They also expedite permit processes and help in any way they can to
make the move easier.
Look carefully however, at communities that offer up-front cash in compen¬
sation for the community’s lack of up-to-date infrastructure. They may be
hiding a high corporate tax rate or some other disincentive that could hurt your
business’s chances of success. In general, the larger the incentives, the more
careful you should be in doing your homework.
Incubators. Some entrepreneurs find it helpful to start their new venture’s life in
a business incubator, which has the same purpose as an incubator for an
infant—to create a controlled environment that will enhance the chances of the
business surviving the start-up phase. Private and state-sponsored incubators
can be found in nearly every region of the country for almost any type of busi¬
ness. They offer space at a lower than market rate to several businesses who may
then share common support functions like receptionist, copy machine, and
conference room. The incubator may even offer business courses and training to
help new entrepreneurs with the myriad details involved in running the busi¬
ness. After about three to five years, depending on the incubator, the young
business is required and helped to move into its own site elsewhere in the
community.
182 Part 4 • The Operating Structure of a New Venture
Some incubators cater only to high-tech firms or to service firms. Others like
the Entrepreneur Partnership Program at the Mall of America in Bloomington,
Minnesota, help entrepreneurs determine if their retail or service businesses are
suited to the demands of a major mall. This particular program helps the entre¬
preneur formulate a business plan and open a store. It also provides incentives
such as waiving the costs of improving the store space and consulting in
marketing and operations.
Competition
Within the trade area you can also identify the competition. To do this, drive
through the area (assuming it is not too large) and spot competing businesses.
Note their size and number, and also gauge how busy they are at various times
Chapter 10 • The Big Picture 183
of the day by observing their parking lots or actually entering the business. If
competitors are located in shopping malls or strip centers, look for clusters of
stores similar to yours and low vacancy rates. This would indicate a strong
attraction for the site. Look at the stores near your proposed site to check for
compatibility. Often locating near a competitor is a wise choice because it
encourages comparison shopping. Observe the character of the area. Does it
appear to be successful and well maintained?
Accessibility
It is important to identify the routes your customers might take to reach the
proposed site: highways, streets, and public transportation routes. If the site is
difficult to locate and hard to reach, you can be certain potential customers will
not exert the effort to find you. Also check the parking situation. Most commu¬
nities require a sufficient amount of parking space for new construction, either
through lots or garages; however, in some older areas, street parking is the only
available option. If parking is a problem to find or too expensive, you will lose
customers.
Do a foot and car traffic count for your proposed site to determine how busy
the area is. Remember, retail businesses rely heavily on traffic for customers.
Whether you need a high volume of foot traffic is a function of the type of busi¬
ness. Obviously, a coffee house benefits immensely from a high volume of foot
traffic, whereas for a warehouse hardware store it may not be as vital. A traffic
count is easily accomplished by positioning yourself near the targeted site and
tallying the customers going by and into the business. City planning depart¬
ments and transportation departments maintain auto traffic counts for major
arterials in the city
service businesses, on the other hand, require attractive office space that is
easily accessible. These are usually professional businesses—lawyers, accoun¬
tants, consultants and so forth. The image they present through the location
and appearance of their office is crucial to the success of the business.
Many service and wholesale businesses do not have customers coming to
their places of business. Some examples are distributors, contractors, and
certain types of consultants. In these cases, it is more prudent for the business
to be located in less expensive, less high-profile areas of town where they are
still near the customers they serve but can take advantage of a savings in rent or
land costs.
Depending on the type of manufacturer, one or more factors may have greater
importance in evaluating a site.
Access to Suppliers
Manufacturers and processors usually try to locate within a reasonable distance
from their major suppliers to cut shipping time and save transportation costs.
Certainly a food processor attempts to set up business near the growing fields
so the food is as fresh as possible when it arrives at the processing plant.
Similarly, a manufacturer that uses steel as one of its main raw materials might
want to locate in the same region of the country as the steel mills to save the
high costs of trucking heavy steel great distances.
Cost of Labor
Today many manufacturers choose a location based on the cost of labor rather
than proximity to suppliers, since labor is generally the single highest cost in
the production of goods. Wages and laws relating to workers, such as workers’
compensation, vary from state to state, and sometimes from city to city. For
example, California laws and cost of living tend to make it a more expensive
place to hire employees than those same employees might cost in Missouri.
Some labor-intensive businesses have found that the only way they can
compete is by having plants in Mexico or China, where labor costs are a frac¬
tion of those in the U.S., and where laborers are not protected by as many laws.
Mattel Toy Company, for example, has a plant in China to produce the hun¬
dreds of different toys it markets every year. The bottom line is that the entre¬
preneur must weigh the costs in terms of access to labor carefully when
considering a particular location for a manufacturing plant.
Access to Transportation
Most manufacturers prefer to locate near major transportation networks: rail¬
ways, major highways, airports, and ports of call. The reasoning is obvious: The
greater the distance between the plant and a major transportation network, the
higher the cost to the company and ultimately the customer. Also, the more
transportation people who handle the product, the greater the cost. Thus, in
terms of simple economics, to remain competitive manufacturers must consider
the cost-benefit of locating away from a major transportation network. The
higher transportation costs will result in a smaller profit margin for the
company or higher costs for the customers. Either way you lose.
186 Part 4 • The Operating Structure of a New Venture
Cost of Utilities
Utility rates vary from state to state, and usually from city to city within a given
state. If the new venture is heavily dependent on electricity, gas, or coal, this
factor could be a significant variable in the cost of producing a product and
therefore should be examined carefully
• Is the building of sufficient size to meet current and reasonable future needs?
• Do the building and site allow for future expansion?
• Is there sufficient parking?
• Is there space for customers, storage, inventory, office space, and rest rooms?
Allowing for future growth is essential. The initial higher cost of a larger
building is often offset by avoiding the extraordinarily high costs of moving and
the potential for lost sales and time away from the fundamental work of the
business while the business is in transition.
When examining an existing building, begin with the exterior and ask the
following questions:
1. Does the building have curbside appeal, assuming customers will come to
the site?
2. Is the building compatible with its surroundings?
3. Does it have enough windows of sufficient size?
4. Is the entrance inviting?
5. Is the signage attractive and does it satisfy the local regulations?
6. Is the parking adequate to meet customer and employee demand and satisfy
local building codes?
Chapter 10 • The Big Picture 187
7. Does the interior of the building meet your needs in terms of walls, floors,
and ceilings?
8. Are there sufficient lighting fixtures, outlets, and enough power to run
equipment?
These are just a few of the questions to ask before finalizing a decision on a
building. Most entrepreneurs can answer the above questions to their satis¬
faction, but to be certain the building is not hiding anything that could come
back to haunt the entrepreneur and be costly for the business, it is wise to hire
a licensed contractor or inspector to examine the building for structural
soundness.
Leasing a Building
The speed of change, innovation, and technological advancement has and will
continue to shorten product and service life cycles, and this has an impact on
the facilities in which businesses operate. Buildings, on the other hand, have
long physical lives and typically are very expensive to refurbish and remodel.
Consequently in many communities factories and retail outlets can be seen lying
vacant for long periods of time, even years. Ultimately they sell for or are leased
at an amount far below what it cost to build the building in the first place.
It has been suggested that one solution to the problem is for businesses to
hold short leases of five years or less. In this way the company does not tie up
precious capital that it may not be able to recover, and it has the ability to move
on when a product or service is deemed technologically antiquated and no
longer in demand. There are, however, some serious disadvantages to short¬
term leasing.
Rents are escalated more frequently due to short-term renewal. Many a
business has found itself in this awkward position. Demand for the product or
service has been successful beyond initial predictions, so the business needs to
remain in its current location beyond the term of the lease. When the entrepre¬
neur goes to renegotiate the lease terms, he or she inevitably finds the landlord
intends to raise the rents for a new lease. This is usually justified by increasing
market rents; however, at the same time, the landlord is aware that it would be
costly for the tenant to relocate. The business would have little time to do so
and still maintain its current production rate. Furthermore, the potential for
having to replace employees and create new logistics for suppliers and buyers is
daunting. All these factors put the entrepreneur in a very weak position to
negotiate a new lease.
188 Part 4 • The Operating Structure of a New Venture
• Buildings that are newer, suitable for a variety of uses, and well-located
generally enjoy higher lease rates, as do buildings in short supply.
• Since rent is normally paid based on square footage of space, the larger the
space, the more costly the lease.
• Retail and service business sites are generally more expensive than industrial
sites.
• A retail site in a regional mall will likely be the most expensive.
Be aware, though, that while manufacturing sites enjoy low rental rates, they
usually pay higher amounts for water, power, and sewage. That is why it is
important to consider all the costs related to leasing a facility. Not including the
cost of expensive utilities or a common use area fee could spell disaster to the
business’s cash flow.
Businesses face three basic types of leases.
• Gross lease. This lease allows the entrepreneur to pay a fixed rate per
month, with the landlord covering the cost (and getting the benefit) of insur¬
ance, taxes, and building operating expenses such as outdoor lighting, secu¬
rity, and so forth.
• Net lease (Also known as triple net). This lease has the entrepreneur
paying a fixed monthly rate plus taxes, operating expenses, essentially every-
Chapter 10 • The Big Picture 189
thing but the mortgage and the building insurance, which the landlord pays.
What the entrepreneur actually rents is a shell with stipulated improvements.
• Percentage lease. This is the most complicated of all the lease types because
it has several variations. It can be written as a percentage of the net income
of the tenant or as a flat rate plus a percentage of the gross revenues. The
latter is very common in retail operations.
Fortunately for businesses seeking lease facilities, it’s a renters’ market and
will probably remain so for the foreseeable future as demand lags the over¬
supply created in the 1980s. Moreover, savvy customers in the 1990s expect
businesses to reflect the trend toward “less is more” by controlling costs and
simplifying operations. In a renters’ market, businesses can expect to negotiate
leases that provide a certain period of free rent, free parking, allowances for
tenant improvements, and greater flexibility to extend or shorten the lease. For
example, one Chicago-based company renegotiated its high-rent lease, reducing
its obligation from $36 per square foot to $22. In addition, the landlord agreed
to cover the $1 million tenant improvements, which would be recovered over
the term of the new ten-year lease.
Even more savings in a lease can be achieved by reading it carefully.
• Make sure there is a provision for examining the books of the landlord to
view the costs related to the building. In this way you may discover “pass¬
throughs,” or costs in the form of capital improvements that should not be
passed on to the tenants, such as the cost of a new security system. You may
also find charges to the tenants for expenses that are rightfully the owner’s,
such as personal services to the owner who is also a tenant of the building.
• Check carefully for clerical mistakes, particularly the easily overlooked
simple items like addresses, suite numbers, square footage, and rental
amounts.
• Talk to other tenants of a building to find out common needs that may be
achieved through a unified effort.
• Ask for a breakdown of taxes and operating expenses for the previous three
years and projections for the next five years.
• Ask for a work letter that explains all improvements the landlord will make
for the tenant as well as work the tenant must complete and all costs associ¬
ated with the completion of these improvements.
• Make certain the building meets requirements and safety levels prescribed by
the Environmental Protection Agency.
190 Part 4 • The Operating Structure of a New Venture
Remember first and foremost, leases are written from the landlords point of
view and are, therefore, negotiable. Just because something appears in printed
form does not mean it is true or that you have to agree to it. A lease represents a
significant portion of a business’s overhead, and you will most likely have to
live with it for a long time, so make sure it’s what you really want. Leases are a
great way for start-up businesses to get into the marketplace, but don’t let your
enthusiasm for starting the business blind you to the potentially disastrous
terms of a poorly written lease. The best advice is to seek the assistance of an
attorney who can represent your interests.
Buying a Building
If the entrepreneur has the resources, buying a building has some advantages. A
valuable asset is immediately created on the balance sheet, which can be lever¬
aged later on when growth capital is needed. For example, the building could
be sold and leased back (called a sale-leaseback), withdrawing equity for other
uses and negotiating favorable long-term lease terms. Sale-leasebacks are attrac¬
tive options for investors and so these buildings generally sell quickly. Of
course, when you sell the building, you effectively lose control of it, so be
certain to negotiate terms that allow you to remodel and extend the lease
should you wish to do so.
One advantage of owning a building is that it can be traded in a tax-deferred
exchange for other property you need. For example, suppose you owned an
office building but needed a distribution warehouse to support a new direction
your business was taking. You might take advantage of a tax-deferred exchange
by trading the office building for the warehouse. The exchange would defer
capital gains tax on the sale of the office, and you would have the warehouse
you need.
One other option to consider is a joint venture between you, the entrepre¬
neur, and a real estate developer on a building in which you will be one of the
tenants. If you are able to occupy a substantial portion of the building, it is
easier for the developer to acquire a mortgage and additional tenants. Of
course, this type of arrangement has the inherent problems of any partnership
and should be considered carefully with the advice of an attorney before any
agreement is executed.
Buying a building requires a contract, much like a lease agreement. It spells
out the terms of the purchase and the items included and excluded from the
purchase agreement. As always, read it carefully to make sure that what you
agreed to verbally has been translated correctly on paper. It would be wise to
Chapter 10 • The Big Picture 191
hire a due diligence team (inspector, contractor, CPA, attorney) to inspect the
building and the agreement so your interests are protected.
Final Thoughts
The information collected on where to locate the business and whether to lease,
buy, or build the facility will be used in various parts of the business plan. For
example, the information on the trade area for the product/service will be
useful in the marketing plan section where you elaborate on how to reach the
target market. One of the “Four P’s” of that marketing plan is place—where the
business will be located. Information on rental rates and building costs will
certainly play a role in the financial plan section of the business plan.
Chapter 10 • The Big Picture 193
iji 4. If you were going to start a manufacturing plant, what characteristics in the
site would you be looking for?
5. How does a sale-leaseback work?
6. How is a trade area determined, and what is the value of defining and
studying a trade area?
CHAPTER 11
Overview
• The technical/operational analysis of the business concept
• The product development process
• The product manufacturing cycle and the role of the various interdependent
functions
• Inventory systems that will allow for the minimum inventory possible while
still meeting demand
• A quality control philosophy for the new business
• Preparation of the operational plan section of the business plan
195
196 Part 4 • The Operating Structure of a New Venture
• International competition
• Sophisticated customers in fragmented markets
• Widely diversified and changing technologies1
International Competition
Since the 1980s the number of companies competing in the global marketplace
has increased enormously. Couple that with the fact that similarity in product
concepts has expanded and you have the makings of an intensely competitive
arena for product development. An American company finds it is no longer
competing simply with other American companies, but with companies from
diverse regions of the world who bring their own trademark to the process and
the products.
'Clark, K & T. Fujimoto. (1991). Product Development Performance. Boston: Harvard Business School Press.
Chapter 11 • The Operational Plan 197
and model building. This effort can be expensive and time consuming, so choos¬
ing the wrong consulting firms can be devastating. As engineers tend to specialize
(mechanical, electrical, civil), it is possible that one product may require the
services of more than one type of engineer. Some of the areas of product develop¬
ment that require engineering analysis, design, and expertise include:
• Component design
• Materials specifications
• Machinery to process
• Ergonomic design
• Packaging design
• Assembly drawings and specifications
• Parts and material sourcing (suppliers)
• Operators and owner’s manuals
Opportunity Recognition
Concept Investigation
1
Initial Design Preparation
I
Initial Test Production Run
I
Market Introduction & Ramp-Up
Chapter 11 • The Operational Plan 199
Opportunity Recognition
Recall from Chapter 2 that the first stage in the development of a business
concept is opportunity recognition: identifying a niche that has not been
served, detecting an improvement in an existing product, or seeing an opportu¬
nity for a breakthrough product. Once the opportunity has been identified, it is
critical to move forward with the next stage, concept investigation, to shorten
the product development cycle as much as possible.
Concept Investigation
Concept investigation is simply doing some investigation to determine if the idea
currently exists, if there is a potential market, how much it will cost to produce
the product, and how much time will it take. This last piece of information is
crucial since an enforced shorter development cycle allows the company to have
a first-mover advantage, better meet its customers’ needs, lower the costs of
production, and cut off the tendency by the entrepreneur or inventor to keep
“improving the product,” instead of getting it out into the market.
product is beyond the current budget. With little money invested, team
members are free to simulate the use of the product and make mistakes while
finding the best version of the prototype.
Technolog}' has even entered the prototyping stage of product development
in the form of “rapid prototyping." Today you can purchase a device that,
working from information in your computer, will cut and shape metal or other
raw materials into three-dimensional parts. In this way you can actually design
a part on the computer screen and then cut it into a real prototype virtually
instantly in your office. The obvious advantage of this is avoiding the shipping
of two-dimensional drawings to a parts manufacturer and then waiting for the
part to be made.
With a prototype it is also easier to acquire more accurate target market
demand information, more accurate cost estimates, and a clearer sense of
whether the product will work as proposed in the design phase. The
added benefit is that eliminating features that do not create value in the
Businesses that do
mind of the customer can reduce manufacturing costs 25-40 percent.
not manufacture
Moreover, through field testing the prototype, adjustments and modifi¬
products—service, cations can be made, leading to a production-quality prototype: in
retail, wholesale, essence, the final product.
and so forth—still Various engineers can be employed to take the crude prototype and
determine the best assembly design, the types of materials to use. the
need to design a
most effective components, the required suppliers, and which other
prototype.
subcontractors might be needed to make the product readv for produc¬
tion. From the engineered assembly drawings, parts lists, and specifica¬
tions, the production-quality prototype can be assembled. Small engineering
firms or solo engineers who support entrepreneurs and inventors, small iob
shops, machine shops and/or model builders may be used to complete the
prototype. These sources are normally quicker and less expensive than the
larger, better-known finns. When seeking an engineer or model builder, the
entrepreneur must use caution. Careful analysis of qualifications, experience,
and references relative to the task are essential. A good source of referrals is a
major university engineering department and/or other engineers.
Businesses that do not manufacture products—sendee, retail, wholesale, and
so forth—still need to design a prototype, but the prototype in this case wTd not
be physical. Instead it will be a design for how the business will provide a
service or product to its customer, maintain and control inventories, hire
employees, and guarantee quality and satisfaction. Entrepreneurs who intend to
Chapter 11 • The Operational Plan 201
PROFILE 11.1
satisfying the need. Where no such product exists, it measures the way that
customers attempt to satisfy the need.
From the House of Quality, the team identifies those design attributes that will
affect customers’ perceptions of the product if modified to meet their needs. The
team also considers the realities of engineering and the costs. What has been
presented here is merely an overview of the QFD process. What has not been
covered are the possibilities for mathematical operations to develop indices and
scales for enhancing decision making. Check Additional Sources of Information at
the end of the chapter for more information on this subject. The key point to
remember about QFD is that it represents a philosophy of product development
that brings all members of the team in at the beginning of the design phase,
including the most important member of the team—the customer. Many entre¬
preneurs have used this team approach successfully without implementing the
complete QFD process, a fairly complex method which usually requires the
assistance of an outside consultant with experience in QFD.
Materials Requirements
Any business that purchases raw materials or parts for production of goods for
resale must carefully consider the quality, quantity, and timing of those
purchases. Quality goods are those that meet specific needs. The quantity
purchased is a function of demand, manufacturing capability, and storage capa¬
bility. Planning purchases so that capital and warehouse space are not tied up
any longer than necessary is the result of good timing. As materials account for
approximately 50 percent of total manufacturing cost, it is important to balance
these three factors carefully.
Locating vendors to sell you raw materials or goods for resale is not difficult,
but finding the best vendors for your purposes is another matter entirely. The
first decision is whether to buy from one vendor or more than one vendor.
Obviously, if a single vendor cannot supply all your needs, that decision is
made. There are several advantages to using a single vendor where possible:
• You will probably get more individual attention and better service.
• Your orders will be consolidated so you may be able to get a discount based
on quantity purchased.
company that was the prime supplier of RAM chips), it may be difficult or
impossible to find an alternate source in a short period of time. To ensure
against this contingency, you may want to follow the general rule of using one
supplier for about 70 to 80 percent of your needs, and one or more additional
suppliers to supply the rest.
When considering a specific vendor as your source, ask yourself several
questions:
1. Can the vendor deliver enough of what you need when you need it?
2. What is the cost of transportation using the vendor you are considering? If
the vendor is located far away, costs will be higher and it may be more diffi¬
cult to get the service you require.
3. What services is the vendor offering you? For example, how often will sales
representatives call on you?
4. Is the vendor knowledgeable about the product line?
5. What are their maintenance and return policies?
Inventory Requirements
Today businesses that hold inventories of raw materials or goods for resale have
found they must reduce these inventories significantly to remain competitive.
Instead of purchasing large quantities and receiving them on a monthly basis,
businesses are purchasing daily or weekly in an effort to avoid costly invento¬
ries. Of course, some inventory of finished goods must be maintained to meet
delivery deadlines; therefore, a delicate balance must be achieved between
goods coming into the business, work in progress, and goods leaving the busi¬
ness to be sold.
208 Part 4 • The Operating Structure of a New Venture
Inventory Costs
There are many costs associated with inventories that can add as much as 25
percent to the base cost of the inventory. They include:
• Financing Costs. The interest paid on the money you borrow to purchase
the inventory.
• Opportunity Cost. The loss of use of the money tied up in inventory.
• Storage Costs. The amount spent on warehouse space to store the inventory.
• Insurance Costs. The cost of insuring the inventory.
• Shrinkage Costs. The money lost from inventory that is broken, stolen, or
damaged.
• Obsolescence. The cost associated with inventory that has become obsolete.
Inventory Turnover
It is important to understand how often inventory turns over in your industry
to help determine how much inventory, and specifically what goods, to main¬
tain in greater quantities. Inventory turnover is the average number of times an
inventory is sold out during the year for a particular product line. If you know
the turnover rate for an industry (men’s clothing is 3; restaurants, 22; and some
chemical manufacturers, 100), you will be able to estimate how much inven¬
tory to keep on hand. For example, suppose an industry has an inventory
turnover rate of 5.
Tracking Inventory
In a start-up venture, keeping track of inventory may simply be a matter of
visually inspecting and counting, since the business is growing in a fairly
controlled manner in the beginning. However, once the business is really off the
Chapter 11 • The Operational Plan 209
Just-in-Time System
In the past, inventories were built up based on the state of the economy or in
reaction to problems in their inventory control system. If times were good,
producers increased stocks of inventory to meet expected demand. Then when
the economy slowed, they were usually left with shelves of leftover stock.
Reductions in inventory succeeded in exposing typical problems: equipment
imbalances, paperwork backlog, excessively long setups, vendor problems, and
problems with purchase lead time.
Newer systems, like Just-in-Time (JIT), help manufacturers maintain better
control of their inventories by eliminating production and inventory problems
and then reducing inventory to only that which is needed. The Just-in-Time
system of materials and inventory management deserves its own heading as it is
fundamentally different from other inventory systems. Coming originally from
Japan, JIT is beginning to take hold in the United States. The philosophy
behind JIT is “to produce the minimum number of units in the smallest
possible quantities at the latest possible time.”2 A well-devised and imple¬
mented JIT system can:
2Hay, E.J. (1988). The Just-in-Time Breakthrough. New York: John Wiley &r Sons.
210 Part 4 • The Operating Structure of a New Venture
Production Requirements
The production function of a manufacturing business is its life blood. Decisions
made in this area directly impact output level, product quality, and costs.
Planning for production, therefore, is key to manufacturing efficiency and effec¬
tiveness. Most manufacturers begin by scheduling, that is, identifying and
describing each activity that must be completed to produce the product and the
amount of time it takes to complete each activity. Two methods traditionally
used to aid the scheduling process are Gannt Charts and Pert Diagrams.
Gannt Charts. Gannt Charts are a way to depict the tasks to be performed and
the time required for each. Consider Figure 11.4, The task to be completed is
outlined on the vertical axis, with the time to completion on the horizontal.
Notice that the solid line represents your plan for completion, while the dashed
line depicts where you are in the process toward completion. Gannt Charts are
best for simple projects that are independent of each other.
5348 1,000
5349 1,500
5350 500
Scheduled Time
Actual Progress
212 Part 4 • The Operating Structure of a New Venture
they occur. Be sure to identify any activities that must occur in sequence; that is,
one activity cannot occur until another is finished. Construct a pictorial network
that describes the process. Then estimate the time to complete each activity and
note it on the chart. This is usually calculated as most optimistic, most likely,
and most pessimistic. The statistics involved in analyzing the network are
beyond the scope of this book, but essentially consist of 1) identifying the critical
path, which is the longest path and is important because a delay in any of the
activities along the critical path can delay the entire project; 2) computing slack
time on all events and activities (difference between latest and earliest times);
and 3) calculating the probability of completion within the time allotted.
The numbered nodes on the diagram (Figure 11.5) refer to the start and
completion points for each event. The dummy line was placed in the diagram
to account for the completion of Event e being preceded by Events b and d.
Both must be completed before Event g can start.
There are several popular software products on the market, such as Micro
Planner X-Pert and Microsoft Project, that can help entrepreneurs schedule
their production capacity. Tracking production from the outset of the business
allows entrepreneurs to make more realistic strategic decisions about growth
and expansion.
Chapter 11 • The Operational Plan 213
PROFILE 11.2
Identifying all the tasks in the production process makes it easier to deter¬
mine what equipment and supplies are needed to complete the tasks. If it is
determined the equipment necessary to produce the product is beyond the
start-up resources of the entrepreneur, it may be time to consider outsourcing
part or all of production to a manufacturer who has excess capacity with the
needed equipment.
After the production tasks are identified, a preliminary layout of the plant to
estimate floor space requirements for production, offices, and services can be
made. It may be beneficial to consult with an expert in plant layout to ensure
you make the most efficient use of the limited space you have.
Quality Control
Quality control is the process of reconciling product output with the standards
set for that product. It has been said that one thing manufacturers have learned
from history is that “the primary objective of the company is to put the quality of
the product ahead of every other consideration. A profit or loss notwithstanding,
214 Part 4 • The Operating Structure of a New Venture
Quality Circles
Quality circles are groups of employees who regularly work together on some
aspect of the production process. They meet several times a month with the
help of an outside facilitator to discuss problems and ideas related to their work
environment. They often come up with new solutions to problems that are then
put into effect, thus improving the efficiency and effectiveness of the manufac¬
turing process and the product as well. Using quality circles gives employees a
vested interest in what they are producing; consequently, they are more likely to
pay close attention to improving the way their task is completed.
^Hopper, Kenneth. (1982). “Creating Japans New Industrial Management: The Americans as Teachers.”
Human Resource Management, p. 13-34.
Chapter 11 • The Operational Plan 215
Using Employees for Quality Control. If you want the employees to buy into
the notion of quality control at every level, they must be given the responsibility
and authority to make changes that will improve the process and product at
every level. If you are going to install new technology to improve the process,
the employees need to be trained not only in how to use it but how to look for
potential problems that would affect quality. The continual use of awareness
and training programs will help employees understand their importance in the
whole manufacturing process.
PROFILE 11.3
For a small, growing firm, however, it is a fairly costly process that includes,
among other things, writing a quality control manual. The cost of achieving the
standards is not as great as the cost of obtaining certification, which is subject
to audit semiannually and must be renewed annually. But these costs must be
weighed against the advantages. With certification, the companies with which
the entrepreneur does business don’t have to inspect to know the company’s
standards for quality, and it makes it much easier to enter the export market.
Two ways to reduce the costs involved include:
4Adapted from Warren H. Schmidt and Jerome E Finnigan. (Feb. 1993). “The Race Without a Finish Line.”
in Small Business Reports, Vol 18 No. 2.
Chapter 11 • The Operational Plan 217
• Check with major customers to see if they will help subsidize the cost of
certification.
• Determine if you really need certification. Perhaps just meeting the standards
is sufficient in your business.
Process Maintenance
At some point any machine will break down, which can mean lost sales and
costly repairs. To prevent unexpected breakdowns from disrupting the produc¬
tion process, one of three things can be done. The process can be organized so
when one machine is down, the work can be shifted to another. Another way is
to build up inventories at each stage of the production process so that machines
can keep working as long as the inventory lasts. (This method, however, will
probably not work in a company that has chosen a JIT system of inventory
management.) The third, and perhaps the best, approach is to regularly under¬
take preventative maintenance by checking and fixing the machines before they
break down. The advantage of this approach is that you control when the down
time occurs.
Product Maintenance
The entrepreneur who subscribes to total quality management will likely wish
to provide warranties with products to protect against potential liability and to
demonstrate that the company stands behind the product. Today product
warranties have also become a marketing tool to sell the product.
Some of the decisions to be made regarding warranties include:
Financial Requirements
Once the raw materials and parts list has been developed, and the manufac¬
turing or assembly process defined, including labor requirements, it is possible
to calculate the total investment required to start the business and the per unit
Chapter 11 • The Operational Plan 219
cost of manufacturing the product. To be sure, the initial units produced will
cost significantly more to manufacture and assemble because the volume will
usually not be sufficient to achieve industry discounts on raw materials and
parts, and the plant and equipment will not be used to full capacity.
Consequently, gross margins may be extremely small in the early stages until a
sufficient increase in volume allows an economy of scale that reduces the per
unit cost.
The calculation of the up-front investment in plant and equipment, coupled
with the high per unit cost of production, has resulted in many entrepreneurs
deciding to outsource manufacturing to an established manufacturing firm.
Some products that consist of off-the-shelf components from OEMs can give
the entrepreneur the option to set up an assembly operation, which is far less
costly than a manufacturing plant. In any case, the process of outlining all the
costs of setting up a product company is invaluable in making the final deci¬
sions about how the business will operate.
exact specifications related to the new product or process are of less impor¬
tance. The question to keep in mind when organizing the operational section of
the business plan is:
Does the reader of the business plan need to know this piece of information to
understand the business?
The technical analysis may warrant the creation of two versions of the busi¬
ness plan. The highly technical version can be reserved for the founding team
and the technical staff and the less technical version for all other readers.
The Product
Several aspects of the product should be presented in the operational section of
the business plan.
The Purpose of the Product/Service. Let the reader know whether the product
solves a problem, recognizes an opportunity, satisfies a need, or is purely for
entertainment purposes.
The Unique Features of the Product/Service. The unique features can result in
a competitive advantage in the marketplace. They may include not only special
features or benefits of the product/service but also any proprietary rights you
own such as patents, trademarks, and copyrights. In the case of patents, be sure
to state where the product is in patent process. If licensing the product is an
option under consideration, the licensee will probably be looking to see that the
patent has been “issued,” or at the very least is “patent pending.” (Recall that
when the product is “patent pending” it has, for all practical purposes, been
conditionally approved by the PTO.) If your business involves licensing and/or
paying royalties to someone else, like an inventor, include that information as
well. Only the major points should be presented in this section with a copy of
any agreement or details in the appendix.
Include discussion of features such as the design, quality, capabilities, and
cost of the product. It is also important to incorporate any photographs or
drawings of the product. Again remember that the reader is primarily interested
in what the product functions are, not how it functions from an engineering point of
view.
