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Chapter 1
INTRODUCTION TO FINANCE FOR ENTREPRENEURS
FOCUS
The purpose of this first chapter is to present an overview of what entrepreneurial finance is
about. In doing so we hope to convey to you the importance of understanding and applying
entrepreneurial finance methods and tools to help ensure an entrepreneurial venture is successful.
We present a life cycle approach to the teaching of entrepreneurial finance where we cover
venture operating and financial decisions faced by the entrepreneur as a venture progresses from
an idea through to harvesting the venture.
LEARNING OBJECTIVES
1. Characterize the entrepreneurial process.
2. Describe entrepreneurship and some characteristics of entrepreneurs.
3. Indicate three megatrends providing waves of entrepreneurial opportunities.
4. List and describe the seven principles of entrepreneurial finance.
5. Discuss entrepreneurial finance and the role of the financial manager.
6. Describe the various stages of a successful venture’s life cycle.
7. Identify, by life cycle stage, the relevant types of financing and investors.
8. Understand the life cycle approach used in this book.
CHAPTER OUTLINE
1.1 THE ENTREPRENEURIAL PROCESS
1.2 ENTREPRENEURSHIP FUNDAMENTALS
A. Who is an Entrepreneur?
B. Basic Definitions
C. Entrepreneurial Traits or Characteristics
D. Opportunities Exist But Not Without Risks
1.3 SOURCES OF ENTREPRENEURIAL OPPORTUNITIES
A. Societal Changes
B. Demographic Changes
C. Technological Changes
D. Emerging Economies and Global Changes
E. Crises and “Bubbles”
F. Disruptive Innovation
1.4 PRINCIPLES OF ENTREPRENEURIAL FINANCE
A. Real, Human, and Financial Capital must be Rented from Owners (Principle #1)
B. Risk and Expected Reward go Hand in Hand (Principle #2)
C. While Accounting is the Language of Business, Cash is the Currency (Principle #3)
D. New Venture Financing Involves Search, Negotiation, and Privacy (Principle #4)
E. A Venture’s Financial Objective is to Increase Value (Principle #5)
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F. It is Dangerous to Assume that People Act Against Their Own Self-Interests
(Principle #6)
G. Venture Character and Reputation can be Assets or Liabilities (Principle #7)
1.5 ROLE OF ENTREPRENEURIAL FINANCE
1.6 THE SUCCESSFUL VENTURE LIFE CYCLE
A. Development Stage
B. Startup Stage
C. Survival Stage
D. Rapid-Growth Stage
E. Early-Maturity Stage
F. Life Cycle Stages and the Entrepreneurial Process
1.7 FINANCING THROUGH THE VENTURE LIFE CYCLE
A. Seed Financing
B. Startup Financing
C. First-Round Financing
D. Second-Round Financing
E. Mezzanine Financing
F. Liquidity-Stage Financing
G. Seasoned Financing
1.8 LIFE CYCLE APPROACH FOR TEACHING ENTREPRENEURIAL FINANCE
SUMMARY
DISCUSSION QUESTIONS AND ANSWERS
1. What is the entrepreneurial process?
2. What is entrepreneurship? What are some basic characteristics of entrepreneurs?
3. Why do businesses close or cease operating? What are the primary reasons why businesses
fail?
Nearly one-half of businesses that fail do so because of economic factors including
fraud, and disasters. Many businesses close and fail due to financial trouble which is mostly
related to lack of sales and unsatisfactory profits.
4. What are five megatrend sources or categories for finding entrepreneurial opportunities?
5. What asset and financial bubbles have occurred recently? How can bubbles and financial
crises lead to entrepreneurial opportunities?