Chapter 11 • The Operational Plan 221
Product Specifications
Design and performance specifications
Level of quality
Service requirements
Status of development
Materials Requirements
Raw materials and parts required
Availability of raw materials and parts
Source of supply for raw materials and parts
Delivery lead time for suppliers
Inventory Requirements
Description of inventory system
Raw materials and purchased parts in inventory
Work in process inventory
Finished goods inventory
Production Requirements
Explanation of production process
Equipment needed, costs and alternatives
Output capacity from production
Materials handling equipment
Labor Requirements
Skills required
Availability of labor and cost
Support staff required
Maintenance Requirements
Plant equipment maintenance and repair
After sale service and warranties on product
Financial Requirements
Start-up investment in equipment and inventory
Manufacturing costs—raw materials, labor, equipment usage
222 Part 4 • The Operating Structure of a New Venture
4l What value does the philosophy that forms the foundation of the QFD,
team-based approach to product development have for entrepreneurs devel¬
oping new products?
What is the difference between product-focused and process-focused compa¬
nies?
What are three factors that should be taken into consideration when
choosing vendors to meet materials requirements?
How can PERT diagrams aid the entrepreneur in production scheduling?
In what ways can the human resources of the business help control quality in
all areas of the organization?
CHAPTER 12
Overview
• The focus of entrepreneurial marketing in the 1990s
• Preparing a marketing plan
• Product, place, promotion, price in the marketing strategy
• Using the marketing plan as part of the business plan
225
226 Part 4 • The Operating Structure of a New Venture
marketing plan for the new business. Market research is definitely a necessity
for operating in the 1990s and beyond. Knowing who your customer is and
how, why, and when they buy is the minimum required information any busi¬
ness must have.
Entrepreneurial Marketing
If you studied marketing in college or gained experience in marketing by
working for a large company, it is possible that you have seen only one side of
marketing. The kind of marketing done by Coca Cola, Burger King, K-Mart,
and the like is an entirely different game, calling for different strategies than
those entrepreneurs use for start-up ventures. Unfortunately, entrepreneurial
marketing is not often taught in business curricula because it isn’t as exciting or
competitive as brand name marketing in big companies. As a result, unsus¬
pecting entrepreneurs often attempt to employ the same techniques as more
established companies; however, since they usually don’t have the required
resources to market at the same level as the large corporations, the desired
results are rarely achieved.
Entrepreneurs must approach marketing from a distinctly different point of
view. While they may employ some of the same techniques as a large corporate
marketer, they will also take advantage of many other marketing opportunities
that the corporate marketer may ignore. In fact, some entrepreneurial strategies,
such as personalized customer service, are so successful that many large, estab¬
lished companies are now adopting similar programs. Levinson has called the
entrepreneurial marketing approach “Guerrilla Marketing,” which is an alterna¬
tive to traditional, expensive marketing tactics.1 Given that entrepreneurs don’t
have the time or money for elaborate, high-profile marketing strategies, they
essentially mimic what the “big boys” do, but do it for much less money and for
a shorter period of time.
This chapter presents some suggestions for creating an entrepreneurial
marketing plan that provides the best results for the least amount of money
possible. It begins by looking at the marketing plan in general and then consid¬
ering the traditional “4 P’s” of marketing—product, price, place, promotion—in
more detail and from an entrepreneurial point of view.
1. Make a list of the options. To even begin to know which marketing options
should be considered, you need to talk to other business owners, customers,
and suppliers. Read some books and articles on marketing strategies for
entrepreneurs, like those suggested at the end of this chapter. This process
will produce a list of possibilities that may range from sponsoring a business
conference to advertising in a national trade publication. Determining which
strategies are the most effective, or even feasible, can be left for later.
2. Think like a customer. Imagine the business from the customer’s point of
view. What would entice you to enter that store, buy that product, take
advantage of that service?
228 Part 4 • The Operating Structure of a New Venture
3. Study the competition. Take a look at the businesses that will be competing
with yours and determine what makes them successful or unsuccessful.
What marketing strategies do they seem to employ, and are they effective?
How could you improve on what they are doing?
4. Analyze the options and rank them. Eliminate first those that either don’t
meet the needs of the target market or are simply not feasible at this time
(usually for budgetary reasons). Then rank the top ten choices. You are now
ready to begin writing the marketing plan.
Many experienced marketers suggest that the first step in creating the
marketing plan is to condense all the ideas about marketing strategy into a
single paragraph that says it all. Impossible? Not at all. A single, well-written
paragraph will force you to focus carefully on the central point of the overall
marketing strategy. The paragraph should include:
PROFILE 12.1
What’s in a Name?
Even the name of your business should be part of the overall marketing plan because
it’s the first point of identity you establish with the customer. It should be easily
remembered and should relate to what you are selling. A name like “Useful Products,”
the name of one California company, would not win any prizes for originality and
style, but “Higher Ground,” an Oregon coffee company, might.
tion industry, and more specifically, those who use power tools in areas
where no power is available. The niche Gentech will enter is that of
construction companies that own or lease power equipment. Initial
marketing tactics will include direct sales to equipment rental outlets,
advertisements in trade publications, and trade shows. Gentech’s
customers will see the company as service-oriented with a quick response
to customer needs both in service and product design. Twelve percent of
sales will be applied to the marketing strategy.
With your paragraph in hand and the focus established, a more detailed
marketing plan can now be created. Every marketing plan incorporates the four
Ps of marketing: product, price, place, and promotion. Once these aspects of
the plan have been dealt with, the creative aspects such as the advertising goals
can be addressed. You will also develop a media plan that details what media
will be used, when they will be used, and how much it will cost.
The Product
There are a number of considerations relative to the product or products that
must be addressed in the marketing plan. They include product features—iden¬
tity, branding, packaging and labeling—product positioning, and product mix.
Product Features
For marketing purposes, think of the product as a bundle of benefits to the
customer. These benefits include a wide variety of things: attractiveness,
distinctive characteristics, quality, options, warranties, service contracts,
delivery, and so forth. But more important to the customer, the product offers
intangible benefits like convenience, savings in time and money, or improved
230 Part 4 • The Operating Structure of a New Venture
PROFILE 12.2
to 60 percent below other furniture retailers. Keeping costs down has been achieved
by controlling the distribution channel from producer to retailer. Their furniture is mass
produced according to their trademarked specifications in Asia. The “ready-to-
assemble” technology, packaged in flat boxes, saves on shipping and handling.
Products can be shipped in standard 40-foot containers. The stores, therefore, main¬
tain only enough stock to meet demand, and excess stock is stored in regional ware¬
houses. They have, however, tested the concept of a superstore with larger,
functional pieces of furniture like sofas with great success and are now in the process
of converting many of their stores to superstores. Nourse is also introducing a new
concept, Alex & Ivy, a store that will feature American and French casual furniture.
health. This bundle of benefits is the information the customer must know
about the product/service in order to feel comfortable about buying it.
Merely offering these benefits is not enough, however. They must be offered
consistently. In other words, the benefits the customer derives from using the
product/service must be received time and time again. Often, for example, a
company will focus on a high level of quality without concerning itself with
minor fluctuations in that quality. The only way to build confidence in
customers and, hence, increase the chance of return customers, is to provide
consistency in all the product benefits.
Packaging. The way a product is packaged reflects the philosophy of the busi¬
ness. If you are producing a consumer product, attractive packaging will grab
the consumer’s attention as it sits among many competing products on the
shelf. In global marketing packaging can often be as important as the product
itself. In Japan, for example, consumers value products that come in artistically
beautiful boxes and will pay more for such packaging.
In general, packaging should depict
Labeling. Today many companies are promoting products they call environ¬
mentally friendly, but they often stretch the limits of that term. In an effort to
protect consumers, the Federal Trade Commission has issued guidelines for the
use of environmental terms in advertising and product labeling. For example, a
product can only be labeled recyclable if the entire product can be collected or
separated from solid waste and used in the manufacture of other products. A
product may be labeled recycled content if the recycled materials in the product
came from solid waste stream. You also have to distinguish between materials
recycled from manufacturing and those from consumer waste by weight. To use
the terms degradable, biodegradable, and photodegradable, there must be evidence
that the product will completely break down and return to nature in a relatively
short period of time. Otherwise you have to qualify just how degradable it
really is.
Product Positioning
Product positioning is the way customers view the product in relation to
competitors’ products. Is the product more luxurious, of higher quality, less
expensive, more attractive and so forth? In other words, product positioning
really defines the product by its benefits to the target customer. Consequently,
234 Part 4 • The Operating Structure of a New Venture
any product will probably be repositioned several times during the course of its
product life cycle as customer tastes and preferences change. And this is
precisely why a small company that is flexible and can move more quickly can
take on a giant in a market niche that the giant has not yet tackled.
It is also important to note that not only will you position the product, but
the company distribution channel, and technology as well. Savvy customers
today are concerned more and more about the reputation of the company they
are dealing with, so if a company, for example, associates with distributors
whose level of service is not up to its standards, it will ultimately reflect on the
company. Realistically a products position in the market will be a function of
the customers’ perception of where it should be. That is, you may have
designed your product to replace another established product, whereas the
customer sees it as a product they would like to have once they have already
bought the existing product. Precious marketing dollars will be wasted if you
don’t respond to the customers’ perceptions.
In positioning the new product, refer to the customer profile devel¬
Not only will you oped when you did your market research. However, be aware that you
position the product, must constantly receive feedback from customers to stay on top of
changes in tastes and preferences that may call for a repositioning of
but the company,
the product later on. Most products will have primary market segments
distribution channel,
and then sub-sets of those segments. Sub-sets are other markets or uses
and technology
for the product. Just as you studied the primary market, you must also
as well.
understand the sub-sets to correctly position the product in those
markets.
It is also important to carefully study your competitors to determine their
strengths and weaknesses and how they might respond to your entry into the
market. If a competitor is a publicly traded company, annual reports are avail¬
able. In the event they are not, talking to distributors, customers, and adver¬
tisers can provide valuable information to help plan a strategy. If you find out a
competitor holds the position you wish to occupy, you have three choices:
1) find another opportunity; 2) try to overtake the competitor in the position;
or 3) attempt to reposition the competitor. Overtaking the competitor is very
difficult to achieve and is rarely accomplished. If you have positioned the busi¬
ness in an emerging niche, there may be an opportunity to re-educate the
customer about the competitor’s product as well as introduce them to the
different benefits of yours.
Studying the market carefully can produce niches that may not have been
considered or vulnerabilities in competitors not previously apparent. It may
Chapter 12 • The Marketing Plan 235
also result in positioning the product a little differently than originally planned.
Remember, however, to look not only for evidence to support a particular posi¬
tioning but also to refute it.
Once you have determined the position you wish to occupy and have
written the positioning statement, it needs to be tested in the marketplace.
There are several methods that can be used, and they vary in the time and cost
involved. In all cases, however, news of the product will be shared prior to
market entry, so have anyone who participates in the testing sign a Statement of
Nondisclosure.
• Peer Review. Ask anyone and everyone you know to give an opinion on the
positioning statement. Ask for their impressions and perceptions of how the
product will do in this position.
• Distribution Channel Review. Ask salespeople, distributors, and retailers
what they think of the position statement. These are people who understand
the industry and will have a pretty good sense of where you and your
product might fit in.
• Focus Groups. Bring together a representative sample of the customer base
and get their opinions.
• Test Marketing. This involves producing a limited amount of product and
selling it in a defined geographic region to determine if the product posi¬
tioning is correct. For most start-up companies, test marketing isn’t econom¬
ically feasible so the cost of this approach must be weighed against getting
out in the market as quickly as possible.
Product Mix
Product mix refers to all the products the business will produce and/or sell. If
the business will offer multiple products, you must consider how these products
relate to each other and if they all serve to communicate your company’s identity
236 Part 4 • The Operating Structure of a New Venture
and product positioning message. The products that comprise the product mix
will be determined by the markets to be served; for example, a more diversified
product mix may be needed when several markets are being served.
Catherine White, founder of Financial Architects, a financial services firm in
Lexington MA., offers social screening of potential investments as an additional
service in her “product mix.” Clients who wish to invest in companies that have
certain social goals can use her services as well as clients who invest based on
purely financial criteria. In this way, she is serving a larger market with a more
diverse product mix.
Price
Price is one of the most important features of a product. As a marketing tool,
price more than any other factor affects customer acceptance of the product, the
business’s cash flow, and in general the profitability. Price is determined by
many factors:
• The demand for the product is strong relative to the supply. Where demand
is greater than supply, a higher price may be commanded.
• The demand for the product is inelastic; that is, people will buy no matter
what the price because they need the product. This is typically true for
commodities with no viable substitute, like milk.
• Intense competition may force the price of the product down.
• Additional features may warrant a higher price.
• New technology may call for a higher price.
• Product positioning may be associated with a certain price level. For
example, positioning a product among luxury items commands a higher
price.
• Increase sales? This may entail lowering prices to raise the volume sold.
• Increase market share? Again, by lowering prices, volume may increase, thus
increasing market share.
Chapter 12 • The Marketing Plan 237
Gross Margins
Place
The place strategy will dictate how products get to the customers. This is essen¬
tially the distribution strategy, which was discussed in detail in Chapter 7. In this
section, however, the scope of distribution and some issues related to transporta¬
tion are addressed. As in any aspect of marketing, consistency is important.
Naturally, the location of the business is a relatively stable feature so customers
2Parrott, M.D. (1988). “Margin for Error." Do It Yourself Retailing. Vol. 154, No. 6, p. 11.
Chapter 12 • The Marketing Plan 239
always know where to find it. It is equally important to establish stable distribu¬
tion channels so customers don’t have to think about how to find your products.
Once a customer associates your product with a particular outlet, whether
wholesale or retail, a major change—such as moving to a mail order channel—
may cause frustration and lead the customer to seek a substitute product.
The distribution strategy dictates how broadly your products are distributed.
Choosing to distribute to all possible outlets involves using an intensive distrib¬
ution strategy. Limiting distribution to select outlets is a selective strategy. With
an exclusive distribution strategy, distribution is limited to one outlet per
geographic area.
when you consider that raw materials as well as finished goods spend a good
part of their time in transit or in inventory, incurring costs at both stages, any
savings in logistical functions brings more to the bottom line for everyone in
the chain. Even where price differentiation is not feasible, value can be added
through differentiation in logistical strategy. The goals of an effective logistics
system include:
• Increasing information
• Reducing inventories
• Increasing cycle times
• Reducing variable costs
• Improving customer service
Information is the key. The company that has a communications system that
lets it stay in touch with its distributors and sales force wherever they are will
be a more efficient and effective company. Some trucking companies, for
example, use two-way satellite communication and track shipments via
computer, so they are never out of touch. Thus, logistics is a significant aspect
of any marketing plan.
Promotion
A new business requires two promotional plans: one for opening the business
and making customers aware of its existence, and the other for growing the
business. The opening plan establishes the identity or philosophy of the busi¬
ness. Remember that identity and philosophy are quite different from image.
An image is what you may aspire to be, while your business character and
philosophy define who you are in reality. The marketing plan for growing the
business is the one you will implement and use consistently for the long term.
It is the plan you invest in to build a customer base. It will define the target
market and market share you wish to achieve, what people and resources it will
take to reach that share, and which services will be needed.
The promotion function of the marketing strategy is the creative one, for this
is where advertising, publicity, sales promotion, and personal selling tactics—in
short, your promotional mix—is decided. Not every business has the same
promotional mix; it is a function of the type of business, the target market, and,
of course, the budget. For entrepreneurs with new ventures, the last item—the
budget—usually dictates a creative approach.
Chapter 12 • The Marketing Plan 241
Advertising
Advertising media generally fall into two categories: print and broadcast. The
following sections examine the various types of media and their uses. It is not
the purpose of this book to provide all the information needed to use each
medium presented, only to create awareness of how and when each is used so a
decision can be made about which media will best serve the business.
Newspapers have disadvantages as well. Broad coverage means you are paying
to reach people who may not be part of the target market. Furthermore, since
newspapers carry hundreds of ads every day, it is not easy (short of taking out a
full page) to attract the attention of the reader. Then too, a newspaper has a very
242 Part 4 • The Operating Structure of a New Venture
short life. A person may read it with breakfast and throw it out before leaving for
work. Even an ad that was noticed may be forgotten by the end of the day.
Therefore, you may want to consider a specialized newspaper that will better
reach the customer you want. Here are some tips for using newspaper advertising.
• Determine which newspaper is best for your business by placing ads in all of
the ones in your target region the first time. Include in the ad a coupon or
800 number so the potential customer will either bring the coupon into your
place of business or call on a special line. In either case, ask them where they
heard about the business. The papers with the highest response rates should
be continued and all others dropped. Once this has been done in one or two
geographic regions, you can safely assume that a similar type newspaper in
another part of the country will give similar results.
• Be sure you or someone you have paid designs the ad so it doesn’t look like
every other one on the page. Often a distinctive border will make the ad
stand out.
• Create a basic design for advertising that reflects the philosophy of the busi¬
ness and use that design consistently in all advertising. Customers will even¬
tually recognize that the ad is for your company before they even read it.
• The best location for the ad is the right-hand page, above the fold of the
newspaper, but it is probably also the most costly.
• Keep track of the results of your ads, particularly if you are experimenting
with size and design.
• A national newspaper like USA Today offers a good opportunity to do
national advertising for less money and a broader reach than a magazine.
Magazines also offer the entrepreneur one thing newspapers can’t: credibility.
According to Jay Levinson, “A properly produced magazine ad, preferably of
the full-page variety, gives a small business more credibility than any other mass
marketing medium.”3 Obviously, you would want to run the ad more than
once; but it is possible to run the ad one time and order reprints at a fraction of
the original cost to use in direct mail campaigns and in brochures.
Here are some tips for magazine advertising.
• If the magazine has a regional edition, run the ad in the region you are
targeting.
• Use a media buying service to gain real cost advantages.
• Ask the magazine if you can run a split-run ad, that is, run one headline in
half the magazines and another in the other half. Be sure to code them so
you can keep track of responses.
• Code all ads to reflect publication, date, run, and ad size.
• Use color effectively and take advantage of the fact that you can provide
more information in a magazine ad than in a newspaper ad because the
reader generally spends more time with it.
• Always give a phone number or mail-in coupon in the ad to encourage
people to contact you for a full brochure or a video.
• Check on “remnant space,” leftover space that must be filled before the
magazine goes to print. It will be a fraction of the original cost of an ad.
Direct Marketing. Direct marketing includes direct mail, mail order, coupons,
telemarketing, door-to-door, and TV shopping networks. The essence of direct
marketing is that the entrepreneur attempts to close a sale at the moment the
advertising takes place. Direct marketing also permits coverage of a wide
geographic area while, at the same time, targeting specific customers; therefore,
more sales can be generated with fewer dollars. Much more information can be
provided in a direct-response brochure; in other words, it can answer all the
customer’s potential questions so they can make an immediate decision.
Consequently, direct mail has the highest response rate of any type of adver¬
tising, and the responses received from a purchased mailing list become the
business’s personal direct mailing list. Another way to create a personalized
mailing list is to have people who “walk in” to the place of business fill out a
database card and suggest other people who may be interested in the product
or service.
The average response rate for direct mail is two percent. That rate can be
increased 50 to 100 percent if you include an 800 number in the advertising,
which is easier than filling out an order form. That response rate can be
increased from 100 to 700 percent by following up the mailing with a phone
call—telemarketing—within 72 hours. As a small, growing company, it is
important to consider the staff resources you have and to control mailings to
the number you can reasonably follow up on within the 72 hours.
Chapter 12 • The Marketing Plan 245
Telemarketing Law
Be sure you understand the Telephone Consumer Protection Act, which says you must maintain a
“do-not-call” list and bans unsolicited advertising via fax machines.
You can find out more about this law by writing for “Marketing by Telephone,” to the Direct
Marketing Association’s Ethics and Consumer Affairs Department, 1101 17th St. NW, Suite 705,
Washington, DC 20036-4704.
To get the highest response rate possible, you have to do several repeat
mailings. For catalogs, four times a year is typical. Also, since most customers
have a tendency to throw out direct, unsolicited mail before reading it, it is
important to put the central selling point on the envelope as well. Customers
must be enticed to open the envelope. A tag line that suggests that what is
contained in the envelope will bring the customer money, health, love, or
success will certainly encourage people to see what you have to offer.
More than half Be sure to continuously update the mailing list and refine it so the
Prodigy and CompuServe also provide an outlet for consumer products and will
be something to look at carefully in the future.
The Yellow Pages. Many businesses can benefit from placing ads in the Yellow
Pages of their telephone directory If you are in the retail business or offer a
service not considered a professional service (consultant, lawyer, accountant),
there is a good chance people will look for what you offer in the Yellow Pages.
However, remember that the Yellow Pages is fairly expensive advertising space
and only targets the local market for your product or service, so it should not
be considered a major source of advertising, particularly if you market nation¬
ally or globally.
Signs. Signs are a relatively inexpensive way to expose a lot of people to the
business. They also encourage impulse buying of consumer products. Naturally,
signs play the most important role in retail businesses where they become part
of the total advertising campaign. In other types of businesses, the sign is
merely a feature to help someone locate the business. Signs do, however,
outlive their usefulness fairly quickly. If a sale sign is left in a window too long,
people will tune it out; they will no longer see it, and it will have lost its value.
can maintain quality and consistency in your advertising. Don’t rely on the
radio station personnel to give your ad the energy and professionalism it needs.
Here are a few more tips for radio advertising.
• Stick to shorter spots. You can usually achieve just as much in a well-
designed 30-second ad as you can in a one-minute ad.
• Use music and sound effects to set the tone for the commercial. Both can be
rented from most radio stations for a modest amount.
• Be sure to design the commercial to catch the listeners attention in the first
few seconds.
• Run your ads three weeks out of every four for good coverage at less cost.
publicity. The media are always looking for news and appreciate the effort to
give them something newsworthy. An effective news release should contain the
following:
There are also several publishing services that can be used to distribute infor¬
mation on the business. The Contact Sheet, a monthly publication, prints news
releases written and paid for by companies. It is sent to over 1,800 editors and
reporters nationally who have free use of the material. Another publication is
the PR Newsletter, which is a membership electronic service that also assists the
company in writing a message targeted to a specific media audience.
Personal Selling
Traditional selling techniques just don’t meet the needs of todays customers.
Today, people expect a quality product at a fair price with good service. That’s a
given. If you start with this in mind, you will find that the way you sell your
products and your business is quite different from the traditional approach.
Today, a business distinguishes itself in the marketplace by identifying and
meeting specific customer needs. So even if you are “selling” a commodity, you
need to figure out some way to add value to the product.
A good example of this is a small manufacturer of molded plastic parts in
Massachusetts. Its largest account is a major acoustic speaker manufacturer, also
in Massachusetts. The speaker company asked the plastics company to assign a
full-time salesperson to their plant, which would help them eliminate some of
the costs of buyers and planners and, at the same time, let the plastics plant
concentrate on service rather than trying to acquire new accounts. As a result,
the plastic company’s sales have increased nearly 40 percent per year.
Becoming a value-added company, tailoring products to meet customers’
needs, requires that everyone in the company become service oriented, a time-
consuming task that necessitates training and educating employees. It also
demands an opportunity mindset, rather than a selling mindset. And as this type
of selling is usually accomplished at higher levels in an organization, it is a more
250 Part 4 • The Operating Structure of a New Venture
lengthy process; however, the returns are potentially greater. Working more
closely with customers can translate into reduced selling and marketing costs.
One of the most difficult issues an entrepreneur faces with regard to selling is
that of compensation—what and how to pay sales representatives. The possibil¬
ities are endless: Incentives can be tied to profit or gross margins, contract size,
the number of new accounts acquired, company goals, and so on. One of the
latest techniques is to pay sales people a salary plus a percentage of the profits.
Yet another issue is how to compensate those who provide service to customers.
Service is the key to customer retention, and the people who provide that
service are becoming increasingly more important to a firms success. Studying
the compensation practices in your industry as well as those of other industries
will help you decide which method is best for your business.
1. Rent booth space. Hire a display designer to design and produce a quality
display booth that will attract attention. Visiting several trade shows prior to
doing your own will give you some ideas as to what works and what doesn’t.
You may also be able to work out a deal with a company that has compatible
products to share a booth and combine resources.
2. Hire a model to distribute an information sheet to as many people as possible
at the trade show that invites people to stop by the booth. Save the expensive
brochures to hand out at the booth to potential customers. Also be sure to ask
for business cards so you can follow up with people who took the brochure.
To learn about trade shows and conventions where you can display your products, check your
library for Tradeshow and Convention Guide, which can also be ordered from Budd Publications,
P.O. Box 7, New York, NY 10004.
Chapter 12 • The Marketing Plan 251
service fee, a per-search fee, an hourly rate, a print charge, or all of the above.
This can run into a considerable amount of money in a short time. Figure 12.1
presents a summary of some of the services available from the most common
database sources. Before signing up for any of these, arrange for a demonstra¬
tion of several at once so you can compare them for speed, ease of use, and
information provided.
• The purpose of the marketing plan. What are you trying to accomplish?
• The plan for achieving that purpose and the benefits that will accrue to the customer.
• The marketing tools used to reach the target market (advertising, direct mail, trade shows, etc.).
• The media plan with the schedule of use and costs of each of the marketing tools.
the sources at the end of the chapter for more details on a specific topic that
may interest you. Including a marketing plan in your business plan is essential
as it helps ensure the business stay on track with its sales goals. It also lets
others who may read the plan (bankers, investors, potential employees) know
something about the company’s philosophy, identity, and goals. See Figure 12.2
for an outline of a marketing plan.
This plan, like the rest of the business plan, is a living document subject to
change based on new information. However, a marketing plan should not be
changed often. It takes time to implement an effective plan, and it takes time to
see the results. The plan you create should be the best one achievable, given the
resources available.
Overview
• The entrepreneurial approach to organizational structure
• Ownership and compensation issues
• Hiring decisions
• The employee handbook
255
256 Part 4 • The Operating Structure of a New Venture
Figure 13.1: Traditional Line and Staff Organizational Chart for a Simple
Manufacturing Plant
Personnel
Manager
Purchasing
Plant Manager J Sales Manager |
Manager
'Krackhardt, D. & Hanson, J.R. (1993). “Informal networks: The company behind the chart.” Harvard
Business Review, Vol. 71 (4), p. 105.
Chapter 13 • The Management and Organization Plan 257
daily basis. For example, the political/trust network might include the book¬
keeper, a sales rep, and a plant employee.
Entrepreneurs seem to have intuitively recognized the value of informal
networks in the organizational structure and often the most successful new
ventures adopt a team-based approach with a more flat structure. Figure 13.2
depicts the nature of this* structure. The lead entrepreneur is the driving force
for the entrepreneurial team, which normally consists of people with expertise
in at least one of the three functional areas of a new venture: marketing, opera¬
tions, and finance. The organization consists of interactive, integrative teams. In
the new venture, these are rarely “departments” in the traditional sense, but
rather functions, tasks, or activities. The statistics reflect this pattern. Fifty-one
percent of the growing companies that have made it to the Inc. 500 list do not
have a marketing director, while 61 percent have neither a COO nor a
personnel director. Thirty-two percent do not have a CFO, and an astounding
67 percent have no one to manage information systems in their companies.2
What is the explanation for this? For one thing, entrepreneurs are usually too
creative and flexible to be bound by the strictures of a formal organizational
structure. They are more comfortable bringing together resources and people as
a team and making decisions on the spot without having to go through layers of
management. Another reason is that growing new ventures must be able to
adapt quickly as they muscle their way into the market. Uncertainty and insta¬
bility are a way of life for young ventures, and a rigid, formalized, bureaucratic
structure would unduly burden a new venture both financially and operationally
Three components make up the entrepreneurial organizational structure:
formal processes, people, and culture. Formal processes include the planning
system, control mechanisms, compensation and reward policies, and other
processes that make the organization run more efficiently and effectively. These
processes are not independent units, but rather are linked to all functions of the
organization that require them. For example, quality control mechanisms are
not solely the purview of a single department, but flow from product develop¬
ment through manufacturing, to distribution, and throughout all of the support
functions needed to facilitate the process of getting the product to the customer.
People who work in market-oriented, entrepreneurial companies must not
only think of their individual tasks but of the product and company as a whole.
People required to make the business work need to have team building skills as
well as the ability to make decisions and implement them with very little input
from top management or the CEO. In new ventures those teams may consist of
independent contractors whose skills are being “rented” on an as-needed basis.
Informal networks create flexibility and speed up operations. They also have
the advantage of managing the personal issues not easily handled through poli¬
cies and structure.
The purpose defines the opportunities, innovations, and parameters the busi¬
ness will pursue. DV Industries, for example, seeks to meet the specialized
Chapter 13 • The Management and Organization Plan 259
integrative, team- Teams come in many varieties: self-directed work teams, problem¬
based approach. solving teams, quality teams, cross-functional teams. Essentially they
serve the same underlying purpose: “A team is a small number of
people with complementary skills who are committed to a common purpose,
set of performance goals, and approach for which they hold themselves
mutually accountable.3
What makes the entrepreneur’s situation unique is that, at least when the
venture is in the start-up or initial growing phases and capital resources are
limited, the team the entrepreneur develops will most likely consist of several
people outside the organization, namely, independent contractors. For example,
the entrepreneur may decide to sub-contract the manufacturing of a product to
an established company. This means he or she needs to understand how that
sub-contractor works and will, of necessity, become a part of that company’s
team in the production of the product. The entrepreneur’s marketing, sales,
operations, and finance people must also be able to work with the manufac¬
turing sub-contractor to ensure that the goals of the new venture are met with
the timeliness and level of quality desired. This requires skills on the part of the
team that are not normally learned in school, skills such as diplomacy in the
management of intra- and inter-team relationships, problem-solving skills, and
the ability to take responsibility for innovative changes on the spot, often
without the direct approval of the entrepreneur.
3Katzenbach, J.R. & Smith, D.K. (1993). The Wisdom of Teams. Boston: Harvard Business School Press.
260 Part 4 • The Operating Structure of a New Venture
PROFILE 13.1
Building a team that works well together is a long process that involves
training the team in both interpersonal and job-related skills. In the beginning
of a new venture, that learning may come through trial and error, but later as
Chapter 13 • The Management and Organization Plan 261
the budget allows, it may come through hiring a team facilitator or consultant
who can help fine-tune the teams efforts. Integrative team building demands
bringing in people who have a vested interest in the success of the business and
are not content to simply do their job but want increasing responsibility,
authority, and accountability. Entrepreneurs must be careful to make that
requirement very clear when bringing someone new into the team.
TQM—Panacea on Solution
Total Quality Management, or TQM, became the buzzword of the early 1980s.
As a management plan it requires businesses to become flexible and more
responsive to their internal and external environments. TQM is an integrated,
systematic, organization-wide management philosophy that helps to build
customer-driven businesses. It strives to improve product and service quality in
all aspects of the business by empowering employees to change processes. It
demands systematic changes in management practice, the redesign of tasks, and
the redefinition of managerial roles.4
Recently TQM has come under attack because despite its popularity, only 20
percent of those companies that institute TQM can identify significant improve¬
ment in their performance.5 Furthermore, it is a difficult concept to measure
without benchmarks as the traditional appraisal and reward systems do not
work with TQM. Some people suggest that TQM will be replaced by the
current buzzword, business process reengineering, which means constantly
questioning and re-evaluating whether or not current processes in the organiza¬
tion are working and make sense. In any case, the basic concept of total quality
throughout the organization is here to stay.
4Grant, RM., Shani, R; Krishnan, R. (1994). TQM’s challenge to management theory and practice. Sloan
Management Review, Vol. 35, Iss. 2, pp. 25-35.
5Fisher, Liz (1994). Total quality: Hit or myth? Accountancy, Vol. 113, Iss: 1208, p. 50.
262 Part 4 • The Operating Structure of a New Venture
prevailing wisdom is that providing stock in the new company will increase
commitment, cause management to be more cost conscious, reduce cash outlay
for salaries, and induce loyalty to the company in the long term. But recent
studies have found this is not always the case.6 More often than not the person
to whom you have given stock in good faith will ultimately leave the company,
taking the stock with him with the potential for future harm to the business.
In the initial growth stage of a new venture, it is difficult to determine with
any degree of accuracy what long-term role a particular person may play in the
organization. Often the entrepreneur, due to limited resources, is not able to
attract the best person to take the company beyond the start-up phase, so a
person with fewer qualifications will be hired for little salary plus a minority
ownership in the company. The entrepreneur is literally betting on the potential
contribution of this person, an eventuality that usually doesn’t pay off. Later
when the company can afford to hire the person it needs, the entrepreneur has
to deal with a minority shareholder who has developed territorial “rights.” When
minority ownership is an important issue to a potential employee, it is important
to make clear to that person what it means. There are few legal and managerial
rights associated with a minority position; thus, for all practical purposes,
minority ownership is simply the unmarketable right to appreciated stock value
that has no defined payoff period and certainly no guarantee of value.
Founder’s Stock
Founder’s stock (144 stock) is stock issued to the first shareholders of the
corporation or assigned to key management as part of a compensation package.
The payoff on this stock comes when the company goes public or is sold.
Assuming the company is successful, founder’s stock at issuance is probably
valued at the lowest level it will ever be relative to an investor’s stock value.
Consequently, one tax problem that arises as a result occurs when private
investors provide seed or working capital to the new venture. Often the value of
the stock the investors hold makes it very obvious that the founder’s stock was
a bargain and not the true value of the stock. According to IRC 83, the amount
of the difference between the founder’s price and the investor’s price would be
taxable as compensation income.
One way to avoid this problem is to issue common stock to founders and
key management, and convertible preferred stock to investors. The preference
6Osborne, R.L. (1992). "Minority ownership for key employees: Dividend or disaster?” Business Horizons,
Vol. 35(1), p. 76.
Chapter 13 • The Management and Organization Plan 263
upon liquidation should be high enough to cover the book value of the corpo¬
ration so the common stockholders would receive nothing. This action would
effectively decrease the value of the common stock so it would no longer appear
to be a bargain for IRS purposes.
Founders stock is restricted, and the SEC rules (Rule 144) state that the
restriction refers to stock that has not been registered with the SEC (private
placement) and stock owned by the controlling officers and shareholders of
the company (those with at least 10% ownership). If a stockholder has owned
the stock for at least three years, and public information about the company
exists, Rule 144 can be avoided in the sale of the stock. If the stockholder has
held the stock for less than three years, the rules must be strictly complied
with. It is not the intent of this chapter to discuss the details of Rule 144.
Suffice it to say that the rule is complex and the appropriate attorney or tax
specialist should be consulted.
Issuing Stock When the Company is Capitalized. The number of shares you
authorize when you form the corporation is purely arbitrary. Suppose you
264 Part 4 • The Operating Structure of a New Venture
decide to authorize one million shares in the new venture. This means you have
one million shares available to be issued to potential stockholders. If you value
each share of stock at $1 and capitalize $100,000, you will have issued 100,000
shares; if each share is valued at $10, you will have issued 10,000 shares. The
value you place on each share is arbitrary; for psychological reasons you may
wish to value a share at $1, so a shareholder who contributes $10,000 to the
business can say that he or she owns 10,000 shares of stock as opposed to
1,000 shares at $ 10/share. In short, the number of shares issued depends on
the initial capitalization and the price per share.
Now suppose that you, the entrepreneur, will be initially contributing
$250,000 in cash and $300,000 in assets (equipment, furniture, etc.) to the
company. At $1 a share, you issue yourself 550,000 shares of stock
Holders of common and own a 100% interest in the company because you have only
stock share in issued 550,000 shares total. At a later date you issue 29,000 additional
shares at $5 a share to an investor. Your minority shareholder has
both the successes
therefore contributed $145,000 to the company and owns a five
and failures of the
percent interest in the company (29,000/579,000 issued stock). The
business and
investor will require that the current value or future additional income
benefit through
of the company be sufficient to justify the increase in price per share.
dividends and the
You can see that as additional shares are issued, the original stock¬
appreciating value
holder’s percentage ownership in the company declines. However, the
of the company. founders shares will not go below 55 percent (550,000/1 million)
unless the company authorizes additional shares and issues a portion
or all of those additional shares.
The type of stock you will be issuing is common stock, which is a basic
ownership interest in the company. This means that holders of common stock
share in both the successes and failures of the business and benefit through
dividends and the appreciating value of the company. Once common stock is
issued, a company can issue preferred stock, whose holders are paid first if the
company is liquidated. Preferred stockholders, however, must accept a fixed
dividend amount, no matter how much profit the company makes. If you form
a sub-chapter S corporation, you may only issue one type of stock.
One form of stock you may want to offer investors as an inducement is
called IRC Sec. 1244 stock, which permits a shareholder of a corporation with
capital and paid-in surplus of $ 1 million or less to treat a portion of any loss on
the disposition of the stock as an ordinary loss, rather than a capital loss. The
amount the shareholder can take as a loss is limited to the shareholders original
investment.
Chapter 13 • The Management and Organization Plan 265
Trusts. An irrevocable trust offers the greatest protection for the ownership of
stock. For example, you may set up a trust for your child that contains his or
her stock in the family corporation. The trust will stipulate that creditors have
no rights to the trust. This also includes a potential spouse that your child
might divorce. The important thing to remember is that you, the entrepreneur,
must set up the trust using an attorney specializing in that area of the law.
vidual’s performance. The employee does not pay taxes on this award until it is
actually paid out at some specified date.
Bonus Plans. With a bonus plan, a series of goals are set by the company with
input from the employee, and as the employee reaches each goal, the bonus is
given. This method is often used with sales people and others who have a direct
impact on the profitability of the company. The key to success with bonus plans
is to specify measurable objectives.
Capital Appreciation Rights. This type of program gives employees the right to
participate in the profits of the company at a specified percentage, while not
being full shareholders with voting rights. Capital Appreciation Rights, or
“phantom stock,” provide for long-term compensation incentives whose value
is based on the increase in the value of the business. The phantom stock will
look, act, and reward like real stock, but will have no voting rights and will
limit the employee’s obligation should the business fail. Typically the employee
has to be with the company for a period of three to five years to be considered
vested, but otherwise they do not have to pay for these rights.
Job Profiles
Part of organizing the business is determining what positions are needed to do
the required tasks of the business. Naturally, in the start-up phase most entre¬
preneurs do the biggest share of the work themselves, but they know that at
some point they will have to hire employees, even if it’s only a receptionist or
administrative assistant. Preparing profiles and job descriptions for all the func¬
tions of the business ensures that you have them when you need them.
Typically when entrepreneurs (and managers) develop job descriptions, they
focus entirely on the duties and responsibilities of a particular job. While this is
important, it is equally important to develop behavioral profiles of these jobs; in
other words, what behavioral traits are typical of and vital to a particular posi¬
tion. An effective bookkeeper, for example, may require the following attrib¬
utes: detail orientation, focused, can work alone, is responsible and organized.
In addition to looking at the best behavioral traits for each position, the
entrepreneur must have a good sense of the business culture. While a job
candidate may have the education and experience required by the job descrip¬
tion and display some of the behavioral traits necessary for success in the posi¬
tion, the candidate’s chemistry may not fit in well with the culture of the
organization. This is an important distinction because education and experience
can be achieved, behaviors can in most cases be taught, but chemistry—fitting
in with the company culture—must already be present in the job candidate.
Resumes
The most important thing to know about a resume is that it is a selling docu¬
ment. The person is attempting to convince you to give him or her an inter¬
view. Therefore, expect most resumes to exaggerate a person’s importance
somewhat. If a resume indicates a person has had a number of jobs in a rela¬
tively short period of time or a number of “very important” positions—vice
president of this company and president of that company—it may either mean
this person truly is in demand and has been wooed away from several compa¬
nies, or it may mean that this person can’t hold a job. Consequently, you need
to think of the resume as a screening tool to see if the candidate has the requi¬
site skills and experience. The more important information will be gained in
the interview.
Interviews
Most entrepreneurs dread interviewing job candidates, primarily because they
don’t know what to say and they don’t understand that they should ask ques¬
tions that get at the person’s personality, how they might react in certain situa¬
tions. This can be accomplished in part by asking open-ended questions,
questions that call for more than a yes or no answer. For example,
While the person is answering the questions, be careful to note the non¬
verbal communication being sent through body language. Does the person
appear confident, at ease with what is being discussed? Does the person look at
you directly? Does the person sit with a very closed posture (arms crossed as if
to protect) or in a more open, relaxed manner. It is said that 90 percent of
communication is nonverbal, so if you don’t trust what a person is saying
verbally, check to see if the nonverbal signals match the verbal ones.
Entrepreneurs should know that certain questions may never be asked in an
interview situation because they are illegal and leave you open to potential
lawsuits. Under the laws administered by the EEOC (Equal Employment
Chapter 13 • The Management and Organization Plan 269
Opportunity Commission) before the point of hire, you may not ask about a
persons:
policies generally have limits from $50,000 to $10 million and are not inexpen¬
sive, averaging about $150 per employee annually.
Employee Contracts
Once you have decided to hire someone, it is crucial to put the terms of the
agreement in writing to avoid misunderstandings about salary, benefits, duties,
and responsibilities. What is not included in the agreement should be spelled
out clearly as well. Include in the contract a clause that calls for mandatory
arbitration in the event of a dispute and a non-compete clause to prevent
someone from leaving your business to start their own competing business with
your confidential information and customer/supplier lists.
Other Policies
Besides policies relating to employees, create policies and procedures for the
routine tasks that are accomplished each day in the business. For example,
procedures for order taking, shipping, handling invoices, billing, and all of the
other administrative functions the business undertakes will be needed. One
way to figure out what procedures may be required is to take the business
through a hypothetical, typical day or week and list all the activities that occur
from the point an order is received to the point at which it is shipped, or from
the point a sale is solicited to the point at which the sale is closed. Activities
that take place over and over again require established procedures to promote
efficiency and effectiveness. Naturally, many of the procedures you develop
when you start the company will be modified as you bring on employees and
receive their input. But it’s still a good idea to start with something.
□ Formulated a plan to find the best candidates for positions in the company?
OHO (A)1
I n the summer of 1989, Sam Farber had persuaded Davin Stowell, owner of
Smart Design, to develop a line of kitchen gadgets (e.g. peeler, can opener,
pizza cutter, garlic press) that would be functional, comfortable, ergonomically
sound, attractive, and affordable. Stowell decided to accept the challenge for a
three percent royalty agreement and a small advance. Farber was expecting
Smart Design to have the kitchen gadgets prototyped and ready for manufac¬
ture so they could introduce the new line at the San Francisco Gourmet Show
in April 1990. Before Davin Stowell would begin the process of generating
prototypes, the Smart Design team needed to meet to reinforce or expand on
Sam Farbers initial product criteria and help set the design goals for these new
products.
1©1994, Corporate Design Foundation. This case was written by Professor William B. Gartner, San Francisco
State University School of Business, with the support of the Corporate Design Foundation as a basic for class
discussion rather than to illustrate either effective or ineffective handling of a business situation.
276 Part 4 • The Operating Structure of a New Venture
and they were looking forward to spending more time writing articles and
curating art shows. They had done both in the past, but only in a limited way
because of the demands of their work. They also loved to entertain and cook,
and they decided they would spend at least a few months each year in the
south of France, writing and cooking.
While they had never been happy with many of the tools they used in the
kitchen, they didn’t realize just how bad these tools actually were until they
began “marathon cooking” for all of their friends that just happened to be trav¬
eling through Provenge. It became apparent that most of the kitchen tools
didn’t seem to meet the basics of good design: aesthetics, function, and form.
Attractive products, when they found them, were a functional disaster. The bit
of arthritis affecting Betsey’s hands made it difficult for her to use the kitchen
tools. She is one of over 20 million Americans who currently suffer from
arthritis, so Sam and Betsey were particularly aware of how virtually none of the
products considered user comfort.
They kept asking, “Why was the kitchen environment at best indifferent and
at worst hostile to human use? Isn’t it possible to combine form with utility in
design, and combine them in such a way that it becomes accessible to the entire
population? And doesn’t it reason that such a design would have great
consumer appeal? Why can’t a kitchen tool be comfortable, easy to use, of good
quality, aesthetically pleasing, and easy to clean?” The seed was planted and
Sam Farber began to think about bringing this idea to market.
Market Research
Sam Farber devised a strategy to generate information on the market for
kitchen gadgets with as few interviews as possible. He decided to interview
buyers in different areas of distribution.
buyers didn’t mention the latter two. Function and user comfort did not enter
into the discussion at all.
All the buyers suggested the same best-selling items: peeler, can opener,
garlic press, grater, pizza cutter, measuring spoons, and measuring cups. The
mail order catalog buyers preferred higher unit retails, and therefore wanted
sets that combined two or three items. All distribution areas were selling
kitchen gadgets in lower price ranges than the prices Sam Farber had contem¬
plated (e.g. peelers ranged from $.99 to $4.99). Sam was considering a peeler at
a price much higher than $4.99.
Sam Farber decided to confine his interviews with consumers to five or six
people he knew were good cooks. Some of these individuals were professional
chefs, but the majority were very good amateur cooks. Sam reasoned that they,
like he and his wife, would have thought a lot about the tools they use in the
kitchen. Their answers concentrated on quality, comfort, and function.
Design Partners
Concurrently with Sam Farber’s exploration of the market, he engaged the
design firm, Smart Design, to undertake the design process from concept to
product. Smart Design had done work for Sam previously at COPCO. Sam felt
Smart Design was forward-thinking, they had good technical expertise, and
they were willing to take chances. The firm also had a wide variety of experi¬
ence. Their client list included Corning Glass, Johnson & Johnson, Citibank,
Clairol, the University of Southern California, and JC Penney.
Sam knew Smart Design would make a good partner, and he wanted them to
be partners, not just hired hands. He worked out a three percent royalty agree¬
ment with Smart Design, plus a small advance. This way their success was
dependent on the success of the products. In addition, Sam wanted to keep
overhead costs (i.e. product design and development) minimal, as much as
possible, rather than start the company with little working capital.
marketing point of view, Sam wanted to appeal to the broadest possible market,
not just a very specific market for arthritics and the infirm. Sam wanted the
design of these products to be of transgenerational, or universal, design.
Universal design stresses the need to make the design of any product or
service fit the needs of as broad a spectrum of the populace as possible.
Products that make life more comfortable for everyone. Products that are easy
for everyone to use. Universal design acknowledges that people change over
time, that their needs vary with ordinary events like pregnancy, an armful of
groceries, carpel tunnel syndrome, skiing injuries, or the unavoidable changes
of aging. Universal design attempts to extend the useful life of both the object
and the user. Sam was hoping to push the boundaries dividing the able from
the encumbered. Transgenerational design considers all these variations in
strength and dexterity. It is a form of ecological thinking because it extends the
life of the product and its materials by anticipating the whole life experience of
the user. One of the designers put it this way: “We’d better design the stuff now
because we’ll need it when our abilities sag.” Sam’s comment was, “I think that’s
why I’m here.”
Sam and Davin Stowell of Smart Design decided to bring in Patricia Moore
as a project consultant. Moore was trained as a designer and had devoted
herself to design problems addressing the older generation. For example,
Procter and Gamble had asked her to help them redesign the Tide soap box to
make it easier to open. So she helped them develop the snap-top box. Smart
Design had collaborated with Moore on a number of universal design projects.
There were eager to demonstrate that designing for a general population that
included the elderly or those suffering from hand infirmities was not an excuse
to make “frumpy prosthetic devices,” but the opportunity to make products
that are better for everybody.
Design Research
The next step was to have the design team do their own research. Information
transmitted from the marketing managers to the designers can lose a lot in
translation. The design team went out into the market. They talked to
consumers. They examined all the competitive products. They interviewed
chefs and spent many hours with volunteers from the New York arthritis group
to learn the problems in hand movement. They used the products that were on
the market for weeks to pinpoint areas that needed improvement. This involve-
Chapter 13 • The Management and Organization Plan 279
ment as the final user brought the designers close to the project and helped
them share Sam Farber’s passion and belief.
It was now time to sit down and determine the product goals.
1. What are the primary product goals for these kitchen tools in terms of
customer needs?
2. Once these product goals are determined, what should happen next in terms
of product development?
3. What problems in the areas of product development, quality control, and
pricing is this business likely to face before the introduction of these prod¬
ucts at the San Francisco Gourmet Products Show?
4. What does Sam Farber need to do before creating a marketing plan?
.
PART 5
Overview
• Bootstrapping savvy
• Equity versus debt financing
• Venture capitalists and angels
283
284 Part 5 • The Financial Plan
Bootstrapping
Creativity is one of the key watchwords for financing start-ups in the 1990s.
Techniques for creative financing are collectively known as “bootstrapping,”
which means getting by on as few resources as possible and using other
peoples’ resources whenever possible. Bootstrapping means begging, borrow¬
ing, or leasing everything needed to start the venture. It is the antithesis of the
“big money model” espoused by many when they talk about entrepreneurial
ventures.1 More often than not, bootstrapping is a model for starting a business
without money—or at least without any money beyond that provided by the
entrepreneur’s personal resources.
Entrepreneur Resources
Most entrepreneurs start their ventures with their own resources, at least
initially. These resources include savings, credit cards, and friends and family.
The Department of Commerce reports that 67 percent of all businesses were
started without borrowed money. Enita Nordick liquidated her stocks and
sold her home to contribute the required capital to start Unity Forest
Products, which re-manufactures lumber blanks into such things as siding
and paneling and sells them to retailers. Bill Gates and Paul Allen started the
software giant Microsoft in a cheap apartment in Albuquerque with virtually
no overhead, a borrowed computer, and very little capital. Ross Perot, one of
the great bootstrapping success stories, started EDS with $1,000. These entre¬
preneurs comprise the rule, not the exception; most new ventures are initially
funded through the resources of the entrepreneur. Gates, Perot, and Nordick
realized early on that no one except friends and family would consider
investing in the new venture until they had gotten it off the ground and had a
viable business.
'Bhide, A. (1992). "Bootstrapping Finance: The Art of Start-Ups.” Harvard Business Review, Vol. 70, No. 6,
pp. 109-117.
Chapter 14 • Financing the New Venture 285
PROFILE 14.1
Personal Resources
As stated earlier, the number one source of start-up money is the entrepreneurs
personal resources: savings, credit cards, parents, and friends and family. The
reasons are many:
1. New ventures by definition have no track record, so all the estimates of sales
and profits are pure speculation.
2. An enormous number of new ventures fail, so the risk for an outside investor
is usually too high.
3. Many new ventures have no proprietary rights that would give them a
competitive advantage.
4. The founders often do not have a significant track record of success.
5. Too many new ventures are “me too” versions of something that already
exists, so they have no competitive advantages.
Angel: Business jargon for a private investor who holds an equity interest in the venture.
Asset-Based Loan: A loan collateralized by accounts receivable, inventory, or other assets. If the
entrepreneur defaults on the loan, the lender can seize the assets.
Equity: An ownership interest in a company based on an investment of capital.
Factor: A lender who purchases a company’s accounts receivable and then advances cash at a
certain percentage of the value of the receivables.
Securities: The interest of a creditor or investor in the property or business of a debtor or owner,
pledged to secure repayment of the debt or investment.
Seed Money: Money needed to complete research and development prior to starting the
business.
Senior Debt: Usually a bank loan that has seniority over all other financial interest should the
business fail.
Subordinated Debt: Non-bank debt that is repaid after senior debt in the event of business
failure. Can often contain rights to convert to equity.
Venture Capital: Professional groups of individual investors whose purpose is to invest money in
new and growing businesses. They typically supply second-stage or buyout financing.
source of credit, and when interest rates fall below those of the typical credit
card, this source of funds becomes very attractive. With a margin loan, the
security in your brokerage account is pledged as collateral for the money
borrowed, just like pledging the equity in your home against a second mort¬
gage. You can still trade the collateralized security (buy or sell), but cannot take
possession of it until the loan is repaid.
Private Investors—Angels
The next source usually investigated for funding is private investors, typically
people the entrepreneur knows or has met through business acquaintances.
These investors who are part of the informal risk capital market—the largest
pool of risk capital in the United States, over $50 billion—are called angels.
They can’t be found in a phone book, and they don’t advertise. In fact, their
intentions as investors are often well-hidden until they decide to make them¬
selves known. They do, however, have several definable characteristics:
• They normally invest between $10,000 and $500,000 and usually focus on
first-stage financing, that is, start-up funding or funding of firms younger
than five years.
Chapter 14 • Financing the New Venture 289
First Stage
(Seed Capital and Start-Up)
Personal Resources Angels
Small Business Investment Public Equity
Companies (SBICs) Second Stage
(Expansion Financing)
Public Equity State-Sponsored Venture
Venture Capital Capital Companies
Strategic Alliances Small Business Investment
Third Stage Companies (SBICs)
(Acquisition/Buyout)
Public Equity
Venture Capital Companies
290 Part 5 • The Financial Plan
business people. Developing these contacts takes time; you can’t wait until you
need the capital to look for it. Of course, taking on an investor means giving up
some of the ownership of the company. It is, therefore, probably wise to plan at
the outset for a way for the investor to exit. Including a buyout provision in the
investment contract with a no-fault separation agreement will ensure that the
entrepreneur doesn’t have to wait for a criminal act like fraud to end the rela¬
tionship. Structuring the buyout to be paid out of earnings over time will avoid
jeopardizing the financial health of the business. Above all, avoid using
personal assets as collateral to protect an angel’s investment.
Private Placement
Private placement is a formal vehicle for seeking funding from private
investors who are “sophisticated” in terms of the rules of private placement,
which are stated in Regulation D. Regulation D was designed to simplify the
private offering process and allow the entrepreneur to seek funding from
private investors as long as they met the requirements. Doing a private place¬
ment memorandum involves the completion of a business plan and a
prospectus detailing the risks of the investment. The rules for private place¬
ment must be carefully followed; they are discussed in detail in Chapter 17 on
financing growth.
As with any complex legal document, it is crucial to consult an attorney well
versed in the preparation of the private placement memorandum and disclosure
of information about the company and its principals. Problems don’t usually
arise if the business is successful; however, if the venture fails and the investors
uncover a security violation, you and other principal equity holders may lose
your protection under the corporate shield and become personally liable in the
event of a lawsuit. Security violations have been dealt with severely by the
courts, and there is no statute of limitations on the filing of such a suit.
Venture Capital
In general, venture capital companies are professional pools of managed funds
that often operate in the form of a limited partnership. Equity venture capital
funds are the most common type. While some venture capitalists invest in start¬
up companies, it is probably prudent not to attempt to seek venture capital
funding at this stage for several reasons. Venture capitalists recognize that start¬
up is the riskiest time for a business, and as there are many growing young
companies with a track record of performance (however short) available, their
Chapter 14 • Financing the New Venture 291
funds are probably better placed with these companies. Venture capitalists
require substantial returns on their investments, generally in the 60 to 70
percent annual return range, and a significant ownership interest, which may
force the entrepreneur to give up controlling interest in the new venture before
the company gets off the ground.
In general funds are not as prolific as they were in the 1980s, and almost 60
percent of available venture capital funds are held by megafunds, usually insti¬
tutional investors who prefer to invest in increments of $2 million and up.
Consequently, most start-up ventures do not waste the time and money seeking
venture capital funding. Instead, they see it as a source of second stage or
growth funding. For this reason, venture capital funding is discussed in detail
in Chapter 17.
Strategic Alliances
A partnership—whether formal or informal—with another business is a
strategic alliance. Through strategic alliances, entrepreneurs can structure deals
with suppliers or customers that will help reduce expenditures for marketing,
raw materials, or R&D. By reducing expenditures, cash flow is increased,
providing capital that wouldn’t have otherwise been available.
Another type of strategic alliance is the R&D limited partnership. This vehicle
is useful for entrepreneurs starting hi-tech ventures that carry significant risk due
to the expense of research and development. The limited partnership contracts
with the new venture to provide the funding for the R&D to develop a market
technology that will ultimately be profitable for the partnership. This is advanta¬
geous for both the limited partner and the new venture. Limited partners are
able to deduct their investment in the R&D contract and enjoy the tax advan¬
tages of losses in the early years on their personal tax returns; they also share in
any future profits. In the R&D limited partnership, the new venture acts as a
general partner to develop the technology and then structures a license agree¬
ment with the R&D partner whereby the venture can use the technology to
develop other products. Often the limited partnerships interest becomes stock in
a new corporation formed to commercialize the new technology.
An alternative to this arrangement is an agreement to pay royalties to the
partnership. Yet another vehicle is the formation of a joint venture, which
allows the entrepreneur to purchase the joint venture interest after a specific
period of time or when the company reaches a certain volume in sales. As with
the private placement, strategic alliances should involve an attorney. The new
292 Part 5 • The Financial Plan
venture may incur significant costs in creating the partnership, a process that
could drag on for up to a year. In addition, giving up the ownership of the tech¬
nology may be too high a price if the partnership does not survive.
Commercial Banks
In depressed economic climates, banks are not a readily available source of
either working capital or seed capital to fund a start-up venture. Today banks
are highly regulated; their loan portfolios are scrutinized carefully, and they are
Chapter 14 • Financing the New Venture 293
told in no uncertain terms not to make loans that have any significant degree of
risk. Consequently, if established firms with good credit risks are being denied
loans and credit lines, it stands to reason that a new venture with no track
record would not be likely to get an unsecured loan from a commercial bank.
Generally, banks make loans based on what is termed “the five Cs”: character,
capacity, capital, collateral, and condition. In the case of the entrepreneur, the
first two—character and capacity—become the leading consideration because
the new business’s performance is based purely on forecasts. Therefore, the bank
will probably consider the entrepreneurs personal history carefully. It is impor¬
tant, however difficult, for the new venture to establish a lending relationship
with a bank. This may mean starting with a very small amount of money and
demonstrating the ability to repay in a timely fashion. Bankers also look more
favorably on ventures with hard assets that are readily convertible to cash.
3“SBA Loans Spur Start-Up Growth,” Inc. magazine, November 1992, p. 66.
294 Part 5 • The Financial Plan
Of course, since these loans are backed by the government, the documenta¬
tion and paperwork are extensive, and interest rates are usually no different
than with a conventional loan.
The Small Business Administration also has a new program, the micro loan,
that makes it easier for entrepreneurs with limited access to capital to borrow
small amounts (up to $25,000). Instead of using banks as in their guarantee
program, they use nonprofit community development corporations. The
Answer Desk at the SBA, 800-827-5722, can provide information on micro
lenders in a particular area of the country.
Grants
The Small Business Innovation Development Act of 1982 requires that all
federal agencies with research and development budgets in excess of $100
million give a portion of their budgets to technology-based small businesses in
the form of grants. Small businesses find out about these grants by checking the
published solicitations by the agencies (see Figure 14.1) to see if they can
provide what the agency needs.
The grants have three levels:
To qualify for an SBIR grant, the company must employ fewer than 500
people, be independently owned, and be technology-based.
The entrepreneur with a new venture has many options. Crafting a capital
structure for the new venture that works, however, depends in large part on the
creativity and persistence of the entrepreneur in securing the capital needed at
the right price to successfully launch the venture.
1. What are some ways a new venture can bootstrap to conserve capital?
Issues to
2. What are some of the pitfalls of bootstrap financing?
Consider
3. What is the role of angels as a source of new venture funding?
Preparing the
Financial Plan
Overview
• Projecting sales and capital expenditures
• Calculating how much start-up capital is needed
• Preparing the pro forma financial statements
• Preparing the financial plan
297
298 Part 5 • The Financial Plan
acquire credit and take on debt at some time. It is important, then, to under¬
stand that as these pro forma statements are estimates, they are subject to
change based on the more accurate information gained when the business actu¬
ally begins operating. This is why entrepreneurs typically re-evaluate the finan¬
cial statements on a monthly basis for the first year.
The sales forecast should be calculated first because sales affects the other
expenditures of the business. The method for forecasting sales varies depending
on the general product or service category. For example, with a new product
that is a line extension or the next generation of an established product, the
entrepreneur can rely on historical data that will help ensure a more accurate
estimate. With a brand new or breakthrough product, however, the entrepre¬
neur is left to rely on market data, comparison of similar products, and the
opinions of market experts. Therefore, to improve the estimate, it is useful to
calculate best case, worst case, and most likely case scenarios that will cover
about 90 percent of all the possible sales results.
established company, you as a new venture will probably not achieve the same
level of sales for some time. Therefore, the sales figures you gather serve merely
as an upper limit benchmark as you determine how much below that figure
your sales level will be. The percentage increase in your sales over a three- to
five-year period will depend on:
Forecasting Expenditures
In wholesale businesses, once the sales forecast has been determined, you can
apply the figures for inventory purchases as a percentage of sales and forecast
from that. So if inventory cost is 25 percent of sales, you can apply that
percentage to sales as they increase to forecast changes in the volume of inven¬
tory. In manufacturing businesses, it is a bit more complex because you must
first derive the Cost of Goods Sold (COGS), which usually consists of direct
labor, cost of materials, and factory overhead. Looking at the sales forecast in
terms of units produced to arrive at a dollar figure for COGS and then applying
costs of goods sold as a percentage of sales will probably suffice for purposes of
pro forma statements when the business is starting. Month-by-month analysis
of outcomes and use of a cost accounting model that considers raw materials
inventory, work-in-process inventory, finished-goods inventory, total inventory,
Chapter 15 • Preparing the Financial Plan 301
unusual major expenses like the cost of participating in a trade show, should be
footnoted separately and explained.
It is not uncommon for a new business to not show a profit in the first year
and it really is a function of the type of business and the cost of start-up. In
particular, high technology and manufacturing start-ups are capital intensive
and generally take longer to realize a profit than service businesses. In the
hypothetical example of NEW VENTURE INC., (see Figure 15.2) the company
ended the year with a net profit before taxes of $15,250 on which it must pay
taxes. For purposes of illustration, a 40 percent tax rate was used to include
federal and state income taxes.