The “dot.com” or Internet bubble burst in 2000. An economic recession that began in 2001
was exacerbated by the 9/11 terrorist attack. The housing asset bubble, fueled by sub-prime
6. What is e-commerce? Why are the Internet economy and e-commerce here to stay?
E-commerce involves the use of electronic means to conduct business online. Activities
7. What is meant by disruptive innovation? What is the “sharing economy” societal trend?
8. Identify the seven principles of entrepreneurial finance.
The seven principles are:
(1) Real, human, and financial capital must be rented from owners
9. Explain the statement: “The time value of money is not the only cost involved in renting
someone’s financial capital.”
10. How do public and private financial markets differ?
11. What is the financial goal of the entrepreneurial venture? What are the major components
for estimating value?
12. From an agency relationship standpoint, describe the possible types of problems or conflicts
of interest that could inhibit maximizing a venture’s value.
There are two basic types of conflicts. Owner-manager (agency) conflicts occur when there
are differences between managers’ self-interests and the interests of the owners who hired the
Subsequently, managers may, on behalf of the owners, make the firm riskier for the benefit
of owners at the expense of debtholders.
13. Briefly discuss the likely importance of an entrepreneur’s character and reputation on the
success of a venture. What role does social responsibility plan in the operation of an
entrepreneurial venture?
A survey of successful entrepreneurs is by Timmons and Stevenson indicated that a majority
14. What is entrepreneurial finance and what are the responsibilities of the financial manager of
an entrepreneurial venture?
15. What are the five stages in the life-cycle of a successful venture?
16. New ventures are subject to periodic introspection on whether they should continue or
abandon. Explain the types of information you would expect to gather and how it would be
used in each stage to aid an entrepreneur’s approach to the venture’s future.
17. Identify the types of financing that typically coincide with each stage of a successful
venture’s life cycle.
Survival Stage – First-Round Financing
Rapid Growth Stage – Second-Round, Mezzanine and Liquidity-Stage Financing
Maturity Stage – Obtaining bank loans, issuing bonds and issuing stocks
18. Identify the major sources, as well as the players, associated with each type of financing for
each life cycle stage.
Development Stage – Entrepreneur’s assets, family and friends
19. Describe the life cycle approach for teaching entrepreneurial finance.
20. From the Headlines—Ice Energy: Briefly describe the “ice battery” market and how Ice
Energy’s Ice Bear system addresses that market. Give some examples of how Ice Energy can
expand its market and tap additional sources of capital.
Answers will vary: The general market would be related to alternative energy sources for air
conditioning systems. There are private and public utility aspects to the market. On the
INTERNET ACTIVITIES
1. Web-surfing exercise: Develop your own list of the five most important societal or economic
trends currently shaping our society and providing major business opportunities. Use the
Web to generate potential venture ideas related to the trends and to gather commentary and
statistics on them.
five societal or economic trends. The instructor can draw on personal experiences, recent
impressions from the Wall Street Journal and Bloomberg Businessweek to supplement any
discussion of the students’ lists.
2. Determining several “resources” available from the Small Business Administration for
entrepreneurs that might be useful in starting, financing, and managing an entrepreneurial
venture. The SBA Web site in http://www.sba.gov/advo/ for information relating to recent
annual numbers of employer firm births and the importance of small businesses to the U.S.
economy.
3. Following are some pairs of famous entrepreneurs. Using the Web if needed, associate the
entrepreneurs with the companies they founded:
1.Steve Jobs and Steven Wozniak
A. Google
2.Bill Gates and Paul Allen
B. Ben & Jerry’s
3.Larry Page and Sergey Brin
C. Microsoft
4.Ben Cohen and Jerry Greenfield
D. Apple, Inc.
Solutions:
1. Steve Jobs and Steven Wozniak
[D. Apple, Inc.]
2. Bill Gates and Paul Allen
[C. Microsoft]
3. Larry Page and Sergey Brin
[A. Google]
4. Ben Cohen and Jerry Greenfield
[B. Ben & Jerry’s]
4. Search the Web for recent developments on the part of Airbnb and Uber to disrupt the
lodging ad taxi industries, respectively. Also search the Web and attempt to identify other
possible innovations that may be disrupting existing markets and networks.
Students can be directed to conduct specific web searches on recent Airbnb and Uber
EXERCISES/PROBLEMS AND ANSWERS
1. [Financing Concepts] The following ventures are at different stages in their life cycles.
Identify the likely stage for each venture and describe the type of financing each venture is
likely to be seeking and identify potential sources for that financing.
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A. Phil Young, founder of Pedal Pushers, has an idea for a pedal replacement for
children’s bicycles. The Pedal Pusher will replace existing bicycle pedals with an easy
release stirrup to help smaller children hold their feet on the pedals. The Pedal Pusher
will also glow in the dark and will provide a musical sound as the bicycle is pedaled.
Phil is seeking some financial help in developing working prototypes.
B. Petal Providers is a firm that is trying to model the U.S. floral industry after its
European counterparts. European flower markets tend to have larger selections at
lower prices. Revenues started at $1 million last year when the first “mega” Petal
Providers floral outlet was opened. Revenues are expected to be $3 million this year
and $15 million next year after two additional stores are opened.
2. [Life Cycle Financing] The following ventures have supplied information on how they are
being financed. Link the type and sources of financing to where each venture is likely to be
in its life cycle.
A. Voice River provides media-on-demand services via the Internet. Voice River raised
$500,000 of founder’s capital in April 2016 and “seed” financing of $1 million in
September 2016 from the Sentinak Fund. The firm is currently seeking $6 million for a
growth round of financing.
B. Electronic Publishing raised $200,000 from three private investors and another $200,000
from SOFTLEND Holdings. The financial capital is to be used to complete software
development of e-mail delivery and subscription management services.
Electronic Publishing is still in the development stage. It has raised funds from angels
3. [Venture Financing] Identify a successful entrepreneurial venture that has been in business
at least three years.
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A. Use historical revenues information to examine how this particular venture moved
through its life cycle stages. Determine the length of the development stage, the startup
stage, and so forth.
Answers will depend on the entrepreneurial venture being discussed.
B. Determine the financing sources used during the various stages of the venture’s life cycle.
Answers will depend on the entrepreneurial venture being discussed.
C. Identify the venture’s equity owners and how shares have been distributed among the
owners. What portion of ownership has been allocated to management team members?
What, if any, agency conflicts can you identify?
Answers will depend on the entrepreneurial venture being discussed.
4. [Financial Risk and Return Considerations] Explain how you would choose between the
following situations. Develop your answers from the perspective of the principles of
entrepreneurial finance presented earlier in the chapter. You may arrive at your answers
with or without making actual calculations.
A. You have $1,000 to invest for one year (this would be a luxury for most entrepreneurs).
You can earn a 4% interest rate for one year at the Third First bank or a 5% interest
rate at the First Fourth bank. Which savings account investment would you choose and
why?
The First Fourth bank loan would be preferred because you would receive $10 more
B. A “friend” of yours will lend you $10,000 for one year if you agree to repay him
$1,000 interest plus returning the $10,000 investment. A second “friend,” has only
$5,000 to lend to you but wants total funds of $5,400 in repayment at the end of one
year. Which loan would you choose and why?
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The second friend is offering you a lower interest rate (8% versus 10%) which would
C. You have the opportunity to invest $3,000 in one of two investments. The first
investment would pay you either $2,700 or $3,300 at the end of one year depending on
the success of the venture. The second investment would pay you either $2,000 or
$4,000 at the end of one year depending on the success of the venture. Which
investment would you choose and why? Now, would your answer change if your
investment were only $1?
A second principle of entrepreneurial finance is: “risk and expected reward go hand in
However, when investments are very small (or are perceived to be small by a specific
Bankruptcy or failure situations may also cause the investor (entrepreneur) to choose
D. An outside venture investor is considering investing $100,000 in either your new
venture or in another venture, or invest $50,000 in each venture. At the end of one
year, the value of the venture might be either $0 or $1,000,000. The other venture is
expected to be worth either $50,000 or $500,000 at the end of one year. Which
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investment choice (yours, the other venture, or half-and-half) do you think the venture
investor would choose to invest in? Why?