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By doing this analysis you learned that the business will probably not
generate a positive cash flow from sales until the 12th month, so, at a minimum,
there is a need to raise sufficient capital to not only cover the start-up costs but
the first 12 months of operation as well. Once the start-up capital is obtained, a
new cash flow statement can be generated to reflect the effect of the infusion of
Chapter 15 • Preparing the Financial Plan 307
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308 Part 5 • The Financial Plan
Pessimistic Optimistic
$(300,000) $ 50,000
-(153,000) -(153,000)
$(147,000) $ 203,000
In this example, the most optimistic case produces a positive cash flow of
$50,000, which means that $203,000 less capital would be needed to fund the
'Stancill, J.M. (1991). “How Much Money Does Your New Venture Need?” In Sahlman, WA. &r Stevenson,
H.H. (1992).The Entrepreneurial Venture. Boston: Harvard Business School Publications.
Chapter 15 • Preparing the Financial Plan 309
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310 Part 5 • The Financial Plan
Forecasting Assets
The first section of the balance sheet is the assets, everything of value the busi¬
ness owns. Assets are valued in terms of actual cost for the item. Current assets
are those consumed in the operation of the business during the year, while
fixed assets are tangible assets used over the long term. Accounts receivable
must be forecasted based on the seasonality experienced by the business. If the
business experiences no pronounced seasonality, you may be able to assume a
Chapter 15 • Preparing the Financial Plan 311
certain percentage of sales that will not be paid in cash each month based on
industry averages or an accounts receivable turnover rate. Once the business is
established, however, it develops its own pattern of receivables and a more
accurate turnover rate can be calculated. To account for the fact that some
accounts receivable will not be collected, some entrepreneurs choose to
subtract from receivables an allowance for bad debt, a small percentage (two to
five percent) based on typical bad debt figures for the industry. Again, your
business will develop its own unique pattern over time and it will be easier to
predict more accurately what the bad debt rate will be. See Figure 15.6 for an
example of an end of first year pro forma balance sheet.
Long-term Liabilities
Notes payable 0
Total Long-Term Liabilities $ 0
Owners’ Equity
G. Brown, capital $137,500
P. Smith, capital 137,500
Retained Earnings 10.210
Total Owner’s Equity $285,210
Liabilities
Liabilities are everything the business owes to its creditors. Those that are due
within one period are called current liabilities. New ventures generally have to
pay for materials and inventory with cash until they have established a line of
credit with suppliers, so you need to show a separate schedule that depicts
when you expect to begin to use credit. Indicate only the total of materials and
inventory for the year on the balance sheet, however. If the business paid cash
for the entire year, which is not uncommon for a start-up, there will be no
accounts payable. The current portion of long-term debt is that portion owed in
the coming year.
Break-Even Analysis
The break-even analysis is a useful tool the entrepreneur can use to calculate
when the business will make a profit in terms of either units sold or total sales
dollars. In order for a business to break even and begin to make a profit, it must
be able to generate a volume of sales that will cover both fixed and variable
costs of running the business.
Figure 15.7: Pro Forma Sources and Applications of Funds: End of First Year
Applications of Funds
Purchase of equipment/furnishings $ 75,000
Inventory 23.000
Total Funds Applied 98,000
Net Increase in Working Capital 202,850
$300,850
314 Part 5 • The Financial Plan
TR = TC SP(Q) = FC + VC(Q)
Selling price = $ 50/unit Variable Cost = $30/unit
Fixed Costs = $278,740
$278,740
BE (Q) =-—- 13,937 units
SP/unit—VC/unit (marginal contribution) $50-$30
Whenever the unit selling price exceeds the unit variable cost, there will be
some contribution to cover fixed costs. When the excess is enough to cover all
fixed costs, break-even has been achieved. Using the continuing example of
New Venture Inc., it can be seen that the business has fixed costs of $278,740,
variable costs per unit of $30, and a selling price of $50 per unit. Therefore, the
break-even quantity is 13,937 units. This means that before New Venture can
begin to make a profit, it must sell 13,937 units.
□ Collected all the operating cost data needed to construct the financial state¬
ments?
□ Calculated the amount of start-up capital required to start and operate the
business until a positive cash flow is achieved?
□ Forecasted best and worst case scenarios for the pro forma financial statements,
as well as the most likely case scenario?
Financial record keeping for small stores, SBA Small Business Management
Series, Stock No. 045-000-00142-3.
Andrews, E.L. (January 1986). “Running Out of Money.” Venture, pp. 32-25.
Frankston, F.M. (January 1981). “A Simplified Approach to Financial
Planning.” Journal of Small Business Management, pp. 7-15.
Stickney, C.P. (1990). Financial Statement Analysis: Theory. A Strategic
Perspective. New York: Harcourt Brace Jovanovich, pp. 275-90.
1. Why is the cash flow statement the most important statement for the entre¬
Issues to
preneur?
Consider
2. What kinds of information must be collected to complete the financial state¬
ments?
3. How is forecasting sales for consumer products different from forecasting
sales for industrial products?
4. What three factors affect the percentage increase in sales over a three-to-five
year period?
5. What are the distinct purposes of the income statement, the sources and
applications of funds statement, and the balance sheet?
Chapter 15 • Preparing the Financial Plan 317
“Unfortunately, our request for the $300,000 loan has been rejected,” stated
Patricia Zinkowski to her two partners, Dara Zapata and Jane McBride, co¬
founders of Flight Time Corporation, a six-month-old air charter broker
company based in Chestnut Hill, Massachusetts. It was June 1985 and the three
partners were seated in the restaurant of the Suffolk Downs race track in East
Boston to discuss Flight Times first period of operations and future financial
needs. The business had not taken off the way they expected. Clients, and
consequently cash inflows, had not been enough to support the company
beyond six months and the relevant net loss had eroded the initial investment
of the three entrepreneurs. They had estimated that $300,000 was needed to
continue Flight Time’s operations, but their request for these funds to Shawmut
Bank had been turned down and their personal finances were not sufficient to
keep the company in business.
They all agreed their new company had potential and the possibility of
dissolving the corporation was not even considered. However, as Patti
observed, what had started as a desire for independence and challenge, “was
now becoming a much more serious game.”
Founder's Background
Jane F. McBride
Jane McBride, Dara’s cousin, was 25 years old at the time of Flight Time’s incor¬
poration. Jane graduated from Wesleyan University in 1981 with a degree in
Cultural Anthropology and her first job was teaching English at A.H. Zapata,
Chapter 15 • Preparing the Financial Plan 319
Inc., Dara’s enterprise. Jane also had a passion for aviation and had obtained her
license as a private pilot, flying more than 200 hours on a Piper Dakota, her
fathers private plane.
The summer of 1982 she left Zapata, Inc. and went to work for International
Weekends, an American tour wholesaler operator which at the time moved the
largest number of passengers per year.1 Jane was a tour escort guiding tourists
to London, Amsterdam and Paris. Because her job at International Weekends
was seasonal, in 1983 she joined American Adventures, a U.S.-based travel
operator, as a tour leader. In this job, Jane led ten tours of foreign tourists
throughout the States, doing everything from driving the 20-seat van to coordi¬
nating the trip, arranging sightseeing and planning overnight accommodations.
A year later, Jane left American Adventures and went to work for Trans National
Travel (TNT), the travel-related wholesaler division of Trans National, a finan¬
cial services company based in Boston. As a tour director, her responsibilities
involved organizing trips and traveling to Asia, Europe, and the Caribbean.
Jane found her job “challenging and satisfying” and stayed with TNT until
the end of 1984. It was then that she had a conversation over dinner at Jane’s
sister’s wedding with her cousin Dara, who convinced her that joining their
business knowledge and skills to start a new company was a good idea.
Patricia A. Zinkowski
Patti Zinkowski, 27 years old, grew up in the Boston area and went to
University of Massachusetts at Amherst, planning to become a veterinarian.
Before graduation Patti switched her major to the Physics/Astronomy
Department and was especially interested in climatology and aviation weather.
However, due to the small number of climatology and meteorology courses,
she graduated with a degree in Physics and, according to her, “with no inten¬
tion of using it.”
After graduation in January 1980, she went to Europe backpacking with a
friend. She spent time in Switzerland, skiing and working as a ski instructor at
summer camps for kids. In November 1980, the head of a Philadelphia-based
company that sent American tourists overseas offered her a temporary six-
month position as tour guide at a hotel in Switzerland. “I had a lot of fun orga¬
nizing the stay of our clients and socializing with them. I had the best time,
made a few bucks and decided that I liked to travel.” After this assignment, she
came back to Boston for a visit, but ended up being hired in January 1982 by
the same company Jane was working for, International Weekends, at their U.K.
accounting office. Patti was appointed Accounts Supervisor and sent to
320 Part 5 • The Financial Plan
London, where she oversaw the bookkeeping activities of related tour agencies.
It was here she met Jane in 1982, who was working for International Weekends
as a tour escort.
In 1983, Patti left International Weekends to join Trans National Travel
(TNT), where she worked as Director of European Accounting, managing all
the financial aspects of tour operations in Switzerland, Italy, and Germany. In
the autumn of 1984, after discussing with Jane the possibility of starting their
own company, Patti decided to leave TNT in December of that year.
The Idea
The idea for Flight Time was conceived by Dara during her consulting experi¬
ence, which involved the short-term leasing of aircraft for new airlines. The
leasing agreements typically required that the lessee guarantee a certain
number of flight hours2 to the owner of the airplane. Dara found that the more
flight hours the operator guaranteed, the more favorable the lease rate. As a
consultant, she tried to increase the number of guaranteed hours by making
some phone calls to tour operators whom she felt might need aircraft space for
tour groups. One of these contacts was a tour operator whose 80 clients had
been stranded in San Juan because of a last-minute flight cancellation.
Scheduled flights were fully booked and the tour operator had no ideas for
providing alternative air travel, so the angry tour group was unable to leave the
island. After a few more phone calls, Dara “discovered that there was quite a
demand for some type of a central clearinghouse, serving airlines operators,
who could let us know about aircraft availability, and the customer, who
needed airplanes.”
In September 1984, Dara, who desired to be “independent and to do things
in the [air travel] industry better than they were done”, approached her cousin
Jane at a wedding and over a glass of wine at the dinner party told her about
the business idea, already having selected the company’s name: “Flight Time.”
Dara wanted Jane to be involved because she “knew her cousin had the neces¬
sary background for the tour operator component needed by the envisioned
enterprise.” Dara believed Janes experience was a necessary complement to her
own expertise in aircraft operations and flight contract agreements. Jane was
extremely interested in the opportunity because of its “excitement, sense of
adventure. I [also] could not imagine working for anybody else.”
Chapter 15 • Preparing the Financial Plan 321
Dara was aware that “the third piece needed would have to be someone with
a solid background in computers, accounting and finance.” Jane remembered
Patti, who was now head of European accounting for TNT, and called her about
the Flight Time idea. Patti, who in her experiences had seen travel groups
getting stranded at various airports around the world, thought that the possi¬
bility of offering air charters to travel groups was very feasible and decided to
join Dara and Jane in the new venture.
Getting Started
The initial business concept was to operate in the air charter industry as a pure
charter broker.3 As Dara explained: “We thought of setting up an intermediary
company that would help aircraft owners to increase their utilization and assist
tour operators in finding an aircraft, whatever their needs might be.” From
September to November of 1984, Dara and Jane met several times to explore
the feasibility of the potential start-up company. Patti, who was abroad at the
time, joined them in December when she returned to Boston. During that
period, they called contacts in the travel business they had made over the years,
to see “if the idea was really off the wall or not.” Patti recalled the outcome of
those phone calls and meetings:
We asked them if we opened a business like this, ‘Would you use our
service?’ And it was an overwhelming response: ‘Are you in business now?
Do you know of any place [that provides this type of service]?’
We just couldn’t see that anything was so wrong with the idea. We just
thought it was a great idea since we also had personal experiences with
people needing planes.
In addition to talking to potential clients, they met with advisors from the
Service Corps of Retired Executives (SCORE)4, experienced in providing free
business and technical consulting to businesses and corporate start-ups. Even
though these counselors did not know very much about the industry or specific
business, they concluded if Dara, Jane, and Patti wanted to start this business, it
was feasible. The three entrepreneurs felt quite reassured with this advice. Jane
recollected later that excitement was growing because “at the time we did not
think there was any other company doing this.”
Enthusiastically they discussed the business idea with their families, but all
their parents expressed reservations and thought it was risky to start a new
company considering the young age of the three partners: “Why don’t you get a
322 Part 5 • The Financial Plan
real job?” was a recurrent suggestion. On the contrary, Jane felt “we did not
have anything to lose [because] we were between seasons with our tours” and
Patti thought that “if it was not going [to work], we could have gone back to
what we were doing before.”
In December, Dara, Jane, and Patti met several more times and decided their
bread and butter would be Part 1355 aircraft. Larger aircraft also were consid¬
ered but they decided to concentrate on the smaller aircraft first. They agreed to
target customers who traveled where scheduled service was
lacking or when times weren’t convenient. The following
description characterizes Flight Times target customer:
“If you went Boston to Atlanta no problem: you got eight
flights a day. But if you had to go from Biloxi, Mississippi, to
Daphne, Alabama, there was not good service. You had to go
back to Atlanta, change planes, go to Daphne, go back to
Atlanta, change planes, go back to Biloxi. It was this hub-and-
spoke. You just couldn’t get around the wheel. You always had to come to the
center where the airlines were.”
Tour operators’ small track programs, which involved prearranged periodical
flights to and from the same destination, were also targeted as a major source of
revenues. Other segments the three principals identified, in no specific order,
were the leisure market (defined as “vacationers”), corporate business travel, and
sports team travel. Dara stated their “target was to have a wider client base. If one
end did not pan out, the other part of the client base could pick up the slack.”
In the beginning, their main objective was to get the word out, to let people
know about the new service their business would provide. Jane and Dara
would concentrate on contacting potential clients and operators to find out
what type of aircraft they were operating and what type of utilization they
would have liked to have.
By chance, Dara met an administrator of the U.S. Military Travel
Management Command (MTMC), a federal military representation division.
This official explained to her how the Military Command arranged air charter
flights for its troops, how the contracts were filled out, and what kind of infor¬
mation was needed when dealing with air carriers. After this conversation, Dara
decided to adopt this framework for Flight Time’s operations.
A hired designer created a windrose high-tech logo, that represented the
three founders and an aircraft style design (see p. 317). Even though a formal
business plan had not been written, time had come to meet with the lawyer for
the official incorporation of the company.
Chapter 15 • Preparing the Financial Plan 323
Business Environment
Between 1976 and 1982, the commercial airline industry was characterized
worldwide by high fragmentation and intense competition. The top 15 airlines
flying between the United States and Europe, the most traveled international
route, had an overall passenger market share on that route of less than 70
percent in 1984. Pan Am,'TWA, and British Airways, the top three international
carriers, were separated only by one percentage point.6 U.S. carriers had the
largest share of world traffic in 1984 with 40 percent of the total Revenue
Passenger Miles (RPMs)7 flown, only a three percent increase from 1976.8
Commercial air carriers provide regularly scheduled and/or charter flights for
both passenger and cargo operations. Scheduled flights serve a specific route on
a regularly scheduled timetable (for instance, biweekly) and are sold to the
public. For charter flights, either public charters (i.e. typically a wholesale tour
operator resells the seats of the leased aircraft to the general public) or single
entities (i.e. a corporation charters a flight for its employees, without reselling
single seats), are purchasers of the services and negotiate their own routing and
timetables. A scheduled airline may provide both scheduled and charter air
service, while charter operators generally offer only the latter. Revenues from
charter flights varied greatly among single airlines, ranging from less than
$100,000 a year for the airline operating a single Part 135 aircraft, to nine-digit
figures for non-scheduled flights of major national scheduled carriers. In 1984,
scheduled air operations accounted for 89 percent of the total airline traffic
measured in Revenue Ton Miles (RTMs)9 and 90 percent of world RPMs (see
Exhibit 1). The Department of Transportation (DOT) estimated that in the
United States 5.5 million people—business travelers and vacationers—took air
charter flights in 1984.
Before the introduction of the Airline Deregulation Act (ADA) in 1978, the
competition among U.S. domestic airlines was regulated similar to public utili¬
ties by the Civil Aeronautics Boards (CAB’s) control of new entries, entries into
existing markets, routes, and pricing policies. Since 1978, when President
Jimmy Carter introduced the competitive aviation policy and the CAB was
dissolved, airlines were allowed to voluntarily modify their route networks and
marketing strategies. One of the most visible effects of the deregulation was the
accelerated growth of “hubbing.” Five years from the adoption of the ADA,
some airlines more than doubled their hub-and-spoke operations, with up to
10 percent increase of the load factor and a 15-20 percent increase of air trav¬
elers who flew a complete journey on a single airline.10 Major commercial
324 Part 5 • The Financial Plan
airlines began to cut regular services to and from locations considered not prof¬
itable enough, while small commuter, corporate jets, and charter operators
blossomed. According to the Financial Times, in the early 1980s “businessmen
are increasingly taking to the air in small, light transport aircraft either owned
by, or chartered on behalf of, their companies. This concept of ‘business avia¬
tion’-—as opposed to ‘business travel’ on scheduled airlines—has been winning
favor . . . [because of] . . . the greater convenience and time savings involved,
by comparison with the scheduled airlines, together with a significant saving in
cost.”11
In 1984 there were more than 12,000 airports in the U.S. but only 400 were
serviced by scheduled flights.12 Worldwide, there were 300 scheduled airlines,
of which fewer than 30 were the U.S. scheduled carriers,
accounting for more than $100 billion in revenues.13
Approximately 4,000 carriers operated air charter flights in the
U.S. accounting for $2.4 billion in sales, flying more than
14,000 aircraft. Revenues from vacationers (the so-called
“leisure travel”) comprised more than 60 percent of the $2.4
billion dollar sales, while 20 percent of the revenues came
from incentive houses14 and corporations. The remainder was
split among the U.S. government (i.e. troops movements), sports teams, and
entertainment.
The largest share of the air charter market was represented by public charter
flights, sold directly to the public or, more often, to tour operators. Most sched¬
uled and non-scheduled airlines marketed their charter flights through in-
house brokerage operations or through their own sales people. The rest was
managed by wholesale and retail tour operators and by a handful of regionally
dispersed and privately held independent brokers, whose revenues rarely
surpassed the one million dollars. Tour operators, corporate incentive planners,
government departments (such as the Defense Department), and sports teams
were, in order, the four main purchasers of the these brokerage services.
Few charter airplanes were large jet aircraft (such as DC-9, B737 and B757)
produced by major aircraft manufacturers, like Boeing and McDonnel-
Douglas.15 Instead, single-engine and two-engine piston planes, produced by
specialized smaller manufacturers, such as Fokker, and having fewer than 20
seats were most frequently chartered. The Part 135 aircraft made up 60 percent
of the 80 seats or less segment.16 Total shipments of general aviation aircraft to
scheduled and charter carriers were declining since 1979 (see Exhibit 2 on
p. 332) and in 1984 experts were forecasting a steady negative trend.
Chapter 15 • Preparing the Financial Plan 325
This downturn in the shipment of aircraft was mainly the result of the
airlines’ attempt to contain fixed costs and to strive for better use of the avail¬
able equipment, to be obtained partially by increasing the number of flight
hours. For airline operators, the average utilization of large equipment was 6 to
7 flight hours a day including scheduled flights, while for smaller airplanes
utilization barely reached.2 flight hours a day. Even though fixed costs such as
aircraft, maintenance, and personnel were steadily increasing, other variable
costs, such as jet fuel and oil prices, after a steady increase and a sharp rise in
1979, were declining beginning in 1981 (see Exhibit 2.)
The Start-Up
On January 2, 1985, Patti, Jane, and Dara went downtown to meet with their
lawyer for the first step of the legal incorporation of the business.
Initial Resources
Each of the three partners was able to withdraw ten thousand dollars from their
personal savings without involving family funds. Flight Time, Inc. was orga¬
nized so that the Dara, Patti and Jane had equal partnership in the business,
each owning one third of the three hundred shares issued at no par value. Dara
described the initial financing: “We figured that $30,000 would let us go on
forever. We would have enough income from our business to perpetuate the
business.” Then, they gave each other titles, a legal condition when an incorpo¬
ration occurred. Dara was named President because she had the original idea,
Patti was appointed Treasurer because she was doing the bookkeeping, and,
considering that the State of Massachusetts required someone to be clerk, Jane
was made Secretary by default.
They leased a one room office with no windows at a travel agency in
Chestnut Hill. To provide the new location with the necessary office supplies,
they went to friends’ basements and dug out old file cabinets, then to yard sales,
other companies, and offices to obtain second hand desks and appliances. On
the first day of business, their office furnishings consisted of a few telephones, a
couple of typewriters, an answering machine, a photocopier, a $4,700 Hewlett
Packard computer with dot matrix printer, and a coffee machine. They distrib¬
uted various Rolodex cards with the names and the addresses of all the contacts
that Dara, Jane, and Patti had made in the airline industry and the tour operator
business. Besides these contacts, they subscribed to Aviation Daily, Travel Weekly,
and other periodicals and newspapers, useful to keep updated aviation-related
326 Part 5 • The Financial Plan
news and to be used as possible sources for their first clients. Flight Time did
not have a firm commitment from anyone who prior to start-up had demon¬
strated interest in using the services of an air charter broker.
At Work
The first day of Flight Time’s operations, Jane, Dara and Patti went to work in
business attire promptly at 8:30. According to their new business cards, Jane
was Director of Operations, Dara was President and Director of Sales and
Marketing, and Patti was Director of Finance. After a few weeks at the office,
however, while it was clear that finance and accounting were Pattis main
responsibilities, most of the other functions were managed together. Decisions
other than those involving ordinary operations, had to be made unanimously.
Most of their time was spent jointly, searching for clients and
ivailable airplanes. Jane recalled that “how to get the word out
was our marketing plan.” Sitting in the same room facing each
other, they looked in the Boston Globe for companies that were
growing and called people they knew, from professional
contacts they had in the tour operator business, to friends
] and family, as well as friends of friends and referrals.
Through letters and follow-up calls, their efforts in convincing
potential Part 135 clients to consider chartering a small aircraft were based on
comparing charter planes to scheduled carriers: “Why change planes and why
stay overnight in a hotel, when you can fly with your own plane?”
With the goal of getting the word out and reaching potential clients, Flight
Time joined the National Business Aircraft Association (NBAA). Patti was able
to generate few descriptive articles about the company for the trade magazines
and local newspapers. Looking for new ideas, Patti went to a Public Relations
seminar, where she conceived the first press release of Flight Time. As she
mentioned, “it was necessary to have a lot of common sense. We did not have
a lot of money to spend in advertising, but we needed to get our name out
there.” Thus, the initial press coverage resulted in many phone inquiries that
were used to build up a list of possible clients. To expand this press coverage,
in April Flight Time also started a two-page newsletter that was sent to
prospective customers and air charter operators (see Exhibit 3 on p. 333).
Travel people began to identify them as “The Three Women in Boston.” In an
attempt to enhance Flight Times image and business network, Patti joined the
New England Women Business Owners (NEWBO) and Jane the National
Association of Female Executives (NAFE.) They were sure that being three
Chapter 15 • Preparing the Financial Plan 327
First Clients
Dara recalled how many of Flight Times early contacts originated from the
consulting service she used to provide. “They were not a lot of contacts, but
certainly enough to get going. I knew the business well enough so that I could
call any airline, introduce ourselves and explain about our company.” In
February, the American Soy Bean Association travel planner called Flight Time
because some of the members had to inspect properties located in
Massachusetts and needed a Part 135 airplane for the tour. This was the first
deal for the newly born clearinghouse.
328 Part 5 • The Financial Plan
The second month of operation the phone rang again. A casino operator
wanted to fly 15-20 people daily from Boston and from Providence, Rhode
Island, to the casinos of Atlantic City, New Jersey.17 The three businesswomen
were speechless: it was a $1,000,000 yearly contract, one hundred thousand
dollars in brokerage fees. They located a start-up airline in New Hampshire
operating just the right size plane, a Dornier 228-201. The casino operator
signed the original contract. Because this track program was a long-term
commitment, he asked for a credit extension. As per Flight Times policy he
would pay for the first flight before the departure and then settle the other trips
a few days later. The plane flew smoothly for two weeks, then suddenly the
aircraft was not being filled, the casino operator stopped paying and the
contract failed. “But it was an eye-opener,” Patti recollected later, “we had this
one contract, but it got screwed up so fast. If there was one of these trips there
were more of these trips.”
A few weeks later, a former client of Dara, a hardware distributor from
Southeastern Massachusetts, was contacted by Flight Time. The owner of the
company was a pilot himself who easily understood the air,charter concept. He
decided that instead of picking up his clients at Boston’s Logan Airport, it
would be better to fly them directly to his factory. This $700 deal, paid a few
days prior to departure, generated a profit of $70 to Flight Time.
By June 1985, the five month old clearinghouse had generated $150,000 in
revenues, primarily from trips arranged at least 3-4 weeks in advance although
some flights were arranged on one-day notice. For every 10-12 price quote
requests, Flight Time was able close one deal, usually settled before the depar¬
ture and subject to a cancellation policy of 2 to 3 weeks in advance. Most of the
booked planes could carry between 10 and 50 passengers, with the 8 seater
Learjet being the most chartered aircraft. However, the time spent to shape a
deal on a Learjet with 8 people was the same as for a Boeing 727, a 100 seat jet.
At the end of the fifth month the names of several potential clients had been
entered into the database and it was clear to Jane that “the only limitation to
our success was creating awareness of our services.”
Second Financing?
During the first week of June, Patti inspected Flight Times financial position.
The business had less than $4,000 in cash. Most of the start-up money had
been used for office supplies, rent, utilities, promotional activities and salaries
to the principals. But Dara, Jane and Patti were not ready to give up.
Chapter 15 • Preparing the Financial Plan 329
“The track program we had set up was not going to sustain itself, which
was what the original plan was. We knew that the business we anticipated
was on the books. We were waiting for the big one to come along and get
us over, [but] the numbers decided for us that we needed a secondary
financing.”
After a quick analysis 'of the situation, they determined that $300,000 was
needed not only to keep the business running, but also to expand it. They
approached a local bank for the $300,000 loan. The bank requested that Flight
Time present a business plan and disclose relevant financial information.
Suggestions from SCORE helped them to construct the business plan (see
Exhibit 4 on p. 334) and a certified public accountant was hired to produce the
financial statements (see Exhibit 5 on p. 338). However, because of Flight
Time’s lack of track record and brief business history, the bank refused to lend
Flight Time the $300,000.
Watching the horses race, Dara, Patti, and Jane were wondering what kind of
future Flight Time could expect.
Footnotes
1 International Weekends was later bought by TWV, another U.S. wholesaler
tour operator.
2 Flight hours are measured block to block, only when the aircraft in moving.
3 An air charter broker is a fee-based business intermediary that links an airline
having aircraft space to rent, with another entity, usually a corporation or a tour
operator, needing to fly people or goods. A pure broker does not own or
personally lease aircraft, but acts only as an agent for the two parties.
4 SCORE, is an affiliate of the Small Business Administration (SBA).
5 In 1985, Part 135 referred to section of the U.S. Federal Aviation Regulation
(FAR) governing safety and operating procedures for aircraft having, among
other requirements and limitations, fewer than 20 seats and not more than a
12,500 pounds gross takeoff weight. Over these two limits, FAR Part 121 regu¬
lations applied. Aircraft operating under Part 135 and those operating under
Part 121 can be generically defined as “small airplanes” and “large airplanes"
respectively.
6 Source: International Air Transport Association (LATA), 1985.
7 Revenue Passenger Mile (RPM): As defined by the Federal Aviation
Administration (FAA,) “one revenue passenger transported one mile in revenue
330 Part 5 • The Financial Plan
EXHIBIT 1
Flight Time
DISTRIBUTION OF WORLD AIRLINE TRAFFIC IN 1985
Charter Services
Passenger-Miles Flown (billions) 30 30 28 30
Ton-Miles Performed (billions) 3.9 3.6 3.5 3.7
Available Ton-Miles (billions) 6.1 5.7 5.5 5.8
Charter Airlines
All Services
Passenger-Miles Flown (billions) 32 37 40 43
Ton-Miles Performed (billions) 4.2 4.8 5.0 5.4
Available Ton-Miles (billions) 5.7 6.6 6.6 7.0
EXHIBIT 2
Flight Time
U.S. General Aviation Aircraft Shipments
Year
EXHIBIT 3
Flight Time
Flight Time’s Newsletter
April/May 1985 Issue
FLIGHT TIME: 1. HELPS you decide if private charters are your best alternative in air travel.
2. LOCATES certified aircraft which best suit your needs.
3. PROVIDES quotes and options which include aircraft descriptions, per
hour costs, and technical data.
4. CONFIRMS and coordinates charter arrangements and itineraries.
OPPORTUNITY No. 3
According to the National Business Aircraft Association, the average business trip involves 4.1
people traveling 338 miles with a four-hour turnaround.
Suppose you and your team of key salesmen want to blitz a customer in Syracuse. Instead
of dealing with complex schedules, two-hour layovers, and missed connections, you jump into
your private plane, make a three-hour presentation and fly back again. You get the job done
fast. Your plane waits for you rather than you waiting for the plane.
Many businesses do not even consider the possibility of chartering aircraft for their business
travel due to the myth that the cost is prohibitive. (Not all itineraries merit a chartered airplane.)
You could be pleasantly surprised to find that on many occasions a business trip would be
more cost-efficient if key employees traveled by private charter rather than scheduled carrier.
For more information call FLIGHT TIME at (617) 965-7060.
EXHIBIT 4
Flight Time
FLIGHT TIME’S BUSINESS PLAN
As Provided by Flight Time to Shawmut, for the Loan Request Application
STATEMENT OF PURPOSE
FLIGHT TIME is a service business dedicated solely to security charter air transportation for
individuals, groups, associations, and corporations. FLIGHT TIME specializes in screening and
locating Part 135 and Part 121 aircraft for this client base. FLIGHT TIME neither owns nor
operates any aircraft.
FLIGHT TIME acts as a charter clearinghouse. The company is in the business of distrib¬
uting information on aircraft prices and availability, negotiating terms of charter contracts and
coordinating details of charter flight operations. Upon authority by client, FLIGHT TIME acts as
agent for the client in security aircraft and arranging charter flight.
FLIGHT TIME charters aircraft (on behalf of clients) from carriers certified for charter. This
means that both commercially scheduled airliners and nonscheduled airliners may be used in
the selection process.
Chapter 15 • Preparing the Financial Plan 335
Note: FLIGHT TIME does not engage in activities such as the following, which are tradition¬
ally associated with retail travel agencies, i.e.:
CORPORATE
According to Travel Weekly, a trade journal, over 500 million business trips of one night or
more are made each year. The report concludes that because few corporation have any orga¬
nized business travel policy, millions of dollars are wasted annually.
FLIGHT TIME works, with corporations of all sizes, many of which are listed in the Fortune
1000. We recommend the following checklist to our clients as a yardstick to determine air
charter feasibility:
• When 3 or more people are charter feasibility • When the destination or point of origin is
• When key personnel travel business more than 45 minutes from a major airport.
or first class. • When a destination does not have
• When the limitations of scheduled airline non-stop or direct air service.
service mean unnecessary hotel
overnights with other added expenses.
Responses to FLIGHT TIME’S service have been extremely positive. Due to the wide array
of available aircraft, FLIGHT TIME has been able to accommodate requests for 15 passenger
turboprops, 5 passenger jets, and 80 passenger jets, just to name a few.
TOUR OPERATORS
There is a very high concentration of tour operators and wholesalers in the Northeast and for
many, the key to the success of a track program is contingent upon reliable and economical
chartered air space. In an industry where last minute changes and failed contracts are
commonplace, FLIGHT TIME assists tour operators in negotiating contracts with FAA certified
air carriers.
FLIGHT TIME recently negotiated a contract between a Boston based tour wholesaler and
regional air carrier for daily flights from Boston and Providence to Atlantic City.
TRAVEL AGENTS
Travel agents are prime targets for FLIGHT TIME'S services with their corporate, leisure, and
affinity markets already established. Since most travel agents, as well as the traveling public,
are unfamiliar with general aviation, FLIGHT TIME'S services complement those of retail and
corporate agents.
336 Part 5 • The Financial Plan
FLIGHT TIME has targeted reputable agents with upscale clientele who have expressed an
interest in private charter. Agents receive a percentage of FLIGHT TIME’S commission.
In addition to F.l.T.s, many agencies organize their own group tour programs and frequently
need larger aircraft. FLIGHT TIME has received requests from agents for groups of 15-100
passengers.
CASINOS
FLIGHT TIME, sponsored by Claridge’s Casino of Atlantic City, is awaiting confirmation of its
vendor registration number, a license to contract directly with New Jersey casinos. FLIGHT
TIME applied for the license in response to several queries from casino operators looking for
charter aircraft to transport VIP clients in from the greater Northeast region.
Casinos are constantly seeking ways in which to entice “high rollers” to their establishments:
flying them directly into Bader Field, located in downtown Atlantic City, is one such way. Bader
Field, however, has a very short runway—only 2950 feet, and few aircraft can land there.
FLIGHT TIME has located a number of high performance STOL aircraft capable of flying
directly into Bader, and is actively marketing these aircraft. Several casinos have expressed
interest in working with FLIGHT TIME once the vendor registration number has been assigned.
REFERRALS
Referrals from airlines constitute a major market segment, and these clients are usually already
qualified buyers. To date, we have received referrals for trips to Cincinnati, Minneapolis,
Bowling Green, Cleveland, and Atlanta.
Personal contacts and referrals have also generated considerable business.
HOTELS
Deluxe hotels are constantly seeking extra amenities to offer their clients. FLIGHT TIME has
contacted general managers of upscale hotels in MA to introduce our services. Executive
charter, like limousine service, is considered by many as a necessity rather than a luxury. Over¬
sized folded business cards, which include a brief description of FLIGHT TIME’S services and
are displayed in selected areas of a hotel, are an inexpensive yet effective way to reach the
discerning business or leisure traveler.
Travel and Meeting Planners, as well as Incentive Houses, are also good sources of poten¬
tial business.
COMPETITION ANALYSIS
As of this writing, there exists no other company operating exactly like FLIGHT TIME. The
existing competition consists of:
A. Direct Airway - New Jersey - Primary focus is corporations utilizing fleet based in Teterboro, NJ.
Chapter 15 • Preparing the Financial Plan 337
PRICING PHILOSOPHY
The difference between FLIGHT TIME and its competition lies in our pricing philosophy.
FLIGHT TIME strives to offer its services free of charge to its clients. Because of the soft
general aviation market, aircraft owners and operators are extremely eager to maximize aircraft
utilization, and pay a sales commission to FLIGHT TIME. FLIGHT TIME receives a commission
based on the overall contract value:
Unlike the competition, which levies 5-10% commission on both the operator and the client,
FLIGHT TIME’S prices are among the lowest in the industry. We believe that by keeping prices
low, we will be able to better demonstrate to our clients that private air charter can be cost-
effective and competitively priced.
CREDIT POLICY
FLIGHT TIME operates on a cash or credit card basis with the majority of sales prepaid. A 3%
bank charge will be assessed on credit card sales. (Once a client has established a favorable
credit history, FLIGHT TIME will extend credit on a net-10 basis, but only in situations where
FLIGHT TIME has at least the same terms with the carrier.)
338 Part 5 • The Financial Plan
EXHIBIT 5
Flight Time
BALANCE SHEET
as of May 31, 1985
(Note A)
ASSETS
Current assets
Cash $3,797
Supplies 866
Prepaid Expenses 229
Deferred Expenses - Note B_5,779
Total Current Assets 10,671
Property and Equipment
Computer 4,700
Equipment_1,853
Total Property and Equipment 6,553
Accumulated Depreciation - Note C_(175)
Total Net Property and Equipment 6,378
Other Assets
Deposits 575
Organization Expenses, Net of Amortization_596
Total Other Assets 1,171
Total Assets $18,220
Note A: Balance Sheet as Prepared by Robert M. Hurst & Company, Certified Public Accountants.
Note B: This Amount Represent Expenses Incurred Prior to the Date Operations Commenced and,
Accordingly, Are Being Amortized Over the First Twelve Years.
Note C: Property and Equipment Are Being Depreciated Using the Straight-Line Method of Depreciation
Over Their Estimated Useful Lives of the Assets for Book Purposes and the Accelerated Cost
Recovery System for Tax Purposes.
Note D: As of May 31, 1985, the Company Was Obligated Under a One-Year Lease Agreement Expires
December 31, 1985 Covering the Premises in Chestnut Hill, Massachusetts. The Terms of the
Lease Stipulate a Monthly Rental Payment of $300.
Note E: No Par Value; 15,000 Shares Authorized; 300 Shares Issued and Outstanding.
Chapter 15 • Preparing the Financial Plan 339
Note A: Income Statement as Prepared by Robert M. Hurst & Company, Certified Public Accountants.
Note B: Dollar Amount as from Billing to Customers.
Note C: Dollar Amount as from Billing from Aircraft Carriers.
Note D: See SCHEDULE OF SELLING, GENERAL AND ADMINISTRATIVE EXPENSES.
% to Sales
Office Supplies and Expenses $4,011 3.2 %
Promotion and Entertainment 3,801 3.1
Auto and Travel 3,405 2.7
Rent 1,567 1.3
Dues and Subscriptions 839 0.7
Equipment Rental 833 0.7
Telephone 715 0.6
Training 698 0.6
Postage 423 0.3
Maintenance and Repairs 418 0.3
Professional Fees 410 0.3
Insurance 383 0.3
Taxes, Other 228 0.2
Advertising 187 0.2
Organization Expense 131 0.1
Miscellaneous 815 0.7
$18,864 15.2
Note A: Schedule of Expenses as Prepared by Robert M. Hurst & Company, Certified Public Accountants.
340 Part 5 • The Financial Plan
SOURCE OF FUNDS
To Operations
Net Income (Loss) ($11,758)
Add Back Non-Cash Expenses:
Depreciation and Amortization 229
Net to Operations (11,529)
APPLICATIONS OF FUNDS
Note A: Cash Flow Statement as Prepared by Robert M. Hurst & Company, Certified Public Accountants.
Chapter 15 • Preparing the Financial Plan 341
1. What was the window .of opportunity, and what allowed these three entre¬
preneurs to take advantage of it?
2. How much did the three really know about the market and the economic
feasibility before start-up?
3. Was there any advantage (or disadvantage) to the three entrepreneurs being
female?
4. Should they continue operations?
A Plan for Growth
Overview
• Positioning the new venture for growth
• Growth strategies within and outside the industry
• Preparing for globalization
• Issues to consider when exporting
Beyond Start-Up
Although some entrepreneurs, for a variety of personal reasons, may ultimately
choose not to grow their businesses, most founders of entrepreneurial ventures
are growth-oriented. Expansion is a natural by-product of a successful start-up.
It helps a new business secure or maintain its competitive advantage and estab¬
lish a firm foothold in the market. Contrary to popular opinion, the fastest
growing small companies come from a variety of industries; albeit, the ubiqui¬
tous computer software industry does dominate the high-growth companies.
When Business Week (May 23, 1994) listed the hottest growth companies in
America, included among the top 20 were:
345
346 Part 6 • A Plan for Growth
What made these companies high-growth companies and set them apart
from others was that they displayed several of the following characteristics.
They were:
Being first in the market with a new product or service is one of the strongest
competitive advantages there is, as it presents the opportunity to establish
brand recognition so that customers immediately think of your company when
they think about a particular product or service. This was certainly the strategy
of Xerox in the copier industry and Microsoft in the operations and applications
software industry.
Many high-growth businesses have developed innovative processes that allow
them to do what they do better and to run leaner operations. For example, Papa
Johns Pizza, which topped the Business Week list, restricted its menu to pizza,
breadsticks, cheesesticks, and soft drinks, while offering a small tub of garlic
butter and two hot peppers with each pizza as a value-added item. They also
have three centralized commissaries that make all the sauce and dough for their
485 stores, which brings costs down substantially while also producing revenue.
A fourth way these companies have achieved high growth is by offering a
unique, innovative product or service. This is the strategy of Davidson &
Associates, the highly successful educational and entertainment software
company that has looked at software development from a child’s point of view
and has succeeded in bringing technology to education.
The size, characteristics, and buying power of the target market. If the niche
market into which the company is entering is by nature small and relatively
stable as to growth, it will be more difficult to achieve the spectacular growth
and size of the fastest growing companies. On the other hand, if the product or
service can expand to a global market, growth and size are more likely to be
attained.
The nature of the competition. Entering a market dominated by large compa¬
nies is not in and of itself an automatic deterrent to growth. A small, well-orga¬
nized company is often able to produce its product or service at a very
competitive price while maintaining high quality standards because it doesn’t
have the enormous overhead and management salaries of the larger companies.
Moreover, if an industry is an old, established one, entering with an innovative
product in a niche market can produce rapid rates of growth.
The degree of product innovation in the market. In some industries like the
computer industry, innovation is a given, so merely offering an innovative
product is not in itself enough. In highly innovative industries, the key to rapid
growth is the ability to design and produce a product more quickly than
competitors. By contrast, in an industry that is stable and offers products and
services that could be considered commodities, entering with an innovative
product or process will provide a significant competitive advantage.
The status of intellectual property rights like patents, copyrights, trademarks, and
trade secrets. Intellectual property rights are also a competitive advantage to a
new venture as they permit a grace period in which to introduce the product or
service before anyone else can copy it. However, relying on proprietary rights
alone is not wise. It is important to have a comprehensive marketing plan that
allows the new business to secure a strong foothold in the market before
someone attempts to reproduce the product and compete with it. True, you have
the right to take someone who infringes on your proprietary rights to court, but
it is a time consuming and costly process, one which the small company can ill
afford to undertake at a time when it needs all its excess capital for growth.
The volatility of the industry. Some industries are by their very nature volatile;
that is, it is difficult to predict what will happen for any length of time and with
any degree of accuracy. The computer industry in the 1980s was such an
industry; it has lately become somewhat more predictable as the leading players
in the industry have emerged. The young and dynamic telecommunications
industry, however, is very volatile at this time. Consequently there are opportu¬
nities for extraordinary growth in new ventures and, at the same time, a higher
risk of failure. A new entry into such an industry needs to maintain a constant
348 Part 6 • A Plan for Growth
Phases of Growth
Start-Up Success. At the first level, the main concerns for the entrepreneur are
to ensure sufficient start-up capital, seek customers, and design a way to deliver
the product or service. At this point, the entrepreneur is a jack of all trades,
doing everything that needs to be done to get the business up and running.
This includes securing suppliers, distributors, facilities, equipment, and labor.
Initial Growth. If the new venture makes it through the first and most difficult
phase, it enters the second level of activity with a viable business that has
enough customers to keep it running. Now the concerns become more focused
on the issue of cash flow. Can the business generate sufficient cash flow to pay
all the expenses and support the growth of the company? At this point, the
business is usually relatively small with few employees and the entrepreneur
350 Part 6 • A Plan for Growth
still playing an integral role. This is a crucial stage for the business, for it is here
that the business will either remain small or move to the next level, high
growth, which entails some significant changes in the organization and strategy
of the business. The owners need to decide if they are going to grow the busi¬
ness to a much larger revenue level or remain stable yet profitable.
High Growth. If the decision is to grow, all the resources of the business have
to be gathered together to finance the growth of the company. This is a very
risky stage as growth is expensive, and there are no guarantees the entrepreneur
will be successful at attempting to reach the next level. Planning and control
systems must be in place and professional management hired. The problems
faced in this stage center on maintaining control of rapid growth. This is
accomplished successfully by delegating control and accountability at various
levels and usually fails due to uncontrolled growth, running out of cash, and
not having the necessary management expertise to deal with the situation. If
growth is accomplished, it is in this stage that entrepreneurs often sell the
company at a substantial profit, assuming it will remain successful in its
growth. It is also at this stage that some entrepreneurs are displaced by their
boards of directors, investors, or creditors, so many entrepreneurial ventures
reach their pinnacle of growth with an entirely different management team than
the one that founded the company.
Market Penetration
With market penetration, the entrepreneur attempts to increase sales using
more effective marketing strategies within the current target market. The
classic example of this strategy is the repositioning of Arm & Flammer Baking
Soda. The manufacturer began advertising and educating its customers about
352 Part 6 • A Plan for Growth
additional uses for the product beyond cooking, such as a refrigerator deodor¬
izer, a toothpaste, and a cleaning agent. Having additional uses for the product
causes customers to buy more. Another way to employ market penetration is
to attract customers from your competitors by advertising product qualities,
service, or price that distinguishes your product from others. A third way is to
educate nonusers of product or service as to its benefits in an effort to increase
the customer base.
Market Development
Market development consists of taking the product or service to a broader
geographic area. For example, if you have been marketing on the East Coast,
you may decide to expand across the rest of the United States. One of the most
popular ways to expand a market geographically is to franchise because it is
generally less costly than setting up a national distribution system. Franchising
allows the business to grow quickly in several geographic markets at once. The
franchiser sells to the franchisee the right to do business under a particular
name; the right to a product, process, or service; training and assistance in
setting up the business as well as ongoing marketing and quality control
support once the business is established. The franchisee pays a fee and a royalty
on sales, typically three to eight percent. What the franchisee may get for the
fee, depending on the business, is:
Product Development
The third way to exploit the current market is to develop new products and
services for existing customers or offer new versions of existing products. That
is the tactic of software companies, who are constantly updating software with
new versions their customers must buy if they want to enjoy all the latest
features. Savvy businesses get their best ideas for new products from their
customers. These new ideas usually come in two forms: incremental changes in
existing products or totally new products. Incremental products often come
354 Part 6 • A Plan for Growth
Branding
The most successful entrepreneurs recognize the power of a brand name; there¬
fore, they strive to gain brand-name recognition for their products and services
as quickly as possible so they can use the recognition to create a family of
related products and services under that name. A company that is able to estab¬
lish brand recognition will find its marketing effort that much easier and its
costs reduced. A brand name that reflects quality, service, and value is an asset
that can ultimately generate huge profits for the business. One example of the
value of brand name recognition is the T-shirt industry. Companies like
Mossimo and Nike buy basic T-shirts from an apparel manufacturer and then
print their design and logo on the shirt. Customers will pay more for a T-shirt
with the Mossimo name on it than they will for the same T-shirt with an
unknown company name on it—that’s brand recognition.
To establish brand recognition:
• Know what you’re good at. In other words, list the strengths your company
and its products possess. For example, do you offer a higher quality product,
a wider range of accessories or models, or exciting new colors?
Chapter 16 • Growing the Business 355
• Educate customers about your strengths. Once you have identified your core
strengths, communicate them over and over again in all your marketing
efforts, from brochures to signs to advertising. They should literally become
a mantra for the customer. The minute customers think of your product,
they should associate it with its strengths.
• Develop a set of rules for using the brand name. If you want your brand
name to only be associated with wholesome things, you probably would not
want to advertise during a television show that contained violence, for
example. How the brand name will be used also needs to be decided.
Gentech Corporation, for instance, wanted the trade name for their product,
PowerSource, always to be associated with the company name, so in all its
advertising and promotion, the product is referred to as the Gentech
PowerSource. In this way, when additional products are developed in the
future, the common thread will be the company name, Gentech.
• Get feedback on brand-name recognition. To make sure the brand name is
achieving the recognition level you are seeking, check periodically with the
target customer.
to have a good relationship with suppliers and distributors so that as the busi¬
ness begins to grow rapidly, they are willing to ramp up to meet demand.
PROFILE 16.1
^he actual names of the parties in this case are not being used.
Chapter 16 • Growing the Business 359
• Relatively low United States interest rates have made it easier for businesses
to finance the exporting of their products.
• The North American Free Trade Agreement (NAFTA) eliminates trade
barriers among the United States, Mexico, and Canada, which makes
exporting to those countries more attractive.
• The decline of the U.S. dollar, while not good for U.S. travelers in other
countries, certainly makes U.S. goods more affordable for other countries.
• The opening up and growth of untapped markets like China and Vietnam
means more potential customers for U.S. products.
• The establishment of the first four Federal Export Assistance Centers give
businesses considering exporting a new source of help. The four centers are
located in Baltimore, Long Beach, Miami, and Chicago.
• The Uruguay Round of GATT (the General Agreement on Tariffs and Trade)
potentially will reduce or eliminate tariffs among 117 countries starting in
1995. It will also provide for improved patent and copyright protection,
which has been a problem for businesses exporting protected products to
other countries where proprietary rights may not be recognized or protected.
While you should include a global strategy in any business planning, you
will probably not be able to export until the business is somewhat established
and offering a high-quality product or service at a competitive price. Exporting
is a long-term commitment that may not pay off for some time. During that
period you may have to adapt the product or service somewhat to meet the
requirements of the importing country and develop good relationships with
agents in the country. If you are dealing in consumer products, target countries
that have disposable income and like American products. If, on the other hand,
you are dealing in basic or industrial products, look to developing countries
that need equipment and services for building infrastructures and systems. One
example is Mexico, which is taking on the enormous task of building bridges
and roads as it positions itself as a major player in the world market.
Export Financing
To make a sale in the global market, the entrepreneur must have the funds to
purchase the raw materials or inventory to fill the order. Unfortunately, many
entrepreneurs assume that if they have a large enough order, getting financing
will be no problem. Nothing could be further from the truth. Export lenders,
like traditional lending sources, want to know that the entrepreneur has a
362 Part 6 • A Plan for Growth
sound business plan and has the resources to fill the orders. Entrepreneurs
desiring to export can look for capital from several sources:
• Bank financing
• Internal cash flow from the business
• Venture capital or private investor capital
• Prepayment, down payment, or progress payments from the foreign
company making the order
Choosing an Intermediary
Before deciding on an intermediary to handle the exporting of your products:
1. Check their current listing of products to see if your company seems to fit in
with their expertise.
2. Understand with whom will you be competing; that is, does the interme¬
diary also handle your competitors?
3. Find out if the intermediary has enough representatives in the foreign
country to adequately handle the market.
4. Look at the sales volume of the intermediary. It should show a rather consis¬
tent level of growth.
5. Make sure the intermediary has sufficient warehouse space and up-to-date
communication systems.
6. Examine the marketing plan.
7. If needed, make sure the intermediary can handle servicing your product.
Once you have decided on the intermediary, draft an agreement detailing the
terms and conditions of the relationship. As it is very much like a partnership
agreement, consult an attorney specializing in overseas contracts. The most
important thing to remember about the contract is that it must be based on
performance so you do not tie yourself up for many years with someone who is
not moving enough product for you. Negotiate a one- or two-year contract with
an option to renew should performance goals be met. This will probably not
please the intermediary as most want a five- to ten-year contract. Be firm; it is
not in your best interests to do a longer contract until you know that the person
is loyal and can perform. Other issues that should be addressed in the agree¬
ment include:
• Your ability to use another distributor; in other words, negotiate for a non¬
exclusive contract so you have some flexibility and control over the situation.
364 Part 6 • A Plan for Growth
• The specific products the agent or distributor will represent. This is impor¬
tant because as your company grows, you may add or develop additional
products and not want this agent to sell those products.
• The specific geographic territories for which the agent or distributor will be
responsible.
• The specific duties and responsibilities of the agent or distributor.
• A statement of agreed-upon sales quotas.
• A statement of the jurisdiction in which any dispute would be litigated.
This will protect you from having to go to a foreign country to handle a
dispute.
Global Franchising
The first franchisors on the global scene were primarily the large food franchises
such as MacDonalds, Kentucky Fried Chicken, and Burger King. Today even
smaller franchisors are going global. Franchisors are generally welcomed by
foreign governments because they bring not only a product to the country but a
way of doing business, which provides jobs for the citizens of the country.
Those who have chosen to try their luck in developing countries or the old
Eastern Block countries have consistently found the cost of doing business there
much higher. In addition, they are likely to have to deal with unstable govern¬
ments, volatile currencies, and a general lack of understanding of competitive
market systems. Many international franchisors have discovered that having a
local partner is one of the keys to a successful global effort because it allows
them to acquire an understanding of the business and consumer culture in the
country. They also tend to look to establish master franchise agreements, which
gives the franchisee the rights to the entire country or region.
One of the challenges facing international franchisors is achieving the same
level of productivity and service they experience in the United States. In some
countries low productivity is simply a way of life, and changing old habits can
require hours of training. One source of help for potential international fran¬
chisors is the International Franchise Association (IFA) located in Washington,
DC. This organization has established a Code of Ethics and, through its
Franchisee Advisory Council, provides dispute resolution for both franchisees
and franchisors.
PROFILE 16.2
D Developed a plan for globalization of the company at some point in the future?
Chapter 16 • Growing the Business 367
Commerce Department, “Flash Facts,” a 24-hour free fax line for information
on specific international regions. Eastern Europe, 202-482-5745; Mexico,
202-482-4464; Pacific Basin, 202-482-3875; Africa, Near East, and South
Asia, 202-482-1064.
Commerce Department—District Offices. The Export Yellow Pages, includes
U.S. export companies, intermediaries, and freight forwarders.
Export-Import Bank, Washington, D.C. 202-566-4490, for a list of lenders
who handle international transactions.
Export-Import Bank’s City/State Program, 800-424-5201.
Rager, L. (June 1989). “How to Expand by Franchising.” Nation’s Business.
Roberts, M.L. & Berger, P.D. (1989). Direct Marketing Management.
Englewood Cliffs, NJ: Prentice-Hall, Inc.
Trade Information Center, 800-USA-TRADE (800-872-8723). Ask for an
industry desk officer who specializes in your industry.
U.S. Small Business Administration, Bankable Deals, a book on export
finance, 202-205-6720. Also has lists of trade events.
Wolf, J.S. (1992). Export Profits. Dover, NH: Upstart Publishing Company,
Inc.
4x 3. What questions should you ask at each level of the new venture’s growth?
4. What advantages do intensive strategies have over integrative and diversifica¬
tion strategies?
5. Why is it important to start a growth-oriented business with a plan for glob¬
alization from the beginning?
6. What are the differences among foreign agents, distributors, and export
trading companies in terms of the services they provide?
CHAPTER 17
Financing Growth
Overview
• The nature oj the venture capital industry
• How to obtain venture capital
• Using the Private Placement Memorandum to raise growth capital
• Going public
• Using strategic alliances as a growth vehicle
• Valuing the growing venture
369
370 Part 6 • A Plan for Growth
easiest time finding capital. To become one of the “best” companies requires an
excellent track record (however short), a sound management team, and potential
for high growth. Often the bottom line criterion for securing a bank loan is to be
a company that doesn’t really need the money. The same can be said for
suppliers of growth capital. They typically will not go into a situation where their
“new money” is paying off “old debt,” or where a company has poor cash flow.
They want to know that the infrastructure is in place, sales are increasing, and
the growing venture needs capital only to take that next leap up the sales ladder.
Make no mistake about it, raising growth capital is a time-consuming and
costly process. Many entrepreneurs opt instead for growing slowly, depending
exclusively on internal cash flow to fund growth. They have a basic fear of debt
and giving up any control of the company to investors. This attitude is
The first thing to fine if it works, but new ventures that begin with obvious high-growth
understand about potential will find themselves hamstrung and frustrated by a level of
raising growth
growth that prohibits them from meeting demand. Plan for growth from
capital is that it will
the very beginning so you will be prepared for the expense and the
invariably take at
demands on your time when they come.
least twice as long
The first thing to understand about raising growth capital (or any
as you thought.
capital for that matter) is that it will invariably take at least twice as
long as you thought to actually have the money in the company’s bank account.
If you are attempting to raise a substantial amount of money, several million
dollars for instance, you can expect it to take possibly several months to find
the financing, several more months for the potential investor or lender to do
due diligence and say yes, and then up to six months more to receive the
money. In other words, don’t wait to look for funding until you need it; it will
be too late, which—if you’re not prepared with a backup source—could spell
disaster for the business. Moreover, as this search for capital can take the entre¬
preneur away from the business when he or she is needed most, it is helpful to
use financial advisors who have experience raising money, and to have a good
management team in place so you don’t have to worry about the business while
you’re out seeking money.
The second thing to understand about raising growth capital is to never rely
on the person you have identified as the financial source to actually come
through for you. Keep looking for additional investors, if only as backups,
because you may ultimately determine that the terms of the first investor are not
compatible with your goals. Often second round financiers request a buy-out of
the first round funding sources, who could be friends or family, because they
feel the first round has nothing more to contribute to the business and they no
Chapter 17 • Financing Growth 371
longer want to deal with them. This can be a very awkward situation, as the
second round funder has nothing to lose by demanding the buy-out. They can
certainly walk away from the deal; there are thousands more out there.
In figuring out how much capital the venture needs to grow, many entrepre¬
neurs concentrate on the cost of the capital in terms of interest rate or return on
investment and fail to ipclude the cost of seeking the capital, which can be
substantial. The costs incurred before the money is received must be paid up
front by the entrepreneur, while the costs of maintaining the capital can often
be paid from the proceeds of the loan, or in the case of investment capital, from
the proceeds of a sale or internally generated cash flow.
If the business plan and financials have been kept up-to-date after the start of
the business, you have taken the first step in preparing the company for presen¬
tation to a funding source and saved some money in the process. If you are
seeking capital in the millions, however, growth capital funding sources prefer
that your financials have the imprimatur of a financial consultant or investment
banker, someone who regularly works with investors. This person is expert in
preparing loan and investment packages that are attractive to potential funding
sources. Your CPA will prepare the business’s financial statements and work
closely with the financial consultant. All of these activities result in costs to the
entrepreneur. In addition, if you are seeking equity capital, you need a
prospectus or offering document, which requires legal expertise and often has
significant printing costs. Then there are the costs to market the offering; such
things as advertising, travel, and brochures can become quite costly.
In addition to the up-front costs of seeking growth capital, there are “back¬
end” costs when the entrepreneur seeks capital by selling securities (shares of
stock in the corporation). These can include investment banking fees, legal fees,
marketing costs, brokerage fees, and various other fees charged by state and
federal authorities. The total cost of raising equity capital can go as high as 25
percent of the total amount of money sought. Add that to the interest or return
on investment paid to the funding source(s) and you can see why it definitely
costs money to raise money.
'Bygrave, W.D. & Timmons, J.A. (1992) Venture Capital at the Crossroads. Boston: Harvard Business School
Press.
2Venture Capital Journal, Special Report, April 1990, p. 1.
Chapter 17 • Financing Growth 373
also seeks varying rates of return depending on the risk involved. An early-stage
investment, for example, characteristically demands a higher rate of return, as
much as 50 percent or more, while a later-stage investment demands a lower
rate of return, perhaps 30 percent. Very simply, as the level of risk increases, so
does the demand for a higher rate of return as depicted in Figure 17.1. This
relationship is certainly not surprising. Older, more established companies have
a longer track record on which to make predictions about the future, so normal
business cycles and sales patterns have been identified, and the company is
usually in a better position to respond through experience to a dynamic envi¬
ronment. Consequently investing in a mature firm does not command the high
rate of return that investing in a high-growth start-up does.
Usually the first thing venture capitalists look at when scrutinizing a potential
investment candidate is the management team to see if experienced people with a
good track record are in place and able to take the company to the next level of
growth. In addition to experience, they are looking for commitment to the
company and to growth because they recognize that growing a company requires
an enormous amount of time and effort on the part of the management team.
Once they have determined that the management team is solid, they look at the
product and the market to see if the opportunity is substantial and if the product
holds a unique or innovative position in the marketplace. Product uniqueness,
especially if protected through intellectual property rights, helps create entry
barriers in the market, commands higher prices, and adds value to the business.
Rate of
Return
374 Part 6 • A Plan for Growth
The other major factor is the potential for significant growth and the amount
of growth possible, because it is from the consequent appreciation in the value
of the business that the venture capitalist will derive the required return on
investment. The venture capitalist weighs that potential for growth against the
risk of failure and the cost to achieve the growth projected. Therefore, when
negotiating with venture capitalists, the entrepreneur should have a good sense
of the value of the business, a topic discussed at the end of this chapter.
Armed with an understanding of what venture capitalists are looking for, the
entrepreneur is prepared to begin the search for the company that meets his or
her needs. As the venture capital community is fairly close knit, at least
The best way to
within regions of the country, it is wise not to “shop” the business
approach a venture
around looking for the best deal. Do some research on the venture
capitalist is through
capital firms in your state first to see if any specialize in your particular
a referral from
industry or type of business. Get recommendations from attorneys and
someone who
knows them. accountants who regularly deal with business investments. In fact, the
best way to approach a venture capitalist is through a referral from
someone who knows them. Once a venture capital company has been chosen,
it is preferable to stay with that company until you are certain the deal will not
work. Under no circumstances should you be talking to two companies at once.
The venture capital company will no doubt ask for a copy of the business
plan with an executive summary. The executive summary is a screening
device—if it can't be immediately determined that the entrepreneurial teams
qualifications are outstanding, the product concept innovative, and the projec¬
tions of growth and return on investment realistic, they will not bother to read
the entire business plan.
If, on the other hand, after studying the plan they like what they see, they
will probably call for a meeting to determine if the entrepreneurial team can
deliver what they project. This may or may not call for a formal presentation of
the business by the entrepreneur. During this meeting, the initial terms of an
agreement may also be discussed; however, the entrepreneur should not be too
eager to discuss issues like owner compensation until the venture capitalist
indicates a deal is imminent. It is also very important that the entrepreneur not
hype the business concept or make claims that cannot be substantiated. Venture
capitalists have literally seen it all and readily recognize when an entrepreneur
is puffing. The entrepreneur should, however, disclose any potential negative
aspects to the business and ways to deal with them.