A venture investor who is not very risk averse might choose your venture to invest in
since there is a possibility of receiving $1,000,000 in return for putting up $100,000.
Of course, such an investor could lose all of his/her investment if the low result occurs.
5. [Ethical Issues] Assume that you have been working on a first-generation “prototype” for
a new product. An angel investor is waiting in the “wings” wanting to invest in a second–
generation model or prototype. Unfortunately you have run out of money and aren’t able to
finish the initial prototype. The business angel has previously said that she would “walk” if
you cannot produce a working first generation prototype.
A. What would you attempt to do to “save” your entrepreneurial venture?
Many entrepreneurs state that high ethical standards are one of a venture’s most
important assets and are critical to long-term success and value. Taking the time and
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B. Now let’s assume that the angel investor will advance you the financing needed for the
second-generation prototype based on your “word” that the first-generation prototype
has been completed and is working? What would you do?
The situation has not changed from the suggested actions noted in Part A. Inform the
SUPPLEMENTAL EXERCISES/PROBLEMS AND ANSWERS
[Note: These activities are for readers who have an understanding of financial statements.
Accountants record the flow of revenues and expenses over a time period such as a year in the
income statement. Accounts also record the amount in asset accounts at the end of each
accounting period in the balance sheet. For readers who need to review basic financial
statements, the following problems can be completed after the materials in Chapter 4 have been
covered.]
6. [Costs or Expenses] Phil Young, founder of Pedal Pushers, expects to spend the next one-
half year developing and testing prototypes for a pedal replacement for children’s bicycles.
(See Part A of Problem 1 for a description of the proposed product.) Phil anticipates paying
monthly rent of $700 for space in a local warehouse where the Pedal Pusher product will be
designed, developed, and tested. Utility expenses for power and heat are estimated at $150
per month. Phil plans to “draw down” a salary of $1,000 per month. Materials needed to
build and test an initial prototype product are expected to cost $9,500. In addition, each
redesign and new prototype will require an additional $4,500 investment. Phil anticipates
that before the final Pedal Pusher is ready for market at the end of six months, the initial plus
two more prototypes will need to be built and tested. Costs associated with test marketing
the Pedal Pusher are estimated at $7,000.
A. Determine the amount of financial capital that Phil Young will need during the six-
months it will take to develop and test market the Pedal Pusher.
Monthly Expenses:
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B. What type of financial capital is needed and what are the likely sources of that capital for
Phil Young?
C. What would be your estimate of the amount of financial capital needed if the product
development period lasted nine months?
The total expenses would be the $36,600 as in (A) plus an additional three months of
expenses:
$5,550
D. What compensation arrangements would you recommend as he hires additional members
of the management team?
7. [Expenses and Revenues] Let’s assume that Phil Young does indeed develop and successfully
market the Pedal Pusher product discussed in Problems 1 and 6. Phil’s venture will
purchase materials for making the product from others, assemble the products at the Pedal
Pusher venture’s facilities, and hire product sales representatives to sell the Pedal Pushers
through local retail and discount stores that sell children’s bicycles. The costs of plastic
pedals and extensions; bolts, washers, and nuts; reflective material; and a “micro–chip” to
provide the “music” when the bicycle is pedaled are expected to be $2.33 per pair of Pedal
Pushers. Assembly costs are projected at $1.50 per pair. Shipping and delivery costs are
estimated at $.20 per pair or set and Phil Young will have to pay commissions of $.30 per
pair of pedals sold to the sales representatives.