If the meeting goes well, the next step is due diligence—that is, the venture
capital firm has their own team of experts check out the entrepreneurial team
Chapter 17 • Financing Growth 375
and the business thoroughly. If they are still sold on the business, they draw up
legal documents to detail the nature and terms of the investment and declare that
“the check’s in the mail.” Don’t spend the money, however, as it may take some
time to receive it. Some venture capitalists wait until they know they have a satis¬
factory investment before putting together a partnership to actually fund the
investment. Others just have a lengthy process for releasing money from the firm.
You should not be surprised if the money is released in stages based on
meeting agreed-upon goals. Also realize that the venture capital firm will
continue to monitor the progress of the new venture and probably want a seat
on the board of directors to have a say in the direction the new venture takes.
Capital Structure
It may seem that the entrepreneur is totally at the mercy of the venture capi¬
talist. That, unfortunately, is true if the entrepreneur enters the negotiation from
a weak position, desperately needing the money to keep the business alive. A
better approach is to go into the negotiation from a position of strength. True,
venture capitalists have hundreds of deals presented to them on a regular basis,
but most of those deals are not big hits; in other words, the return on the
investment is not worth their effort. They are always looking for that one busi¬
ness that will achieve high growth and return them enough gain on their invest¬
ment to make up for all the average or mediocre-performing investments in
their portfolio. If the entrepreneur enters the negotiation with a business that
has a solid record of growth and performance, he or she is in a good position to
call many of the shots.
Any investment deal has four components:
How these components are defined will affect the venture for a long time,
not only in constructing its growth strategy but in formulating an exit strategy.
Venture capitalists often want both equity and debt—equity because it gives
them an ownership interest in the business, and debt because they will be paid
back more quickly. Consequently, they tend to want redeemable preferred stock
or debentures so that if the company does well, they can convert to common
stock, and if the company does poorly or fails, they will be the first to be repaid
their investment because they have preferred stock. If you have entered the
376 Part 6 • A Plan for Growth
negotiation from a position of strength, you will more likely be able to convince
them to take common stock, which makes things much easier for you. In
another scenario, the venture capitalists may want a combination of debentures
(debt) and warrants, which allows them to purchase common stock at a
nominal rate later on. If this strategy is carried out correctly they can conceiv¬
ably receive their entire investment back when the debt portion is repaid and
still enjoy the appreciation in the value of the business as a stockholder.
There are several other provisions venture capitalists often ask for to protect
their investment. One is an antidilution provision, which ensures that the
selling of stock at a later date will not decrease the economic value of the
venture capitalists investment. In other words, the price of stock sold at a later
date should be equal to or greater than the price at which the venture capitalist
could buy the common stock on a conversion. One way to ensure that dilution
does not occur is to have a full ratchet clause that allows the venture capitalist
to buy common stock at the lowest rate at which it has been sold. For example
if the lowest price at which the stock has been sold to this point is $ 1, then that
is the conversion rate for the VC. However, if subsequently the stock is
Venture capital is sold at $.50, then all the VC’s convertible shares can be purchased at
only one source, the new lowest rate. Where their $1 million investment would have
and with the advice bought 1 million shares at $ 1/share, they now can buy 2 million shares
of experts, the at $.50 a share, effectively reducing the equity holding of the founders.
entrepreneur should A better method from the entrepreneurs point of view is to use a
consider all other weighted ratchet approach, which uses the weighted price per share of
possible avenues. all the stock issued after the founder’s stock and before the lowest stock
price that will cause dilution. This is certainly fairer to the founders and
prevents them from losing control of the company should the value of the stock
decrease substantially.
In addition, the VC may often request a forfeiture provision, which means that
if the company does not achieve its projected performance goals, the founders
may be required to give up some of their stock as a penalty to the VC to guard
against their having paid too much for their interest in the company. This
forfeited stock increases the VC’s equity in the company and may even be given
to new management that the VC brings on board to steer the company in a new
direction. One way to mitigate this situation is for the entrepreneur to request
stock bonuses as a reward for meeting or exceeding performance projections.
Using venture capital is certainly an important source for the entrepreneur
with a high-growth venture. It is, however, only one source, and with the
advice of experts, the entrepreneur should consider all other possible avenues.
Chapter 17 • Financing Growth 377
The best choice is one that gives the new venture the chance to reach its poten¬
tial and the investors or financial backers an excellent return on investment.
Private Placement
Private placement is a way of raising capital from private investors by selling
securities in a private corporation or partnership. Securities are common and
preferred stock, notes, bonds, debentures, voting-trust certificates, certificates
of deposit, warrants, options, subscription rights, limited partnership shares,
and undivided oil or gas interests. It is a less costly, less time-consuming
process than a public offering, and many states now offer standardized, easy-to-
fill-out disclosure statements and offering documents.
The advantages of a private offering are many. The growing venture does not
have to have a lot of assets or credit references, which they would need for bank
financing, or a lengthy track record. They also don’t have to file with the
Securities and Exchange Commission (SEC). They do, however, have to qualify
under the rules of Federal Regulation D. Not all states recognize the exemptions
under Regulation D in their “Blue Sky” laws, so the issuer of a private placement
memorandum may have to register with the state. Essentially, Regulation D says:
• The entrepreneur must file five copies of Form D with the SEC within 15
days after the first sale of securities, then every six months thereafter, and 30
days after the final sale.
• The entrepreneur must follow the rules for notices of sale and payment of
commissions.
• Rule 504 permits the entrepreneur to sell up to $1 million worth of securi¬
ties to any number of investors, whether they are sophisticated or not during
a 12-month period. Sophisticated in this context refers to people who invest
on a regular basis and have a net worth of at least $1 million.
• Rule 505 allows the founders to sell $5 million of unregistered securities in a
12-month period to up to 35 investors of any type in addition to an unlimited
number of accredited investors. Accredited investors include institutional
investors such as banks and insurance companies, investors who purchase at
least $150,000 of securities in the entrepreneur’s venture, investors with a net
worth over $1 million or annual income of over $200,000 in the previous two
years, and directors and officers of the company.
• Rule 506 allows the founders to sell an unlimited number of securities to 35
investors and unlimited accredited investors and relatives of the founders but
378 Part 6 • A Plan for Growth
The burden is on the issuer to document that the exemption from registra¬
tion requirements have been met. Therefore, the “sophistication” of all offerees
should be examined closely and the reasons why they qualify carefully docu¬
mented. The issuer should also number each private placement memorandum
and keep a record of who has looked at the memorandum or discussed the
offering with the issuer. The memorandum should have a qualifying statement
on it that the contents must not be copied or disclosed to anyone other
Within the structure
than the offeree. If an offeree becomes an investor, the issuer should
of the corporate
document when and where the offeree examined the books and records
private placement,
of the company. When the offering is complete, the issuer should place
the entrepreneur
a memo in the offering log stating that only those persons listed in the
can sell preferred
log have been approached regarding the offering.
and common stock,
convertible Even if the offering qualifies as exempt from registration, it is still
debentures, and subject to the antifraud and civil liability provisions of federal securities
debt securities laws and state Blue Sky securities laws. Many states have adopted the
with warrants. Small Corporate Offering Registration Form, also called SCOR U-7,
which makes the registration process much simpler by providing 50
fill-in-the-blank questions that ask for the basic financial, management, and
marketing information for the company. Your lawyer should be consulted as
some of the adopting states restrict who can use Form U-7.
Within the structure of the corporate private placement, the entrepreneur
can sell preferred and common stock, convertible debentures, and debt securi¬
ties with warrants. Recall that preferred stock has dividend and liquidation
preference over common stock in addition to antidilution protection and other
rights as may be specified in a stockholder agreement. Common stock, on the
other hand, carries with it voting rights and preserves the right of the corpora¬
tion to elect S-Corporation status. Convertible debentures are secured or unse¬
cured debt instruments that can be converted to equity at a later date as
specified in the agreement. In its debenture form, however, it provides for a
fixed rate of return (interest), which can be deducted by the corporation. Debt
securities with warrants give the holder the right to purchase stock at a fixed
price for a specified term. Purchasing common stock under this instrument
does not invalidate the preferred position of the debt holder as creditor.
Chapter 17 • Financing Growth 379
PROFILE 17.1
their stock on one of the stock exchanges. All the proceeds of the IPO go to the
company in a primary offering. If the owners of the company subsequently sell
their shares of stock, the proceeds go to the owners in what is termed a
secondary distribution. Often there is a combination of the two events;
however, an offering is far less attractive when a large percentage of the
proceeds are destined for the owners, as it clearly signals a lack of commitment
on the part of the owners to the future success of the business.
More and more smaller corporations are using the IPO vehicle to raise
growth capital; in fact, well over half of all IPOs are companies with an asset
value under $500,000. This trend has been helped by SEC Form S-18, which
applies to offerings of less than $7.5 million and simplifies and reduces the
disclosure and reporting requirements. There is no “rule of thumb” for when to
go public; but, in general, many companies consider it as an option when their
need for growth capital has exceeded their debt capacity. On average, the
company should have an attractive rate of annual growth, at least $10 million
in annual sales and $1 million in earnings, and a history of audited returns.
3Zeune, Gary D. (Febmary 1993). “Ducks in a Row: Orchestrating the Flawless Stock Offering.” Corporate
Cashflow.
Chapter 17 • Financing Growth 381
the underwriter, which compensates the investment bank that sells the securi¬
ties. One way to prevent a financial disaster should the offering fail is to ask for
stop-loss statements from lawyers, accountants, consultants, and investment
bankers. The stop-loss statement is essentially a promise not to charge the full
fee if the offering fails.
Going public is an enoirnously time-consuming process. Entrepreneurs report
that they spend the better part of every week on issues related to the offering
over a four- to six-month period. Part of this time is devoted to educating the
entrepreneur about the process, which is much more complex than this chapter
can express. One way many entrepreneurs deal with the knowledge gap is to
spend the year prior to the offering preparing for it by talking to others who
have gone through the process, reading, and putting together the team that will
see the company through it. Another way to speed up the process is to start
running the private corporation like a public corporation from the beginning,
that is, doing audited financial statements and keeping good records.
A public offering means that everything that the company does or has
becomes public information subject to the scrutiny of anyone interested in the
company. The CEO of a public company is now, above all, responsible to the
shareholders and only secondarily to anyone else. The entrepreneur, who
before the offering probably owned the lion’s share of the stock, may no longer
have the controlling stock (if the entrepreneur agreed to an offering that
resulted in the loss of control), and the stock that he or she does own can lose
value if the company’s value on the stock exchange drops, an event that can
occur through no fault of the company’s performance. World events and
domestic economic policy can adversely (or positively) affect a company’s stock
regardless of what the company does.
A public company faces intense pressure to perform in the short term. Where
an entrepreneur in a wholly owned corporation can afford the luxury of long¬
term goals and controlled growth, the CEO of a public company is pressured by
stockholders to show almost immediate gains in revenues and earnings which
will translate into higher stock prices and dividends to the stockholders. Last,
but not least of the disadvantages, the SEC reporting requirements for public
companies are very strict, time-consuming, and, therefore, costly.
banking firms only handle well-established companies because they feel smaller
companies will not attract sufficient attention among major institutional
investors. Consequently, the entrepreneur should contact anyone he or she
knows who has either gone public or has a connection with an investment
bank to gain entry.
The importance of investigating the reputation and track record of any under¬
writer cannot be stressed enough, as investment banking has become a very com¬
petitive industry with the lure of large fees from IPOs attracting some firms of
questionable character. The entrepreneur should also examine the investment
mix of the bank. Some underwriters focus solely on institutional investors, others
on retail customers or private investors. It is often useful to have a mix of share¬
holders, as private investors tend to be less fickle and more stable than insti¬
tutional investors. The investment bank should also be able to provide the IPO
support after the offering by way of financial advice, buying and selling stock,
and helping to create and maintain interest in the stock over the long term.
Once chosen, the underwriter draws up a letter of intent, which
The importance of outlines the terms and conditions of the agreement between the under¬
investigating the writer and the entrepreneur/selling stockholder. It normally specifies a
reputation and track price range for the stock, which is a tricky issue at best. Typically,
record of any under¬ underwriters estimate the price at which the stock will be sold by using
writer cannot be a price/earnings multiple that is common for companies within the
stressed enough. same industry as the IPO. That multiple is then applied to the IPO’s
earnings per share. It should be emphasized that this is only a rough
estimate. The actual going out price will not be determined until the night
before the offering. If the entrepreneur is unhappy with the final price, the only
choice is to cancel the offering, something that is highly unpalatable after
months of work and expense.
A registration statement must be filed with the SEC. This document is known
as a “red herring,” or prospectus, because it discusses all the potential risks of
investing in the IPO. This prospectus is given to anyone interested in investing
in the IPO. Following the registration statement, an advertisement, called a
“tombstone,” in the financial press announces the offering. The prospectus is
valid for nine months; after that the information becomes outdated and cannot
be used except by officially amending the registration statement.
Another major decision to make is which exchange to list the offering on. In
the past, smaller IPOs automatically listed on the American Stock Exchange
(AMEX) or National Association of Securities Dealers Automated Quotation
(NASDAQ) only because they couldn’t meet the qualifications of the New York
Chapter 17 • Financing Growth 383
Stock Exchange (NYSE). Today, however, the NASDAQ, with companies like
Microsoft and Apple, is the fastest growing exchange in the nation.
There is a difference between the way NASDAQ and the other exchanges
operate. The NYSE and AMEX are auction markets with securities traded on the
floor of the exchange, enabling investors to trade directly with one another. The
NASDAQ, on the other hand, is a floorless exchange that trades on the National
Market System through a system of broker-dealers from respected securities
firms who compete for orders. In addition to these three, there are also regional
exchanges like the Pacific and Boston stock exchanges that are less costly alter¬
natives for a small, growing company.
The high point of the IPO process is the road show, a two-week, whirlwind
tour of all the major institutional investors by the entrepreneur and the IPO
team to market the offering. This is done so that once the registration statement
has met all of the SEC requirements and the stock is priced, the offering can
virtually be sold in a day. The coming out price determines the amount of
proceeds to the IPO company, but those holding stock prior to the IPO often
see the value of their stock increase substantially immediately after the IPO.
Strategic Alliances
Chapter 16 talked about how to use strategic alliances to create the virtual
company or grow the business. Strategic alliances with larger companies are also
an excellent source of growth capital for young companies. Sometimes the part¬
nership results in major financial and equity investments in the growing venture.
Such was the case of United Parcel Service of America, which acquired a 9.5
percent ownership interest in Mail Boxes Etc. for $11.3 million. This gave Mail
Boxes Etc. capital to grow and UPS additional pickup and drop-off outlets.
Growing companies that link with established companies can usually get a better
deal than they would have gotten from a venture capitalist. In addition, they
derive some associated benefits that give them more credibility in the market¬
place. The large, investing partner is, at a minimum, looking for a return of the
cost of capital, but in general a return of at least ten percent on the investment.
Strategic alliances are every bit as tricky as partnerships, so the entrepreneur
must evaluate the potential partner carefully as well as do “due diligence” on
the company. It is also crucial not to focus on one partner but consider several
before making a final decision. For the partnership to really work, the benefits
should flow in both directions; that is, both partners should derive cost savings
and/or revenue enhancement from the relationship. It is probably best not to
384 Part 6 • A Plan for Growth
form a partnership that requires one of the partners (usually the smaller
company) to be too heavily dependent on the other for a substantial portion of
their revenue-generating capability. It is a dangerous position to be in should
the partnership dissolve for any reason.
• Fair Market Value. This is the price at which a willing seller would sell and
a willing buyer would buy in an arm’s length transaction. By this definition,
every sale would ultimately constitute a fair market value sale.
• Intrinsic Value. This is perceived value arrived at by interpreting balance
sheet and income statements through the use of ratios, discounting cash flow
projections, and calculating liquidated asset value.
• Investment Value. This is the worth of the business to an investor and is
based on the individual requirements of the investor as to risk, return, tax
benefits, and so forth.
• Going Concern Value. This is the current status of the business as measured
by financial statements, debt load, and economic environmental factors such
as government regulation that may affect the long-term continuation of the
business.
• Liquidation Value. This value assumes the selling off of all assets and calcu¬
lating the amount that could be recovered from doing so.
• Book Value. This is an accounting measure of value and refers to the differ¬
ence between total assets and total liability. It is essentially equivalent to
shareholder’s or owner’s equity.
business as a whole is the goal, the most common measure and the one that
gives more accurate results is future cash flows, because only cash or cash equiv¬
alents are used in the calculations. The method is called discounted cash flow
analysis or capitalization of future cash flows to the present value. What this
means is simply calculating how much an investor would pay today to have a
cash flow stream of X dollars for Y number of years into the future.
For this analysis, the entrepreneur uses pro forma cash flow statements for the
business and determines a forecast period. To do this, the length and nature of
business cycles in the industry must be understood so a forecast period that goes
either from trough to trough or peak to peak in a cycle is chosen. In other
words, you need to have at least one complete business cycle within the forecast
penod to give a fair representation of the effect on cash flow. (See Figure 17.2)
The forecast period is also affected by macroeconomic cycles, particularly if
the business is in the consumer products area. A study of leading, lagging, and
coincidental indicators can provide information on macroeconomic cycles that
may affect the future cash flow of the business in some industries. For example,
leading indicators such as Manufacturers’ New Orders for Consumer Goods or
Orders for Plant and Equipment have typically declined for nine months prior to
the beginning of a recession. One way to mitigate the problems associated with
business and macroeconomic cycles is to calculate a weighted average of three
cash flow projections: worst case, best case, and most likely case. The entrepre-
Product Demand
1 2 3 4 5 6 Year
386 Part 6 • A Plan for Growth
neur should assign a subjective probability to each case based on best estimates
of the chances for that case occurring, given certain economic conditions.
Once the forecast period has been defined and the cash flow projections
prepared (See Chapter 15 for a discussion of pro forma cash flow statements), a
discount rate must be chosen. This is not a purely arbitrary exercise. The deci¬
sion should be based on two factors:
1. The rate achievable in a risk-free investment such as U.S. Treasury notes over
a comparable time period. For example, for a five-year forecast, the current
rate on a five-year note is appropriate.
2. A risk factor based on the type of business and industry should be added to
the interest rate in #1. Several precedents for determining what these factors
are have been established over years of study. The most recent, widely
accepted standards are offered by Schilt4 and Pratt.5 in the form of five cate¬
gories of business. Note that even within each category there is room for
degrees of risk.
a. Category 1: Established businesses with good market share, excellent
management, and a stable history of earnings: 6-10%
b. Category 2: Established businesses in more competitive industries, still
with good market share, excellent management, and a stable earnings
history: 11-15%
c. Category 3: Growing businesses in very competitive industries, little
capital investment, average management team, and a stable earnings
history: 16-20%
d. Category 4: Small businesses dependent on the entrepreneur or larger
businesses in very volatile industries, and the lack of a predictable earn¬
ings picture: 21-25%
e. Category 5: Small service businesses operating as sole proprietorships:
26-30%
4Schilt, James H. (1982). “A Rational Approach to Capitalization Rates for Discounting the Future Income
Stream of Closely Held Companies.” The Financial Planner.
5Pratt, Shannon P. (1989).Valuing a Business, 2nd Edition, Homewood, IL: Business One Irwin.
Chapter 17 • Financing Growth 387
Assuming the current rate on a ten-year treasury note is 6 percent and you
are dealing with a Category 2 business at a 14 percent risk factor, the adjusted
discount rate becomes 20 percent. Using a calculator or a present value table,
the present value of the five-year cash flow stream can be calculated. What this
example shows is that this hypothetical business will throw off $1,575,000 of
positive cash flow over five years. Hence, a buyer would be willing to pay
$875,000 today for that business, given the discount rate.
In addition to the discount rate and risk factor, a business may have an
ability to generate cash virtually into perpetuity, assuming a strong position in
the marketplace and an excellent management team. Tuller and others have
advanced similar proposals to deal with what they call “continuing value” of the
business.6 It involves choosing a period of time subsequent to the forecast
period of at least 50 years so the final years will have little or no impact on the
cash flow stream being discounted and applying the last years cash flow figure
from the forecast period as if it would go on unchanged for the next 50 or more
years. In other words, multiply the last years cash flow figure by 50 (or 75 or
100 depending on the period chosen). Discount that product using a discount
factor of double the original factor (or triple depending on subjective assess¬
ment of risk) to account for the unknown probability that the business will
continue for that period of time and produce that amount of cash flow. The
total for the discounted continuing period can then be added to the discounted
cash flow from the forecast period to arrive at an estimate of value. If you have
prepared three scenarios—best, worst, and most likely cases—you will end up
with three values for the business. At this point the “real” value for the business
is determined through negotiation with investors, lenders, or the underwriters
who are helping to take the company public. However, doing the calculations
just discussed provides an excellent jumping off point for the negotiations.
As careful as this procedure is, it still has a significant “crystal ball” aspect to it
because at several crucial points in the process subjective decisions are made by
6Tuller, Lawrence W (1994). Small Business Valuation Book. Holbrook, MA: Bob Adams, Inc.
388 Part 6 • A Plan for Growth
the entrepreneur. There is really no way to avoid this dilemma; it is the nature of
the beast. The entrepreneur, nevertheless, must recognize that everyone inter¬
prets value differently and must be prepared to discuss and defend the assump¬
tions used to estimate value. Another point needs to be made. While the
entrepreneur is attempting to place a value on the business as a whole, the
potential investor/owner is looking at the business in terms of what the business
will return to the investor/owner. This is a very specific type of return and includes
three categories of items: cash flow returns, appreciation, and tax benefits.
• Cash Flow Returns. The investor/owner can receive the benefits of cash flow
through “perks” such as expense accounts and company cars, the repayment
of debt which is a tax-free transaction, interest, salary, and dividends. Each of
these has personal advantages and disadvantages to the investor/owner.
• Appreciation. The investor/owner can sell off a portion of his or her interest in
the company and enjoy a tax-free event up to the amount of his or her cost
basis.
• Tax Benefits. The investor/owner may be able to receive pass-through losses
that generally occur in the early years of a venture, if the business has elected
an S-corporation status.
This chapter has focused on one accepted method for valuing a young, grow¬
ing business. Valuation is by its very nature an incremental process that involves
bringing together key pieces of information that will, hopefully, give some
insight into the health and future of the business. In all discussions of value, the
entrepreneur should be clear on whose definition of value is being used.
Bygrave, W.D. & Timmons, J.A. (1992). Venture Capital at the Crossroads.
Cambridge: Harvard Business School Press.
Gladstone, D. (1988). Venture Capital Handbook. Englewood Cliffs, NJ:
Prentice Hall.
Tuller, L.W. (1994). Small Business Valuation Book. Holbrook, MA: Bob
Adams, Inc.
M Case StudyT^
I n the summer of 1989, Sam Farber and a design team lead by Davin Stowell
from Smart Design, were involved in the development of a line of kitchen
gadgets (e.g., peeler, can opener, pizza cutter, garlic press) that would be func¬
tional, comfortable, ergonomically sound, attractive, and affordable. Farber
expected the Smart Design team to have the kitchen gadgets prototyped and
ready for manufacture so they could introduce the new line at the San
Francisco Gourmet Show in April 1990. A number of design, marketing, and
manufacturing challenges would need to be solved in the next nine months.
■©1994, Corporate Design Foundation. This case was written by Professor William B. Gartner, San Francisco
State University School of Business, with the support of the Corporate Design Foundation as a basic for class
discussion rather than to illustrate either effective or ineffective handling of a business situation.
Chapter 17 * Financing Growth 391
of polypropylene plastic and rubber. This material has a warm non-slip feel to
it. Since Santoprene is used for dishwasher gaskets, there was no doubt that it
was dishwasher safe. By using Santoprene it was also possible for the designers
to incorporate another feature of the handle, “fingerprints softspots,” which are
flexible fin sections. These resilient fins help the handle to bend to an indi¬
vidual finger grip, thereby giving the user more cushion and control, even
when hands are wet or soapy. The flexible fin feature was subsequently
patented. The “fingerprints softspots” were added to the handle
because Sam Farber saw a need to make an innovative feature
of the general handle (soft spots) visible.
In conducting their research on the usability of different
handle prototypes, the Smart Design team had identified the
need for “soft spots,” a portion of the handle that was softer
than the rest of the handle in order to make the handle easier
to grip and maneuver. The Smart Design team had originally
designed in many of the prototypes for the soft spots to be “invisible,” that is, the
handle looked the same from tip to end, but when grasped, a portion of the
handle where the finger gripped the tool, gave more, and therefore provided a
better grip. Sam Farber felt that this feature needed to be visible to the customer:
“the handle should invite involvement.” By creating flexible fin sections for the
soft spots on the handle, the handle had a distinctive and visually descriptive
design. Much like an elegant sneaker built for the hands, the flexible fins on the
handle were a sign to prospective customers that this was not another “me too”
product.
In order to achieve the necessary rigid inner structure in the handle to
support the tool end of a particular gadget as well as provide a base for the soft
flexible outer handle, the metal part of the tool was molded to an inner core of
inexpensive ABS plastic. The injection-molded Santoprene handle was then
slipped over the ABS core.
The squeeze tools were designed with wide flat handles, so that in the
clenching motion of the whole fist, the pressure on the hand was evenly distrib¬
uted to alleviate sore spots and finger cramps. In designing the scissors they
added a hidden spring in the hinge that opens the blades automatically. The
user does not have to use the tender backside of the thumb to pull the blades
apart. The scissors were designed to use the strength of the whole hand for
cutting. They were designed so that the bottom of the handle was flat, so that a
user could press the scissors down on a table or countertop and, therefore, put
the weight of one’s shoulder into cutting through tough items like poultry joints
Chapter 17 • Financing Growth 393
or tree branches. The scissors were also designed to be used in either the right
or left hands. A pair also latches shut for safe storage in a drawer or on a hook.
The measuring cups and measuring spoons were designed with wide handles
for extra control and big easy-to-read size markings that were color coded. This
feature helps the eye perform better, as well as the hand. Finally big holes on the
gadgets, and big rings for the measuring items enhance their ease in hanging.
Manufacturing
The key group of items that would be Sam Farber’s focus of attention when
selecting a factory for production involved the peeler group of gadgets. Peelers
are the biggest selling item in a line of kitchen gadgets. A factory was required
that could manufacture a high quality peeler and OXO peelers would require a
factory that had expertise in both metal parts production and plastic production.
Because of Sam Farber’s prior experience at COPCO in manufacturing kitchen
products abroad and in selling kitchen wares in the United States market, he
knew that OXO’s products would have to be made in the Far East to be price
competitive. Sam knew that the cost of tooling in the Far East would be lower
and that he could get factories to share in the costs of making the tooling. Yet,
Sam did attempt to coax American manufacturers to bid. When Sam approached
a factory in the United States that was making bicycle grips with a material
similar to Santoprene, the factory manager looked at the Santoprene/ABS
composite prototype handle and said, “It can’t be done.” When Sam visited a
Japanese factory, the factory manager looked at the prototype handle and said.
“Very interesting—why not?” Sam selected a Japanese factory to make the
peelers. He had used this factory before to make knives for COPCO.
Sam turned to other factories in the Far East to manufacture the scissors,
garlic press, measuring cups and spoons. He researched many factories in
Taiwan and found three quality producers offering competitive prices. For
manufacturing the large stainless steel tools, such as spoons and turners, Sam
sought out factories in China. These large tools require a great deal of hand
labor for a polished finish, and labor for this type of work is cheaper in China.
Sam worked with a Hong Kong company that would ensure quality control in
China. Sam sought companies that had experience selling to the German
market. German consumers demanded higher quality than American
consumers. The Hong Kong company was producing products for a number of
quality German importers.
394 Part 6 • A Plan for Growth
In summary, all of the factories that Sam Farber choose met the following
criteria:
1. They were producing similar products, so that they were familiar with the
production problems that could arise and could consult effectively with the
designers during the final stages of design.
2. They were quality conscious.
3. They understood the process of exporting to the U.S. market.
4. They were willing to help pay for the cost of tooling as well as accept low
minimum quantities on the original order.
While this schedule was ambitious, Sam felt it could be achieved. In bringing
the kitchen gadgets into production. Sam never went to the Far East without
Chapter 17 • Financing Growth 395
someone from the design team. He believed that the designer needed to be
familiar with the factories and their production capabilities, what a factory can
and cannot do. Sam felt that “factory guys” are notonous for saying “it can’t be
done.” Sam found that the design team couldn’t just work in the studio, but had
to be actively involved in the early marketing studies and in the production tech¬
niques and manufacturing. “You can’t accomplish design innovation in a vacuum.
All the players have to participate and feel they are partners all along the way”
Other Considerations
All of the distribution areas (e.g., department stores, specialty kitchen shops,
mail order catalogs, discount retailers) suggested the same best selling items:
peeler, can opener, garlic press, grater, pizza cutter, measuring spoons, and
measuring cups. The mail order catalogs preferred higher unit retails and were
therefore interested in selling sets that combined two or three items.
All distribution areas were used to selling kitchen gadgets in lower price
ranges than OXO had contemplated, e.g., most peelers were selling from $.99
to $4.99 while the 0X0 peeler would be sold from $5.99 to $7.99. The mass
market companies were interested in the lower end of the price range. This was
an important factor in the decision to produce a second line for this distribu¬
tion area that would be lower priced. This line, labeled “Prima,” would sell
peelers for $3.99, which is at the higher end for mass merchants. In order to
manufacture gadgets at this lower price, tradeoffs in the quality of the product
would have to be made. While the handle would be “user friendly,” it would be
made of hard plastic and in one piece, rather than made from Santoprene, and
in two pieces. Farber also decided he was willing to take a lower gross margin
on the Prima line in order to sell the product for a lower price.
Department stores and mass merchants wanted items packaged on cards in a
traditional manner. Farber and the design team realized that their “story” was in
the handle, so they designed cards so that the handle swung free. Customers
could actually grab the handle and feel it. 0X0 also realized that many
specialty stores didn’t like cards, so gadgets were also sold uncarded, or with
small counter top displays. The demands from the mail order catalogues were
mixed. Some wanted cards for customer information and some didn’t.
The accepted display technique in all stores was to hang the items on the
“gadget wall.” The team’s marketing observations were that these walls were
unsightly—it was difficult to find a product and none of the lines were
presented together as one package. Since 0X0 had a story to tell, they wanted
396 Part 6 • A Plan for Growth
to keep their line separate from the others. The department stores and specialty
stores were receptive to the idea of a free-standing display. The mass merchants
only used the wall. The design team created a large display at first and subse¬
quently created a smaller revolving display, and finally, a display that holds six
items that could be placed near the cash register.
Most department stores wanted service, either complete service such as
inventory counting and display maintenance, or display maintenance. Some
mass merchants were not interested in service because they had sophisticated
scanning devices for quick reordering through EDI setups as well as trained
stocking people in the stores. Other retailers wanted merchandise sold to a
distributor who would handle the stocking and service. For example, they
found that Target stores wanted merchandise sold directly to them, while
Caldor wanted merchandise to be sold to Federal Wholesale, who maintains
their inventories and displays.
Because the handle was the key to the whole line, they realized that they
needed to have a name for the gadgets that told the customer what was special
about the product. “Good Grips” proved to be a perfect name. This name
communicated the major advantage of the line to the customer quickly: these
products were comfortable kitchen tools.
key factors in the original concept. She decided to join the company rather than
return to the practice of architecture. She came to be in charge of all publicity,
trade shows, brochures, copywriting, and in-house graphic design.
Though Sam had many contacts with buyers, he knew he needed to focus
his own efforts on developing new products. OXO would need a sales force and
someone to manage this sales force. One of his former sales vice-presidents
from COPCO, Ed Beren, was presently working as a sales consultant to two or
three companies in the housewares field. When Sam explained the idea of
“Good Grips” to Ed and showed him some of the initial models, Sam had
another passionate believer. Ed agreed to work as OXO’s sales manager and as a
consultant to the company for a percentage of the sales and a small advance.
Though 0X0 would not get all of Eds time, they would only have to share in
paying for his expenses, thereby turning what is often a fixed overhead expense
into a variable cost.
The meeting with Ed took place in February. They agreed that Ed would find
a sales force of manufacturers’ representatives and bring them together for the
first time at a sales meeting during the San Francisco Gourmet Show in April.
The manufacturers’ representatives would all work on commission.
A three-year marketing plan was developed. The initial line of kitchen
gadgets would be sold to upscale distribution outlets to establish the concept
and the name. They targeted January 1992 as the time to introduce a second
line of kitchen gadgets geared to mass merchants, like Wal-mart, K-Mart and
Target. By the end of 1993 they would produce a third line aimed at the super¬
markets and lower-priced kitchen stores. Although the lines would be different
from each other, they would adhere to the same basic principles of universal
design: all of the tools would be easier to hold and use.
In order to catch the buyer’s eye quickly and communicate the features of these
unique products, the booth was constructed of photo murals of the products.
A week before the Gourmet Show the Japanese factory sent the initial
samples for the show. But the grade of material chosen for the handles was
noticeably harder than what the design team had wanted. The Japanese worked
around the clock and through the weekend to produce another set of samples
in time for the show. Sam’s view of this burst of cooperation was:
They too had become believers. They felt involved as partners. Making
the supplier a part of the team in the early stages is one of the keys to
success of a project. In any innovative design project, you’re probably
pushing way beyond the boundaries of present products and present tech¬
niques—and in many cases present technology too. Those land mines
hide all over the road. It is hard to imagine this statement in relation to a
fairly prosaic item like the potato peeler. But we were using a material
unfamiliar to our factories, and one never before used in kitchen tools. We
were asking them to mold very thin uniform sections in the material. We
were convinced it could be done and Monsanto felt it could be done.
Naysayers are a serious impediment in the process of design innova¬
tion. They can be outside suppliers, technical people, or people within
your own company who always follow the safe path. Safety and self-doubt
don’t flourish along the pathway of the entrepreneur. It’s not the way of
someone trying to push through a revolutionary design project. That’s
why it is so important to have the suppliers involved. When they believe,
they will continually try to help you prove that it can be done.
The Good Grips line was an instant success when it was presented at the San
Francisco Gourmet Show in April 1990. Everyone wanted the merchandise.
While the product had been promised for delivery in July, shipments did not
begin until September. OXO was able to place the products in all the major
department stores and specialty stores. Sales did meet initial projections.
Other products that were introduced include a hand-held jar opener which
easily twists off stubborn jar lids and bottle caps. A “flying nun” corkscrew, that
has a large easy-to-turn knob, .and wide wings contoured to the curve of the
hand to facilitate the downward push which lifts out the cork. The screw is
coated with zylon, a non-stick material that enables it to glide easily into the
cork without tearing it. •
OXO has also introduced a line of tools designed for the garden. The handle
uses a soft material similar to the Santoprene. It has the patented fingerprint
fins, but the shape of the handle has been altered slightly to conform to the
different ways the hand moves when using a garden tool. 0X0 signed a
licensing agreement with the Sierra Club to market the tools as “Good Grips
Sierra Club Garden Tools.” Part of the proceeds from the sale of these tools goes
to the Sierra Club to help preserve and protect the environment.
The company is developing nonskid mixing bowls. They are also conducting
extensive studies on arm and wrist movements when lifting a pot filled with
food in order to design a line of cookware using a version of the patented
handle. In terms of the future, Sam commented:
In the four years since the first showing, these products have won a number
of design awards:
1. How was OXO’s philosophy and mission used to develop the product line?
2. Was it necessary for 0X0 to join forces with General Housewares
Corporation to grow and why?
3. Is 0X0 a kitchen company or are they a company developing comfortable
universal design products for any place in the home, office, or outside the
home? Why is it important for Sam to answer this question?
PART 7
Contemplating
the Future
Overview
• The purpose and uses of a contingency plan
• The purpose and uses of an exit plan
• Issues related to the selling of a business as an exit strategy
• Mechanisms for cashing out of the business while still maintaining a
degree of control
• Bankruptcy as an escape plan or an entrepreneurial tool
• Presenting the contingency plan in the business plan
405
406 Part 7 • Contemplating the Future
It is a sad fact that most entrepreneurs with growing ventures do not have
time for contingency planning; they are just too busy keeping the business
alive. But planning is essential. In the absence of planning, the business puts
itself in a reactionary mode, virtually at the whim of the environment in which
it operates. Instead of dealing from a position of strength, entrepreneurs may
find themselves reacting in panic and without information to situations for
which they are not prepared. As a result, the quality of decision making is
reduced and the business suffers.
By forcing entrepreneurs to consider multiple outcomes and possibilities,
contingency plans help a growing business deal with the ubiquitous downturns
and upturns in the economy, new regulations, changes in customer
In the absence of
tastes and preferences, and many other events that regularly, and often
planning, the busi¬
without much warning, disrupt the equilibrium of the business. For
ness puts itself in a
example, the reason many businesses fail in a recession is that they
reactionary mode,
haven’t prepared for it by forecasting the potential impact on demand
virtually at the whim
of the environment. when signs of a recession appear and calculating how they can adjust
and still maintain a positive cash position.
Recessions do not happen overnight. There are signs, even within specific
industries, that signal a slowdown. Since the government began compiling
indices on the economy after World War II, some consistent trends have
appeared. For example, the leading index, which consists of such items as the
Producer Price Index, the Consumer Confidence Index, and the Manufacturers’
Orders for Durable Goods, declines for nine months prior to the onset of a
recession. The coincident/lagging index, which is a ratio of the coincident index
(employment, personal income, industrial production) to the lagging index
(Consumer Price Index, interest rates, unemployment), declines for 13 months
prior to the onset of a recession.
Being able to recognize the signs of recession before they impact the business
gives the entrepreneur the chance to prepare in many ways, including maintain¬
ing a higher degree of liquidity. In recessionary times it is more difficult to raise
capital from either bankers or private sources, so being liquid allows the entrepre¬
neur to take advantage of opportunities that become available only during reces¬
sions. For example, the entrepreneur may be able to purchase a building that in
good economic times was beyond reach, or he or she may be able to negotiate
more favorable terms from suppliers just to keep the business moving forward.
Growing entrepreneurial ventures need to engage in both short- and long-
range planning. Short-range planning involves setting quantitative goals for the
coming year and developing a plan for achieving them. If a business does any
Chapter 18 • Planning for Change 407
Product Liability
The chances are fairly good that if you manufacture a product, your company
will at some point face a product liability suit. The Administrative Office of
408 Part 1 • Contemplating the Future
very inception of the Moreover, if your insurance company must pay on a claim, your
premiums will, no doubt, increase.
business.
A growing company must plan for potential litigation from the very
inception of the business. One proven method is to establish a formal
safety panel that includes people from all the major functional areas of the busi¬
ness. During the start-up phase, that panel may only consist of the entrepreneur
and one or two outside advisors with experience in the area. It is the job of the
safety panel to review safety requirements on a regular basis, establish new ones
when necessary, and document any injuries or claims made against the product.
Prior to product introduction in the marketplace, the panel should see that
careful records of all decisions regarding final product design, testing, and eval¬
uation procedures are maintained. Any advertising regarding the product
should not contain exaggerated claims or implied promises that may give
customers the impression that you are claiming more safety features than the
product actually has. Implied promises can be used against you in a court of
law. Instruction manuals should be easy to follow and should point out poten¬
tial hazards. They should also include guidelines for when and how to service
the product, which components made by other manufacturers are not covered
by your warranty (unless pass-through warranties have been negotiated), and
statements that the warranty is invalidated by misuse, misassembly, or modifi¬
cation, and is only valid if the specified maintenance procedures are followed.
Of course, the best insurance is to keep in contact with your customers so that
if a problem occurs, you will be given the opportunity to fix it before legal
action is taken.
Chapter 18 • Planning for Change 409
Decline in Sales
When sales decline and positive cash flow starts looking like a memory, entre¬
preneurs often go into a period of denial. They start paying their suppliers more
slowly to preserve cash; they lay off people; they stop answering the phone and
insulate themselves against the demands of their creditors. Their panic often
causes them to make poor decisions about how to spend the precious cash they
have. They figure that if they can just hold on long enough, things will turn
around. Unfortunately, this attitude only makes the problem worse, effectively
propelling the business toward its ultimate demise. How can an entrepreneur
lose touch with the business and the market so much that he or she puts the
business at risk? What often happens is that entrepreneurs get so tied up with
the day-to-day operations of the business that they don’t have time to contem¬
plate the “big picture” or stay in tune with their customers. Consequently, many
times they don’t see a potential crisis coming until it’s too late.
When sales decline, the solution isn’t necessarily to lower prices. If you have
educated your customers about the value of your product or service, they will
be confused by the sudden discounting. When there is a decline in sales it is
especially important to look at all possible sources, not just the economy. You
may have been lax about checking the credit status of customers and distribu¬
tors, or the inventory turnover rate may have changed. You may have failed to
notice an emerging competitor offering a product or service more in line with
current tastes and preferences.
When a growing business first notices a dip in sales, it is time to find the
cause and make the necessary changes. This will be easier if the business has a
contingency plan in place. If, however, those changes cannot be made in time
to forestall a cash flow problem, it is time to consult a debt negotiation
company, a crisis management consultant, or a bankruptcy attorney who is
willing to work through the problem outside of court. These experts can help
the entrepreneur work with creditors until the problem is resolved. To make
the best effort at avoiding a cash flow crisis, the entrepreneur must be continu¬
ally committed to:
• Making liquidity and positive cash flow the prime directive, so that the
company can ride out temporary periods of declining demand
• Having a contingency plan in place
next section. For now suffice it to say that before selling the business, the entre¬
preneur should plan for what will happen after the business is no longer part of
his or her life.
The best way to sell a business is to know almost from the beginning that
selling is what you want to do. This is so that you will make decisions for the
business that will place it in the best position for a sale several years later. For
one thing you will maintain audited financial statements that give the forecasts
more credibility. The tax strategy will not be to minimize taxes by showing low
profits but to show actual profits and pay the taxes on them because you will
probably more than make up for the expense at the time of sale. Higher
recorded profits will likely help the business be worth more. You will keep the
business expenses and activity totally separate from the personal expenses and
ensure that the business has value without you by preparing a successor. You
will also plan for the time it will take to sell the business and wait to sell until
the window of opportunity has opened.
Smaller businesses often use the services of business brokers to sell the
business; however, a high-growth venture will more likely employ the services
of an investment banking firm that has experience with the industry.
Investment banks normally want a retainer to ensure the seriousness of your
commitment, but that retainer will be applied against the final fee on the sale,
which averages five percent of the purchase price. It is recommended,
however, that a third party with no vested interest in the sale be employed to
judge the fair market value of the business. This “appraiser” can also prepare
financial projections based on the history of the company and their indepen¬
dent market research.
When a business is sold, the entrepreneur does not have to sell all the assets.
For example, the building could be held out of the sale and leased back to the
If you have used your name as the name of the business, it becomes a negotiable asset in the
sale. To sell the business you may have to give up the right to use your name in any future
venture or in any advertising you do after the sale. Remember it has probably taken several years
to establish your business’s name in the marketplace. A purchaser will probably not want to
change that name and confuse customers. You may, however, be able to pay for the right to use
your name in a non-competing business, perhaps in a different industry. This is a serious issue
that should be discussed with an attorney.
Chapter 18 • Planning for Change 413
business purchaser, with the original owner staying on as landlord. While the
potential purchaser is conducting due diligence on the entrepreneur and the
business, the entrepreneur needs to do the same with the purchaser. The
purchasing firm or individual should be thoroughly checked out against a list of
criteria the entrepreneur has developed. The purchaser should have the
resources necessary to continue the growth of the business, be familiar with the
industry and the type of business being purchased, have a good reputation in
the industry, and offer synergies that will ensure that the business continues in a
positive direction. It is often helpful to make a complete list of criteria and then
weight them by importance to fairly compare one potential buyer with another.
Selling Stock. If the company is still privately owned, the remaining share¬
holders may want to purchase your stock at current market rates so control
doesn’t end up in other hands. In fact, the shareholder’s agreement that was
drafted when you set up the corporation may have specified that you must first
offer the stock to the company before offering it to anyone else. If the company
is publicly traded, the task is much simpler; however, if you own a substantial
portion of the issued stock, you must follow strict guidelines set out by the SEC
in the liquidation of your interests. If the company had a successful IPO, the
entrepreneur’s founders stock will have increased substantially in value, which
presents a tax liability the entrepreneur should not ignore. That is why many
entrepreneurs in such situations cash out only what they need to support what¬
ever goals they have. This, of course, is based on the presumption that the
company stock will continue its upward trend for the foreseeable future.
Using an ESOP. If the business has more than 25 employees, one option for
the entrepreneur is to cash out via an Employee Stock Ownership Plan (ESOP),
but still maintain control for as long as desired. ESOPs, which are tax-qualified
pension plans or defined-contribution plans governed by ERISA and IRS regu¬
lations, have long been considered viable devices for succession planning but
work only where certain ingredients are present. The potential ESOP company
Chapter 18 • Planning for Change 415
• The entrepreneur can reinvest the proceeds of the sale in other securities
within 12 months of the stock sale and thereby defer the gain until the new
securities are sold. This assumes that the entrepreneur has owned the stock
Loan
1 ■ Contributions^ I Payments
CORPORATION Stock ESOP Stock as
BANK |
OWNERS TRUST Collateral
for more than three years. If the securities remain in the entrepreneur’s estate
at death, the heirs avoid having to pay a capital gains tax.
• The ESOP creates a ready market for any remaining owner shares in the
entrepreneur’s estate upon death. The heirs can sell those shares to the ESOP
• ESOP loan interest rates are much lower than normal borrowing rates
because banks can deduct 50 percent of the interest income when an ESOP
owns 50 percent of the company’s voting stock.
• Assuming the ESOP owns 50 percent of the stock, it can deduct interest and
principal payments on the loan, which benefits cash flow enormously.
• ESOPs can also fund retirement plans and health care coverage.
• Employees participating in the ESOP can accumulate significant amounts of
money over time, once they are vested.
• Employee shareholders have no voting rights but are represented by the
trustee.
There are also several disadvantages the entrepreneur should be aware of:
• A company with an ESOP cannot elect a sub-chapter S corporation election,
partnership, or professional corporation.
• ESOPs are expensive to set up and maintain, with annual expenses running
about $10,000-$15,000.
• Private companies are required to repurchase the shares of employees who
leave the company.
• New shares issued dilute the value of existing shares of stock.
• An ESOP creates a much more open environment in terms of information
that must be shared with the ESOP participants than many entrepreneurs are
accustomed to.
in mind as the exit strategy; but sometimes the forces working against the busi¬
ness are so great that the entrepreneur must have an exit vehicle so he or she
can move on to do something else. What forces a corporation into bankruptcy
is difficult to pinpoint. The immediately precipitating cause is the failure to pay
debt; however, a myriad of other events led up to that cause. They include
economic and business, cycles, excessive debt, surplus overhead, shifts in
demand, excessive expenses, poor dividend policies, union problems, supplier
problems, and poor financial management. Of course, the common denomi¬
nator for all of these factors is poor management.
The title of this section referred to bankruptcy as a “tool,” suggesting a
vehicle by which the entrepreneur can accomplish something. The use of bank¬
ruptcy law as a tool stems from the fact that once any bankruptcy action is
filed, all lawsuits and creditors’ calls stop. This was certainly important to
Manville Corporation, who filed for bankruptcy protection in 1982 based on an
anticipated 32,000 lawsuits related to injury from asbestos products. Manville,
which was a healthy corporation at the time, determined it could not stay in
business and pay the lawsuits. Some firms have used Chapter 11 to nullify a
union contract and force a change. At this point it should be noted that not all
businesses can file for bankruptcy protection. Those that are exempt include
savings and loans, banks, insurance companies, and foreign companies.
Furthermore, a bankruptcy filing cannot occur where the intent is to defraud,
and a company may file only once every six years.
Bankruptcy is normally a voluntary event; however, a company can be forced
into bankruptcy by its creditors if they are:
• One or more creditors whose claims amount to $5,000 over the value of any
assets if there are fewer than 12 claims, or
• Three or more creditors under the same above conditions where there are
more than 12 claims, or
• Any number fewer than all the general partners in a limited partnership.
Involuntary bankruptcies are not common because the courts deal harshly
with creditors that force a business into bankruptcy in bad faith.
The Bankruptcy Reform Act of 1978 and Public Taw 95-958 provide for
more than just liquidation of the business. Therefore, a clear understanding of
the bankruptcy mechanisms available to the entrepreneur is essential in consid¬
ering the options when a venture is faced with financial adversity.
The two chapters that are pertinent to the entrepreneur are Chapter 11 and
Chapter 7.
Chapter 11. Chapter 11 under the bankruptcy code is really not a bankruptcy
in the commonly used sense of the word. It is simply a reorganization of the
finances of the business so it can continue to operate and begin to pay its debts.
Only in the case where the creditors believe the management is unable to carry
out the terms of the reorganization plan will a trustee be appointed to run the
company until the debt has been repaid. Otherwise, the entrepreneur remains
in control of the business while in a Chapter 11 position. After filing for reorga¬
nization, the entrepreneur and the creditors must meet within 30 days to
discuss the status and organization of the business. The court then appoints a
committee, which usually consists of the seven largest unsecured creditors, to
develop a plan for the business with the entrepreneur. That plan must be
submitted within 120 days and acceptance of the plan must come within 60
days of submittal. Of the total number of creditors affected by the plan, repre¬
senting at least two-thirds of the total dollar amount, at least one half must
accept the plan. Once the reorganization plan is approved by the court, the
entrepreneur is discharged from any debts with the exception of those specified
in the plan.
Any of the above conveyances may be recouped by the court during the
bankruptcy proceedings.
420 Part 7 • Contemplating the Future
Presenting the Contingency Plan in the Business Plan. The contingency plan
is normally a small section of the business plan. It represents the entrepreneurs
effort to demonstrate that the new venture has considered future contingencies
that may affect the business’s ability to perform as projected in the pro forma
D Developed a contingency plan for various scenarios that may impact the busi¬
ness at some future date?
Consider 2. How can the entrepreneur prepare for potential product liability litigation
both to minimize the chance of occurrence and to give the company the best
423
424 Part 7 • Contemplating the Future
You have no doubt noticed that this book was designed to carry you through
the business planning process in a “logical” progression. Following this progres¬
sion may be the ideal way to go about preparing a business plan, but, frankly, it
doesn’t often happen in such an orderly fashion. Typically, information for all
parts of the business plan is gathered at various points in time, usually at the
convenience of the entrepreneur. The entrepreneur may talk to a distributor in
the industry seeking a sense of market demand for the proposed product and
wind up getting, in addition, an understanding of typical gross margins in the
industry, information that will not be needed until after it has been
Preparing a busi¬ determined that there is a market for the product. From talking to
suppliers during market research, the entrepreneur may become
ness plan doesn’t
concerned that the cost to produce the product is too great, so he or
often happen in an
she will quickly calculate the cost to produce and the probable selling
orderly fashion.
price based on preliminary information to see if there will be enough
money left over to pay overhead and eventually make a profit. If it
looks as though there isn’t enough profit in it to make the effort worthwhile, the
entrepreneur may decide to abandon the concept even before finishing the
market research.
As you can see, business planning is a fluid and dynamic process. One way
to gain a measure of control of the information gathered over time is to set up
files for each of the major sections of the business plan. As each piece of infor¬
mation is collected, it is filed in the appropriate folder. When it’s time to analyze
and prepare that section of the business plan, all the information needed to do
it will be there.
You will find people who will proudly proclaim that they never had a busi¬
ness plan and yet were successful. That may be true—there are always excep¬
tions to every rule—but more often than not, these entrepreneurs started small
businesses rather than high-growth, world-class ventures, or perhaps never had
to seek capital from outside sources. Also many of the more famous companies
that were started without plans—Pizza Hut, Crate and Barrel, Microsoft, and
Reebok—were started in the 1970s and early 1980s in a less global, less tech¬
nologically complex business environment. Moreover, most of these companies
eventually had to write business plans when expansion required taking on
investors, going public, or being acquired by a major corporation. Then, too,
you can’t dismiss the luck aspect. Being in the right place at the right time has
played a telling role in the early success of many ventures.
No one will deny that writing a business plan is a chore, but if you organize
the information in advance and plan for the time it takes to actually do the
Chapter 19 • Packaging and Presenting the Business Plan 425
• Projecting rapid growth beyond the capabilities of the founding team. This is a
common problem. The new venture shows potential for rapidly increasing
demand, sales doubling or tripling on an annual basis in the first few years.
The entrepreneur believes this will be very attractive to investors. What he or
she doesn’t realize is that there is no evidence in the business plan to prove
that the founding team can manage and control this type of growth, and this
is a cause for great concern on the part of the investors. Too often they have
seen a business fail during rapid growth because management didn’t have
the systems in place to deal with it. The entrepreneur should be careful to
project controlled growth and have a plan for bringing on the necessary
personnel at the point at which the company is ready for more rapid growth.
The other danger in projecting too high a level of success is that you increase
the chances you will not be able to achieve it. It is better to project a little
more conservatively and try to exceed those projections.
• The three-ring circus with only one ringleader. Many entrepreneurs pride them¬
selves on being a “jack of all trades.” They claim to have expertise in all the
functional areas of the new venture. What they really have is general knowl¬
edge of all the functional areas and maybe a real expertise in only one.
Investors are very nervous about relying on solo entrepreneurs to lead
world-class ventures. They much prefer a team of founders with at least one
person specializing in each of the functional areas.
• Performance in some or all areas that exceeds industry averages. While it is
possible for a new venture to exceed industry averages in a particular area, it
is not likely. Most averages, such as those for receivables turnover and bad
Chapter 19 • Packaging and Presenting the Business Plan 427
debt losses, have come1 about as a result of economies of scale, which the
new venture is not likely to achieve for some time. It is better for the busi¬
ness plan to initially indicate performance measures at or slightly below
industry averages with a plan for how to exceed those averages at some point
in the future.
• Underestimating the need for capital. Investors need to know that the business
plan projects sufficient capital infusion to grow the company until internal
cash flows can carry the load and then provide a plan for an additional infu¬
sion of capital when the company is ready for rapid expansion. If the entre¬
preneur underestimates the amount of capital needed, most savvy investors
will recognize it and attribute the error to naivete on the part of the entrepre¬
neur, or, conversely, they will rely on the figures presented in the plan and
ultimately suffer the potential loss of their investment as a result. Every esti¬
mate for capital should contain an additional amount for contingencies.
• Confusing strategy with tactics. It is much easier to develop tactics than strate¬
gies. Strategies define the overall focus of the business, while tactics are the
methods by which those strategies will be achieved. When an investor asks
what the entrepreneur’s strategy is for achieving a projected market share by
year three and the entrepreneur responds with “attending trade shows and
advertising in trade journals,” the entrepreneur has lost the confidence of the
investor by responding with tactics. This mistake is often made, as many entre¬
preneurs focus too much attention on tactics, often to the exclusion of identi¬
fying the overall strategy those tactics will support. The strategy for achieving
the market share may be to become the first mover in a market niche.
• Focusing on price as a market strategy for a product or service. This is similar to
projecting performance above industry averages. It is rarely possible for a
new venture with a product or service that currently exists in the market¬
place to enter based on a lower price than competitors. Established compa¬
nies have achieved economies of scale that the new venture is usually unable
to do and will no doubt easily match the price set by a new entrant into the
market. Furthermore, this strategy does not impress investors. They are more
interested in how the new venture will differentiate itself in terms of product,
process, distribution, or service.
• The entrepreneur’s investment in the business. Investors are more comfortable
investing in a new venture where the entrepreneur has contributed a
substantial amount of the start-up capital. That signals to the investors a level
of commitment necessary to achieve the goals of the company.
428 Part 7 • Contemplating the Future
• The amount of money the entrepreneur needs. Lenders are looking for a specific
amount that can be justified with accurate calculations and data.
• What positive impact the loan will have on the business. Lenders would like to
know that the money they are lending is not going to pay off old debt or pay
salaries, but rather improve the business’s financial position, particularly with
regard to cash flow.
• What kind of assets the business has for collateral. Not all assets are created
equal. Some assets have no value outside the business because they are
custom-made or specific to that business and therefore cannot be sold on the
open market. They prefer to see industry-standard equipment and facilities
that can easily be converted to another use.
• How the business will repay the loan. Lenders are interested in the earnings
potential of the business over the life of the loan, but more important, they
want to know that the business generates sufficient cash flow to service the
debt. While fixed expenses are fairly easy to predict, variable expenses—
those related to the production of the product or service—present a more
difficult problem. That is why lenders are also interested in the market
research section of the business plan, which tells them what the demand for
the product/service is, and the marketing plan, which tells them how the
entrepreneur plans to reach the customer.
• How the bank will be protected if the business doesn’t meet its projections. Lenders
want to know that the entrepreneur has a contingency plan for situations
where major assumptions prove to be wrong. They want to ensure they are
paid out of cash flow, not by liquidating the assets of the business.
• The entrepreneur’s stake in the business. Like investors, lenders feel more confi¬
dent about lending to a business where the entrepreneur has a substantial
monetary investment in the business. That way the entrepreneur is less likely
to walk away, leaving the lender stranded.
discussed and outlined in detail in various chapters of the book will only be
listed here.
Some ways to make the business plan stand out are to use color on the cover,
the business’s logo with the name, or a design that reflects the personality of the
business.
the first sentence, is critical. It must convey the excitement and personality of the
business without using such time-worn, over puffed phrases as “There is nothing
like this in the market today” Statements like that are sure to turn an investor off,
because they know immediately that it isn’t true; very few new ventures are based
on concepts that are entirely new and nonexistent, and investors know this.
The first paragraph should also clearly show how the product or service
being represented differentiates itself in the marketplace. One way to do this is
to use the approach Gentech Corporation employed in its executive summary
(See Figure 19.1, for a portion of that summary). They briefly described a.prob¬
lem in their industry and how they were going to solve it. This approach lets
the investor know right away that the company is customer-oriented and has
differentiated itself in the marketplace.
Another important thing to remember about the executive summary is that it
should be a stand-alone document—that is, you should be able to hand it out
independent of the business plan.
GENTECH CORPORATION
EXECUTIVE SUMMARY
Businesses and individuals who use both power and pneumatic tools have always had to deal
with using two distinct power units—a generator and a compressor—and leaving those units
running continuously for extended periods of time. This inefficiency results in:
• Increased operating costs of using two units
• Increased fuel consumption
• Increased costly maintenance and repairs
• Increased nuisance level of noise associated with gasoline engine-powered generators and
compressors running continuously
• Increased environmental pollution
GENTECH CORPORATION’S PowerSource™ alleviates these problems by providing:
• A combination air compressor and generator unit driven by a single gasoline engine and
providing both AC electric power and air power from one portable unit
• A patented start/stop system to control the engine remotely and automatically based on
demand, which reduces fuel consumption, costly maintenance repairs and is less polluting to
the environment as the engine only runs during tool usage or to replenish tank pressure
• Patented electronic switching between the generator and compressor to monitor AC and air
power requirements to ensure maximum power output on demand
• A variable timer delay system which avoids numerous engine shutdowns if tools are being used
frequently
• Portability through the use of one lightweight engine to power both functions
432 Part 7 • Contemplating the Future
Business plans contain a lot of private information, some of which you may
not want to share with everyone who reads the plan. Again, that is the reason for
several versions. A section like “Deal Structure,” for example, should probably not
be included when giving a plan to a lender or potential management employee,
but is usually needed when dealing with investors or venture capitalists.
Be sure that the body of the business plan answers the basic questions:
• The plan should be bound in such a way that it lies flat when you read it. A
spiral type binding or binder works well.
• Use index tabs to separate major sections and make it easier for the reader to
find something.
• Use 12- or 13-point type fonts and an easily read font style like Times
Roman for readability.
• Use bolded subheadings and bullets generously, again to facilitate finding
information. (See Figure 19.2 on p. 434 for an example of one style of head¬
ings and sub-headings.)
• If you have a logo, use it at the top of every page.
434 Part 7 • Contemplating the Future
GENTECH CORPORATION
PRODUCT PLAN
Purpose Gentech Corporation, a privately held California corporation, was established to
manufacture and distribute portable power equipment incorporating patented, state-of-
the-art technology and satisfying a need for efficient, energy-saving and environmen¬
tally friendly power equipment. Gentech Corporation has been actively involved
since 1989 in the research and development of a portable dual-purpose power source
_ for power and pneumatic tools.
Product PowerSource ™, the first product to be offered by Gentech Corporation, is a combi¬
nation air compressor and generator unit mounted on a typical twin-tank, wheel¬
barrow-style frame. Driven by a single gasoline engine, the dual purpose
PowerSource ™ provides both AC electric power and air power from one portable,
lightweight unit. When operating as a generator, it supplies electrical power to 110 volt
outlets. When an electrical tool is in use, an electronic switching device automatically
sends a signal to open a valve to vent the compressor piston to the atmosphere, thus
significantly reducing the demand on the engine. As long as there is air stored in the
tanks, air tools and power tools can be used simultaneously. A powerful AC generator
and a high-output air compressor, the PowerSource ™ eliminates the need to trans¬
port both a generator and compressor to the work site.
PowerSource ™ features a state-of-the-art, start/stop system which controls the
engine remotely and automatically based on demand. This innovative system starts
the engine immediately upon demand from a power tool or when the pressure in the
air tank reaches the lower limit. The engine stops automatically when power tools are
not in use and the pressure in the air tank reaches the upper limit. No special tools,
electric cords, or air hoses are required. This system is considered to be fuel efficient
and less polluting since the engine is only running while an electrical tool is being
used or tank pressure is being replenished. To avoid numerous shutdowns if tools are
used frequently, a variable timer delay mechanism can be activated to allow the gas
engine to idle down for a set period prior to shutting down altogether. In addition, an
override switch allows the option of operating the engine continuously when a
constant power source is preferred.