A. What will it cost to produce and sell a pair of Pedal Pushers?
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Unit Costs:
B. What price will Phil Young have to charge for a pair of Pedal Pushers if he wants a
“markup” of 50 percent on each sale? Now, what would the retailers have to ultimately
sell a pair of Pedal Pushers for if they, in turn, desired a mark-up before their expenses
of 40 percent?
C. Now that Pedal Pushers is up and operating, Phil Young feels he should be paid a salary
of $5,000 per month. Other administrative expenses will be $2,500 per month. How
many units (pairs) of Pedal Pushers will the venture have to sell to cover all operating
and administrative costs during the first year of operation?
$90,000
Units needed to be sold to reach breakeven:
To check that this is breakeven, note that:
MINI CASE: INTERACT SYSTEMS, INC.
Interact Systems, Inc. has developed software tools that help hotel chains solve application
integration problems. Interact’s Application Integration Server (AIS) provides a two-way
interface between central reservations systems (CRS) and property management systems (PMS).
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At least two important trends in the hotel industry are relevant. First, hotels are shifting away
from the manual booking of room reservations and electronic bookings will continue to increase
as more bookings are made over the Internet. Second, competitive pressures are forcing hotels to
implement yield management programs and to increase customer service. By integrating the
CRS and PMS through Interact’s AIS, inventories can be better managed, yields improved, and
customer service enhanced.
All reservation traffic is routed from the CRS to individual hotel properties. This allows
Interact Systems to create a database that can be used to track customers and to facilitate
marketing programs, such as frequent stay or VIP programs, as a way of increasing customer
satisfaction. Interact forecasts application integration expenditures in the hospitality industry
exceeding $1 billion by 2019.
Greg Thomas founded Interact Systems in 2013 and developed the firm’s middleware
software and hospitality applications. He has twelve years of systems applications experience
and currently is Interact’s Chief Technology Officer. Eric Westskow joined Interact in early
2016 as President and CEO. Prior to that time, he worked in sales and marketing in the software
industry for more than twenty years.
Interact Systems’ AIS software development which began in 2013 went through several
design changes in 2014. The first product was sold and installed in 2015. Sales were only
$500,000 in 2015. However, now that the firm has dependable market-tested AIS products ready
to be shipped, revenues are expected to reach $20.8 million in 2019.
Greg Thomas founded Interact Systems with $50,000 of his own savings plus $50,000
from friends. Two private investors provided an additional $200,000 in 2014. In addition, $1
million was obtained from a venture capital firm, Katile Capital Partners, in early 2016 in
exchange for an equity position in Interact. The firm currently is seeking an additional $5
million to finance sales growth.
A. Verify the two important trends that are developing in the hotel industry.
1. Hotels are shifting away from the manual booking of room reservations to electronic
B. Describe how Interact Systems’ AIS software products are to benefit the hotel industry from
a profitability standpoint.
C. Describe how Interact Systems’ AIS software is to help hotels improve customer satisfaction.
All reservation traffic is routed from the CRS to individual hotel properties. This allows
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D. Describe the life cycle stages that Interact Systems has progressed through to date.
Interact Systems’ AIS software development which began in 2013, went through several
E. What types of venture financing have been obtained, or are being sought, by Interact?
Seed Financing: Greg Thomas founded Interact Systems in 2013 with $50,000 of his own
F. Relate major sources or players with the venture financing described in Part E.
Major sources or players include:
G. What types of agency problems or conflicts should the founding entrepreneur have
anticipated?
Agency relationships arise when principals hire agents to perform specified activities or
H. What, if anything, should the founding entrepreneur have done in anticipation of agency
conflicts?
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I. Assuming the venture succeeds, what are the potential advantages to other stakeholders
(customers, employees, and society more broadly)?
The goal of maximizing the entrepreneurial venture’s value is not inconsistent with ethical
J. If internal sales growth projections are revised downward after the current financing round,
what, if any, disclosure to stakeholders (investors, employees, customers, etc.) should occur?
Why?
The entrepreneur-manager has the responsibility to inform investors in a timely and