• Make sure your writing is focused and concise. Prune excess words with a
vengeance.
• Make sure all claims are supported by solid evidence.
• Ask several people to edit the plan.
Chapter 19 • Packaging and Presenting the Business Plan 435
If the founding team has successfully made it through the presentation, they
have cleared the first hurdle. The second hurdle, however, is the hardest:
answering questions from the funders. One thing to learn about funders is that
they generally like to ask questions for which they already know the answers;
this is a test to see if the founding team knows what they’re talking about.
Furthermore, they will ask questions that either require an impossibly precise
answer or are so broad as to make the entrepreneur wonder what the questioner
is looking for.
Another type of question typically asked is “What are the implications of...?”
With this question they are looking for an answer that addresses their needs
and concerns relative to the request for capital. Finally, the type of question that
poses the most problems for the founding team is the inordinately complex
question that contains several underlying assumptions. For example, “If I were
to analyze your new venture in terms of its market share before and after this
potential investment, how would the market strategy have changed and how
much of the budget should be allotted to changing that strategy?”
The first thing the entrepreneur should do when faced with such a compli¬
cated question is to ask that it be repeated to ensure nothing has been missed
that might cause the entrepreneur to make an incorrect assumption. Alterna¬
tively, you can restate the question and confirm that it has been understood
correctly. Another suggestion is to ask for a few minutes to formulate your
answer. With this type of question, you may only feel comfortable answering
part of it, for example, you may have evidence to support a change in market
share as a result of the capital infusion which you could present. On the other
hand, you probably don’t want to commit to any course of action or any budget
amount without having had time to consider it further and gather more facts.
Saying this in response to the question will no doubt gain you a measure of
respect, for you will have demonstrated you don’t make important decisions
precipitously without considering all the facts.
If you are asked a factual question for which you do not know the answer
(usually these are tangential to the business plan and asked to see how you will
Chapter 19 • Packaging and Presenting the Business Plan 437
respond), admit that you don’t have that answer off the top of your head but
will be happy to find it after the meeting is completed and get back to them. If
the presentation or anything the team has proposed is criticized (a likely possi¬
bility), be careful not to be defensive or turn the criticism in any way on the
audience. If you do so, you will have lost your chance with them immediately
and may never regain it-. Remember, you are playing in their ballpark. They
make the rules. If it appears they will be difficult people to deal with as
investors or lenders, you don’t have to use them. Chalk up the presentation to
practice and go on to the next one.
Preparing and presenting the business plan is the culmination of months of
work. The business plan represents the heart and soul of the new venture and,
if it was researched and written well, it can enhance the chances of starting a
successful, high-growth venture.
Issues to 1. Why is the business planning process an excellent exercise for any entrepre¬
ih 2. How might the business plan change if the reader were an investor versus a
potential management hire?
3. What are the key components of the business plan?
4. When might you need to include a personal financial statement in the
appendix?
5. What are three key elements of a successful business plan presentation?
Chapter 19 • Packaging and Presenting the Business Plan 439
The Product
Tapemate®, a registered trademark of Simtek, Inc., is an AC electric tape
dispenser that dispenses and cuts any desired length of tape by pressing a
button. The TM-100 is designed to be quick and efficient and incorporates a
patented disposable tape cartridge containing Scotch brand tape. The original
Scotch brand tape did not sell well when it was introduced as there was no easy
way to remove the tape from the roll. The first tape dispensers invented are
those still in common usage today. They all contain a means for holding a roll of
tape and a serrated blade for tearing a desired length of tape. 3M, the manufac¬
turer of Scotch brand tape, produces an excellent adhesive product, but diffi¬
culties continue to arise when customers attempt to remove the desired length
from a tape roll even with the use of a traditional dispenser. Invariably, the tape
has unwanted finger prints, smudges, jagged edges, and so forth. The TM-100
solves this problem by pulling tape off the roll at a smooth three inches per
second without finger prints or smudges and also cutting the dispensed length
of tape cleanly without serrations or jagged edges.
To further ensure the quality of the Tapemate dispenser and its intended
functions, Simtek also designed a disposable tape cartridge, much like a type-
^teven Johnson is not the real name of the entrepreneur/inventor who founded Simtek.
440 Part 7 • Contemplating the Future
writer ribbon cartridge. The cartridge helps keep the dispenser clean while
ensuring that the correct type of tape is being used in the dispenser. The
cartridge is easy to load into the dispenser and comes in several types of tape in
a variety of widths, lengths, adhesives, thicknesses, and overall quality. Simtek
felt it was important to control the type of tape used in the dispenser to guar¬
antee the highest quality. It also planned to price the product at a price point
similar to the electric pencil sharpener so it would sell well in major office
supply outlets. A retail price point of $79.95 was determined.
Simtek applied for and was granted a United States Patent, #4,638,696, for
the electric tape dispenser. Research found that previous similar inventions
suffered from a number of difficulties, including the jamming of the operative
mechanisms due to the adhesive surfaces contacting the operative mechanism
of the dispensing device. Another chronic problem was the propensity for slack
to form in the lead portion of the material within the device that would then
become entangled in the operative mechanism, thereby jamming the dispenser.
It was based on this research that Simtek believed that a need existed for its
Tapemate product.
It was estimated that to be competitive, the new unit must sell at a retail price
of approximately $15. This translated to a manufacturing cost of $3-$4.50 per
unit. The estimates from the product design firms came in at $74,000-$91,000
for concept design, breadboard design (the first stage of a design using models),
documentation, prototyping, and pre-production. The entire process would take
from 28 to 33 weeks to complete, with the deliverable being a production-quality
prototype.
SIMTEK, INC.
Pro Forma Income Statement
(Year 1 after redesign)
Expenses
1. Promotion and Advertising 250
2. Entertainment and Travel 500
3. Meals 100
4. Wages 12,083
5. Payroll Tax 483
6. Medical/Workers’ Comp 725
7. Telephone 400
8. Supplies 250
9. Rent 1,500
10. Freight 300
11. Model Making R&D 1,000
12. Drafting R&D 2,500
13. Materials R&D 1,000
14. Tooling 11,000
15. Legal 750
1. With regard to Simteks product development process, what were the key
problems with the process and how could they have made it more efficient
and less costly?
2. What were the advantages and disadvantages of taking on venture partners
during the product development phase?
3. With consideration to Johnsons pro forma statement for what he expects to
happen after redesign, what should Steve Johnson do now that the partners
have dissolved the company?
A World-Class
Venture
447
448 Part 8 • A World-Class Venture
company may have the financial resources and clout to become world-class,
they may be outdistanced by the scrappy entrepreneurial venture that under¬
stands how to be world class from the very beginning. In the 1990s, make no
mistake about it, being world class is a distinct competitive advantage.
How do you know when you have achieved world-class status? While there
certainly are exceptions, there seem to be eight characteristics common to
world-class ventures:
• A global vision
• An established network of strategic alliances
• Innovative, proprietary technology
• A market-driven strategy
• A globally experienced management team
• An integrative, organizational team philosophy
• Absolute integrity
• A passion for excellence
A Global Vision
World-class ventures are born with a global view. From sourcing materials and
parts, to distributing product, selling product, and setting goals for the future,
these ventures know no geographic boundaries. It has often been said that new
ventures should wait to go global until they are well established and have
achieved a certain level of sales. If Water Ventures, Inc., a resort watersports
equipment and services company in California, had listened to that advice, it
might not be in business today. Water Ventures found that the best markets for
its products lay overseas, in particular the Middle East. Consequently, the
domestic market is a relatively small portion of its total sales.
Having a global vision is not just a world-class attribute—it is a matter of
survival. An entrepreneur has two choices: take the leap into the international
arena or retreat within the boundaries of the U.S. and watch its market share
being eaten up by international competitors. Of course, “taking the leap” does
not necessarily mean establishing a physical presence in another country via a
manufacturing or other facility. It may mean establishing a strategic alliance with
a foreign company or simply exporting products internationally to gain a pres¬
ence in a region before investing large amounts of capital in something more
permanent. If you are an original equipment manufacturer (OEM), it may mean
responding to a customer that has gone global by locating a distribution center
in the region where the customer is selling product. In fact, in some countries,
Chapter 20 • Achieving World-Class Status 449
the only way to do business is through a joint venture or contract with a local
company. The U.S. venture maintains control of its R<SrD, finance, manufac¬
turing, and quality control, but uses locals for marketing and service functions.
Having a global vision is much more than merely recognizing an opportunity
in another country, however. It entails understanding the way business is
conducted in that country, learning the rules and regulations of trade, and
having an awareness of global monetary markets.
Advanced Processing of Electronic Materials in the United States and Japan; A State-of-the-Art Review Conducted
by the Panel on Materials Science of the National Research Council. (1986). Washington, DC: National Academy
Press.
2Hayes, R.H., Wheelwright, S.C. & Clark, K.B. (1988). Dynamic Manufacturing: Creating the Learning
Organization. New York: The Free Press.
3Drucker, Peter F (1985). Innovation and Entrepreneurship. New York: Harper & Row.
Chapter 20 • Achieving World-Class Status 451
A Market-Driven Strategy
The world-class venture of the 1990s lives for its customers. Customers will
decide what is produced, when and how it is produced, how much is
produced, how much it will cost, and where it can be purchased and serviced.
To paraphrase Ross Perot, the customers are the owners of the company.
Keeping the customers happy is essential to the survival and success of the
business. In a market-driven business, it is not just the sales personnel who
4Hawkin, Paul. (1983). The Next Economy. New York: Holt, Rinehart & Winston., pp. 172-3.
452 Part 8 • A World-Class Venture
deal with the customer. Everyone from the engineers to the plant workers to
the office staff knows the customers. This means that those responsible for
product development spend time with customers assessing needs; those who
handle billing and invoicing spend time with customers to assure that the
service they provide is meeting its mark; and senior line management spends at
least a third of the time with customers so they don’t lose touch with the
company’s greatest asset. In short, all actions taken by the organization are first
assessed based on their impact on the customer and secondarily on their impact
on the business. Without the customers, there is no business.
In a world-class business, the customer is an integral part of the organization
and is encouraged to participate in the company through letters, newsletters,
visits to the company facilities, and attendance at special meetings. Customers
are given numerous opportunities to express their feelings, give their sugges¬
tions, and are regularly sampled for their degree of satisfaction with the
company and its products or services. When a world-class business makes
promises to a customer, those promises are kept no matter what the cost to the
business to do so. The customer is always right.
Trade, the North American Free Trade Agreement, the European Community,
and the Association of South East Asian Nations.
Absolute Integrity
To accomplish the successful networks of strategic alliances necessary to
operate in a global economy requires integrity. The old adversarial mindset that
business has traditionally held no longer works when you are striving to
become a world-class venture. The environment for entrepreneurial ventures
has always been volatile and uncertain. Add to that the global dimension and
there aren’t too many things that can be relied upon to remain constant. Hence,
456 Part 8 • A World-Class Venture
the one constant that must be present is the security that relationships are
based on integrity, ethics, and trust. Often, in an effort to be competitive,
companies promise what they can’t deliver or change the terms of an agreement
at the last minute when the other party is at its most vulnerable. These tactics
may be successful in achieving certain ends in the short term, but the cost in
loss of customers and reputation will be devastating in the long term.
Integrity is consistency in what the company says, does, and stands for. It is
fair and uncompromising treatment of every supplier, every distributor, every
customer, and every employee. If you are going to expect the best from these
people and ask them to assume some of the risk with you, they must feel confi¬
dent you will do what you promise. Integrity is confidence that the company is
who they say they are. It means knowing that you will not be short-changed on
a payment, or on a quantity order, that products will meet the level of quality
advertised, and that service will be provided as promised.
In a global economy the issue of business ethics often displays its formidable
presence. It is common knowledge that not all countries operate under the
same rules of ethics as the United States. Is it OK for an American business to
accept a bribe in another country or pay a government official under the table
to speed up a process? For a world-class venture the question is moot. Absolute
integrity means maintaining high ethical standards in all business dealings no
matter where they take place. How can an entrepreneur expect employees to
act fairly and honestly toward the business if the business is not doing the
same? Honesty is still the best policy.
5Peiers, Tom & Austin, Nancy. (1985). A Passion for Excellence. New York: Warner Books.
6Hayes, R.H., Wheelwright, S.C. &r Clark, K.B. (1988). Dynamic Manufacturing. New York: The Free Press.
Chapter 20 • Achieving World-Class Status 457
• Hire the very best people and work hard to keep them
• Become experts in integrating product/process design
• Be flexible and fast
• Maintain a state-of-the-art philosophy in every area of the organization
• Manage on the leading edge
• Use an integrated, team-based approach
• Have a customer focus
• Take a return-on-quality approach to excellence
• Engage in lifelong learning
• Maintain a state of perpetual self discovery
One of the more recent buzzwords to hit the business world is “return on
quality” (ROQ). ROQ is really a reaction to the frustration faced by those compa¬
nies that took up the mantra of Total Quality Management in the 1980s and did
not achieve the results they were seeking. TQM pushed for quality in all func¬
tional areas of the organization, a worthy goal, but it now appears that no one
ever really considered the cost/benefit side of TQM; in other words, what was
the return on the investment in TQM? Many companies leaped into TQM with
total dedication, applying a good share of their resources to that end. Some, like
Wallace Co., an oil equipment company, won the Malcolm Baldrige National
Quality Award (1990). Unfortunately, Wallace filed for Chapter 11 two years
later, due in large part to falling oil prices and mounting quality program costs.7
Today, more and more companies are taking a bottom-line approach to quality
control and measuring each quality improvement effort against its costs to judge
the ultimate value. And the bottom line is whether or not a particular quality
improvement makes good economic and business sense.
How does ROQ correlate with a customer focus? It is interesting that some¬
times businesses think they really know their customers’ needs when they don’t
because they haven’t been asking the right questions. UPS, for example, always
figured that on-time delivery was the number one concern of their customers,
so that was their focus. They had delivery times down to a science. The reason
they thought that on-time delivery was the most important thing to the
customers was that all of their customer surveys had only asked about that
particular issue. When they recently began asking more broad questions like
how can UPS improve its service, they found to their surprise that what
customers most wanted was greater interaction with the drivers. They actually
wanted to get to know their drivers better. Accordingly, UPS, while it still
emphasizes on-time delivery, encourages its drivers to spend more time with
the customer. The ROQ for this new effort is increased sales—the bottom line.
Focusing on the return on quality forces everyone in the organization to
think more about what they are doing. A common complaint about TQM in its
later incarnations was that it had become mechanistic. True, costs were cut,
defects were reduced, and cycle times were shortened, but along the way the
customer was lost from the equation. Quality for quality’s sake was the result.
ROQ attempts to correct that situation by getting customers involved in the
quality process from the beginning. It is not about short-changing the customer
on quality just to make the bottom line look better. It is about finding out what
is really important to the customer and getting the customer involved in
bringing it about.
On Becoming Successful
A business’s success is easily measured by total revenues, earnings, return on
investment and so forth, but entrepreneurs don’t typically measure success in
these terms. Entrepreneurs seem to take a much more personal view of what
constitutes success; consequently, the definition varies from entrepreneur to
entrepreneur. Wally Amos of Uncle Noname Cookies believes that success is
“turning lemons into lemonade.” For Sue Szymczak of Safeway Sling in
Milwaukee, success is “being happy with what you’re doing and feeling as
though you’re accomplishing something.” One group of entrepreneurs decided
Chapter 20 • Achieving World-Class Status 459
that measuring their success in terms of the financial performance of the busi¬
ness did not reflect their definition of success, even at the company level. These
are the entrepreneurs who started many of the so-called “socially responsible”
businesses, most of which came into being in the 1980s. Ben and Jerry’s, The
Body Shop, and Patagonia are just a few of these new-age businesses that set
out to make a difference in the world by establishing very ambitious social goals
that were virtually impossible to reach.
Consequently, success in their terms can never really be achieved. For
example, one of The Body Shops goals was to end Third World poverty. No one
would dispute that this is a lofty and worthwhile goal. But realistically, can one
corporation do what nations have been unable to accomplish? The Body Shop
was setting itself up for failure. It should be noted that The Body Shop has since
modified its goal to changing the lives of hundreds of poor people and has seen
success in that effort.8
The unfortunate thing for these companies is that they have used
Entrepreneurs who their social goals as the focus of all their advertising and promotion, so
aspire to socially every day they are reminded by the ever-vigilant media of how they
responsible success have not succeeded. They are also held to impossibly high standards by
must understand their employees, who expect working conditions to be substantially
that unless the busi¬ better than those at traditional, nonsocially responsible companies—
ness of the business and often they are not. Entrepreneurs who aspire to socially responsible
is conducted well, success must understand that unless the business of the business is
there will be no busi¬ conducted well, there will be no business from which to achieve the
ness from which to goal of social responsibility.
achieve the goal of No matter what your definition of success, there seem to be some
social responsibility. constants that comprise the very essence of what is success. One of
those constants is purpose. To feel successful, entrepreneurs need to
know that what they are doing is taking them in the direction of a goal they
wish to achieve. True success is a journey, not a destination—even the achieve¬
ment of a goal will just be a step on the way to the achievement of yet another
goal. Success attained serendipitously, without purpose, is usually fleeting.
Entrepreneurs purposefully avoid the path of least resistance to success. An
electric current will follow the line of least resistance; a light bulb will only glow
8As of this writing The Body Shop is embroiled in a controversy over assertions that it has been misleading
customers in its claims. For example, one allegation is that the Body Shop uses non-renewable petrochemi¬
cals as ingredients in its products while it advertises them as all natural. In response, The Body Shop has
hired an ethicist from Stanford University to look into the claims.
460 Part 8 • A World-Class Venture
A Aspartame, 44
A & M Records, 152 Assets: asset-based lenders, 293; asset-based loans,
AARP, 242 288; forecasting, 310-312
ABS plastic, 392 Association of South East Asian Nations, 453
Accessibility, customer, 183 Attorneys, 64; for product liability claims, 409
Accountants, 65, 384 Austin, Nancy, 456
Accredited investors, 377 Aviation Daily, 325
Achievement, entrepreneurs need for, 6 B
Ackerman, Alan, 24 Baby boom generation, 19
Acquisitions and mergers, 357-358 “Back-end” costs, 371
Advertising: media, 241-244; “tombstone,” 382; truth Bankers/lenders, 36, 65-66; business plan focus
in, 162 towards, 428
Advertising Age, 242 Bankruptcy, 416-420
Advice network, 256 Bankruptcy Reform Act of 1978, 417
Advisory boards, 69 Banks, commercial, 292-293, 362
Agents: foreign, 362; and manufacturers’ representa¬ Barbecue grills, 260
tives, 118-119 Bargaining power, buyers,’ 87
A.H. Zapata, Inc., 318, 319 Barrios Technologies, 20
Airline Deregulation Act (ADA), 323 Bartering, 285
Alex & Ivy, 231 Beaver, Don, 44, 45, 56
Allen, John, 126-127, 128-129 Ben and Jerry’s, 232, 459
Allen, Paul, 284 Beren, Ed, 397
Allott, Jeff, 176 “Best suited,” 179
Ambiguity, entrepreneurs tolerance for, 8 Biodegradable products, 233
American Adventures, 319 Blind testing, 108
American companies, and foreign competition, 15-16 Blue Sky securities laws, 377, 378
American Distribution Systems, Inc., 210 Board of directors, 67-69
American Stock Exchange (AMEX), 382, 383 The Body Shop, 5; business philosophy of, 232;
Americans with Disabilities Act, 158-159 business regulations, 150; business success of, 30;
Amos, Wally, 7, 458 emphasis on social responsibility, 18, 241, 459
Angels, private investors, 288-290 Bombay Company, 230-231
Anti-dilution protection, 376 Bond protection, 66-67
Apparel industry, 356 Bonus plans, 266
Apple Computer, 5, 15, 192, 232, 451; Apple II Book value, 384
computer, 16; trademark for, 51 Bookkeeping, 65
Appreciation, 388 Bootstrapping, 70, 168, 284-287
Arm & Hammer Baking Soda, 351-352 Boston Globe, 326
463
464 Index
Computers: computer creativity, 24; high-growth soft¬ Customer: accessibility, 183; business plan focus towards
ware industry, 345; information availability, 19-20; major customers, 429; customers from fragmented
microprocessors, 16; on-line services, 245-246; markets, 196-197; describing the target customer,
online market research, 251-252; patent protection 100-101; marketing to industrial customers, 251;
for computer programs, 47; start-up ventures, 63, perceptions of performance, 203- 204; primary, 57;
178 product development and customer needs, 202-203;
satisfying customer needs, 102; using customers for
Concept investigation, product development and, 199
quality control, 215
Conglomerate diversification, 357
Constructing a building, 191 0
Consultants, 73, 409 Database marketing, 243-244
Davidson & Associates, 346
Consumer channels of distribution, 116-119
Davidson, Inc., 233
Consumer Confidence Index, 406
Davidson, Jan, 233
Consumer credit, 161-162
Dealerships, 352
Consumer Price Index, 406 Debentures, convertible, 378
Consumer Product Safety Commission, 16, 160 Debt: debt capacity, 380; debt securities, 378; debt-to-
Consumer products and services, forecasting sales with, equity ratio, 312; financing with debt, 292-295;
299-300 subordinated debt, 288
Consumer protection, 160 Deferred compensation plans, 265-266
Growing the business, 345-346; diversification growth Industry: analysis, 91-95; competitive strategies, 89-91;
strategies, 357-359; factors that affect growth, 346- data in the feasibility study and business plan, 96;
348; growing by going global, 359-365; integrative defining the, 83-85; forecasting sales with industrial
growth strategies, 355-357; intensive growth strate¬ products, 300; industrial channels of distribution,
gies, 351-355; problems with growth, 351; stages of 119; marketing to industrial customers, 251; pricing
growth in a new venture, 348-350. See also strategies, 238; structure, 85-89; volatility of the,
Financing growth 347-348
Growth capital, 369-371, 380 Informal networks, 256-257
Guerrilla Marketing (Levinson), 226, 248 Information availability, 19-20; sources of industrial
Gutenberg, Johann, 29 information, 92-93
Information needs, assessing, 103-104
H
Ingersol-Rand, 130
Hardigg Industries, 176 Initial Public Offerings (IPOs), 68, 139, 379-380, 413;
Harmonized System (HS) of commodities classification, advantages and disadvantages of going public, 380-
361 381; public offering process, 381-383
Hatlen, Roe, 19 Innovative, and proprietary technology, 449-451
Hawkin, Paul, 451 Inspection process, quality control and the, 214
Hayes, R. H., 456 Insull, Samuel, 461
HDI Engineering, 169 Insurance: agents, 66-67; costs, 208; Directors and offi¬
High technology start-ups, 61-62 cers (D & O) liability insurance, 69; workers’
High-tech companies, 5; growth capital, 369; growth compensation insurance, 156-157, 185
patterns of, 350 Integrative growth strategies, 355-357
Historical analogy, using substitute products or, 109 Integrative team based approach (ITB), 258, 453-455
Home Shopping Network, 13, 245 Integrity, absolute, 455-456
Ideas: and opportunities, 25; keeping an idea file or International Business Machines (IBM), 88, 451
notebook, 27; sources of new venture ideas, 25-29; International competition, 196
testing your business idea, 31-32 International Franchise Association (IFA), 365
Inventors: and entrepreneurs, 44; patents, 45, 47-50, Limbaugh, Rush, 246
449-450 Limited Liability Corporation (LLC), 144-146
Inventory requirements, 207; inventory costs, 208; Limited partnerships, 139, 291
inventory turnover, 208, 312; Just-in-Time (JIT) Limited production, going into, 109
system, 209-211; tracking inventory, 208-209 Liquidation. See Bankruptcy
Investment banking firms, 381-382, 412 Liquidation value, 384
Investment value, 384 Litigation, product liability and, 408
Investors, 36; business plan focus towards, 425-42*9 Livermore, Jesse, 461
Involuntary bankruptcies, 417 Loans: asset-based loans, 288; margin loans, 287-288;
IRC Sec. 1244 stock, 264 securing a bank loan, 370
ISO 9000, 215-217 “Local attorney”, hiring a, 409
Location of the business. See Business site
J
Locus of control, 7
Jefferson, Thomas, 45
Logistics firms, 118
JH Collectables, 168, 285
Long-range planning, 407
Job shop, 14
Lunsford, Bruce, 19
Jobs, Steven, 5, 15
Joint ventures, 190-191, 291 M
“Jointing a check,” 191 McBride, Jane E, 317-329
Just-in-Time (JIT) inventory control system, 209-211, McDonalds, 169, 365
356 Magazine advertising, 242-243
Mail Boxes Etc., 383
K
Mail surveys, 105-106
K-Mart, 397
Major corporations: downsizing of, 18; virtual enterprise
Kearns, Bob, 46
concept, 177-178
Keiretsu, 206
Malcolm Baldrige National Quality Award, 216, 457
Kempner, Michael, 285
Mall of America, Bloomington, MN, 182
Kentucky Fried Chicken, 352, 365
Management: business plan focus towards key, 429;
Keynes, John Maynard, 4
internationally experienced management team, 452-
Kitchen gadgets industry, 275-279, 390-401
453; management team section of the feasibility
Kohler, 130
study/business plan, 34, 75; using management for
Krueger, Ivan, 461
quality control, 215-217
L Management and organization plan: employee hand¬
Labeling, product, 233 book, 270-272; entrepreneurial approach to organi¬
Labor, cost of, 185 zational structure, 258- 261; hiring, job descriptions
Lagging index, 406 and specifications, 266-270; organizational chart,
Lauder, Tom, 379 255-258; other policies, 272; ownership and
Lauer, Daniel, 110 compensation in a corporation, 261-266; section of
Lax, Michael, 275 the business plan, 272; Total Quality Management
Leading index, 406 (TQM), 261
Leasing: a building, 187-190; employees, 407; equip¬ Manufacturer’s Orders for Durable Goods, 406
ment, 285 Manufacturers’ representatives, agents and, 118-119
Lee Apparel Company, 213 Manufacturing Industrial Classifications, 92
Legal structure: corporation, 139-143; Limited Liability Manufacturing process, maintenance in the, 217-218
Corporation (LLC), 144-146; of the new venture, Manufacturing site, choosing the, 184-186
135-136; nonprofit corporation, 146-147; partner¬ Manufacturing start-ups, 305
ship, 138-139; S corporation, 143-144; sole propri¬ Manufacturing support, 73
etorship, 137-138 Manville Corporation, 417
“Let the buyer beware,” 161 Margin loans, 287-288
Liabilities, 312 Maritime Services, 285
Life forms patent, 47 Market analysis, feasibility study and, 34
Life-long learning, 20 Market development, 352-353
470 Index
Market niche, 100 New England Women Business Owners (NEWBO), 326
Market penetration, 351-352 New entrants, threat of, 85-87
Market research. See Target market New Pig Corporation, 44, 45, 56, 57-58, 100
Market-driven strategy, 451-452 New product development, 196-197
Marketing plan, 227-229; marketing in the 1990s, 225- New venture process, 11-14; sources of new venture
226; online market research, 251-252; place strategy, ideas, 25- 29; stages of growth in a new venture,
238-240; price, 236-238; the product, 229, 231- 348-350. See also Legal structure
236; promotion, 240-251; writing the, 252-253 New York: high product liability claims in, 408; state-
Massachusetts Metalforming Network, 175 funded venture capital programs in, 294
Massachusetts, state-funded venture capital programs in, New York Stock Exchange (NYSE), 139, 382-383
294 Newspaper advertising, 241-242
Mats, Yoshiro Naka, 26 Newsweek, 242
Mattel Toy Company, 19, 185 NEXIS, 252
Mergers and acquisitions, 357-358 The Next Economy (Hawkin), 451
Micro loans, 294 Niche strategy, 89-90
Micro Planner X-Pert, 212 Niche, the market, 100, 347
Microbits Peripheral Products Inc., 24 Nike, 231, 354
Microprocessors, 16 1990 Census Basics, 104
Microsoft, 5, 284, 346, 424, 460; Windows, 86, 88 Nirvana (musical group), 152
Microsoft Project, 212 Nonprofit corporations, 146-147
Mid-Atlantic Packaging, Inc., 157 Nordick, Enita, 284
Miscellaneous advertising, 247-248 North American Free Trade Agreement (NAFTA), 360,
Mission statement, 258 453
Mitsubishi, 201 Nourse, Robert, 230, 231
Model builders, 200 Nutrasweet, 44
Modular growth strategies, 356-357
0
“Mom and Pop” businesses, 13-14
Obsolescence, 208
Monsanto, 391
Occupation health and safety, 156-158
Moore, Patricia, 278
Occupational Safety and Health Act of 1970, 157
Mossimo, 354
Occupational Safety and Health Administration (OSHA),
Motors and generators industry, 129-130
U.S., 16, 29, 154, 157-158
Mrs. Gooch’s Natural Foods Market, 10, 78-80, 100
Odysseum, Inc., 20
N Office of Health and Emergency Planning, 154
Nader, Ralph, 161 Ohio, high product liability claims in, 408
Name: selling your name, 413; of your business, 229 Oil ventures, 357
Napoleon 1, 460 Old Country Buffet, 19
National Aeronautics and Space Administration “One-to-one trades,” 285
(NASA), 20 Operational plan: designing an, 195-196; financial
National Association Female Executives (NAFE), 326 requirements, 218-219; inventory requirements,
National Association of Manufacturers, 105 207-211; materials requirements, 206-207; new
National Association of Securities Dealers Automated product development, 196-197; product develop¬
Quotation (NASDAQ), 382-383 ment and the entrepreneur, 197-204; product manu¬
National Business Aircraft Association (NBAA), 326 facturing cycle, 205-206; product/process
National Market System, 383 maintenance requirements and warranties, 217-218;
National Staff Leasing Association, 74 production requirements, 211-213; quality control,
National Toy Information Hotline, 166 213-217
Need for achievement, entrepreneurs, 6 Opportunity: cost, 208; enhancing your creative skills,
Nelson, Bill, 126-127, 128 24-25; recognition and product development, 199;
Net lease, 188-189 recognizing, 23-24, 199; sources of new venture
Network growth strategies, 356-357 ideas, 25-29; success and failure, 30-31; testing your
Networking, 27; and business alliances, 175 business idea, 31-32
Index 471
if ^ ■
Allen. l^auu
Launching new venture^
A s the year 2000 approaches, successful high-growth start ups will need to embrace new
organizational approaches in order to compete in a global market. Whether your
company is built around a single product, new technology, or a new marketing idea,
you’ll need to know the fundamentals of building a world-class venture. Grounded on the
business, marketing, and operational planning process, this comprehensive entrepreneurship
text includes real-world case studies and “new venture checklists” to help organize your start¬
up. The author focuses on the how-to aspects of:
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