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Chapter 2
DEVELOPING THE BUSINESS IDEA
FOCUS
In this chapter we examine how one can move from an idea to a determination of the feasibility
of the related business opportunity. We present an opportunity screening system to aid in
determining whether an idea should be discarded or pursued. We conclude the chapter with an
overview of a business plan.
LEARNING OBJECTIVES
1. Describe the process of moving from an idea to a business model/plan.
2. Understand the components of a sound business model.
3. Identify some of the best practices for high growth, high performance firms.
4. Understand the importance of timing in venture success.
5. Describe the use of a Strength-Weakness-Opportunity-Threats (SWOT) analysis as an
initial “litmus test.”
6. Identify the types of questions that a reasonable feasibility assessment addresses.
7. Identify quantitative criteria that assist in assessing a new venture’s feasibility and its
ability to attract external financing.
8. Describe the primary components of a typical business plan.
CHAPTER OUTLINE
2.1 PROCESS FOR INDENTIFYING BUSINESS OPPORTUNITIES
2.2 TO BE SUCCESSFUL YOU MUST HAVE A SOUND BUSINESS MODEL
A. Component1: The Business Model must Generate Revenues
B. Component 2: The Business Model must Make Profits
C. Component 3: The Business Model must Produce Free Cash Flows
2.3 LEARN FROM THE BEST PRACTICES OF SUCCESSFUL ENTREPRENEURIAL
VENTURES
A. Best Marketing Practices
B. Best Financial Practices
C. Best Management Practices
D. Best Production or Operations Practices are also Important
2.4 TIME-TO-MARKET AND OTHER TIMING IMPLICATIONS
2.5 INITIAL “LITMUS TEST” FOR EVALUATING THE BUSINESS FEASIBILITY OF
AN IDEA
2.6 SCREENING VENTURE OPPORTUNITIES
A. An Interview with the Founder (Entrepreneur) and Management Team: Qualitative
Screening
B. Scoring a Prospective New Venture: Quantitative Screening
C. Industry/Market Considerations
D. Pricing/Profitability Considerations
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E. Financial/Harvest Considerations
F. Management Team Considerations
G. Opportunity-Screening Caveats
2.7 KEY ELEMENTS OF A BUSINESS PLAN
A. Cover Page, Confidentiality Statement, and Table of Contents
B. Executive Summary
C. Business Description
D. Marketing Plan and Strategy
E. Operations and Support
F. Management Team
G. Financial Plans and Projections
H. Risks and Opportunities
I. Business Plan Appendix
SUMMARY
APPENDIX A:
Applying the VOS IndicatorTM: An Example
CSC Profile
Market Opportunity
Products
Management Team
CSC Assessment
DISCUSSION QUESTIONS AND ANSWERS
1. How do we know whether an idea has the potential to become a viable business opportunity?
2. Identify three types of startup firms.
Salary-replacement firms are firms that provide their owners with income levels comparable
3. Briefly describe the process involved in moving from an idea to a business model/plan.
Refer to Figure 2.1 “From Entrepreneurial Opportunities to New Businesses, Products, or
Chapter 2: Developing the Business Idea
20
It is the production or operations area that carries the responsibility of delivering high-quality
8. Time to market is generally important, but being first to market does not necessarily ensure
success. Explain.
“Time–to–market” is particularly critical when ideas involve information technology, as a few
months might determine success or failure. EBay’s rapid progression from concept to market
9. What is meant by a viable venture opportunity?
10. Describe how a SWOT analysis can be used to conduct a first-pass assessment of whether an
idea is likely to become a viable business opportunity.
A SWOT analysis is an examination of strengths, weaknesses, opportunities, and threats to
11. Describe the meaning of venture opportunity screening.
12. An analogy used relating to venture opportunity screening makes reference to “caterpillars”
and “butterflies.” Briefly describe the use of this analogy.
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Venture screening usually begins with an assessment of the management team’s experience
16. Describe return on assets (ROA). What are the two major components of the ROA model?
The return on assets is a metric calculated by dividing the venture’s net after-tax profit by
its venture total assets and it represents a measure of the firm’s performance relative to its
17. How do asset intensity and asset turnover differ? What is implied by a high asset intensity?
Asset intensity is calculated as total assets divided by total revenues. Asset turnover is
18. How do the concepts of operating cash flow and free cash flow to equity differ?
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Free cash flow to equity is the cash available to the entrepreneur and venture investors after
19. What is a business plan? Why is it important to prepare a business plan?
A business plan is a written document that describes the proposed venture in terms of the
20. What are the major elements of a typical business plan?
A typical business plan contains, in its Introduction, a cover page, confidentiality statement,
table of contents, and executive summary. The Business Description section presents some
21. What are real options? What types of real option opportunities are available to
entrepreneurs?
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Real options are real or non-financial options available to a venture’s managers as the
venture progresses through its life cycle. Examples of real options include growth options,
22. From the Headlines—Diluting the Angels’ Share: Briefly describe how the idea of a
shortened aging process can be the basis of financial profitability for Cleveland Whiskey.
Answers will vary: The barrel-aging process is extraordinarily time consuming, placing a
large gap between when money is invested in an inventory and when that inventory is
INTERNET ACTIVITIES
1. Access the Inc. magazine Web site at www.inc.com. Identify a list of recent articles that
relate to how business opportunities are evaluated by venture investors and/or articles
discussing why venture investors chose not to invest in potential business opportunities.
Web-researched results vary due to constant updating of the related web sites.
2. Access the Center for Business Planning Web site at www.businessplans.org. The site
provides examples of business plans prepared by MBA students from top business schools
and presented to panels of investors at recent Moot Corp. competitions hosted by the
University of Texas at Austin. Review one of the business plans. Write a brief summary
comparing the segments or elements included in the business plan to the key elements of a
typical business plan presented in the chapter.
Web-researched results vary due to constant updating of the related web sites.
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Venture ZZ would be a Case 1 type of venture opportunity (very high profit margin).
E. Use the information in Figure 2.9 relating to pricing/profitability, and “score” each
venture in terms of potential attractiveness.
Pricing/Profitability Venture XX Venture YY Venture ZZ
3. [Revenues, Costs, and Profits] In early 2013, Jennifer (Jen) Liu and Larry Mestas founded
Jen and Larry’s Frozen Yogurt Company, which was based on the idea of applying the
microbrew or microbatch strategy to the production and sale of frozen yogurt. They began
producing small quantities of unique flavors and blends in limited editions. Revenues were
$600,000 in 2013 and were estimated at $1.2 million in 2014. Because Jen and Larry were
selling premium frozen yogurt containing premium ingredients, each small cup of yogurt sold
for $3 and the cost of producing the frozen yogurt averaged $1.50 per cup. Other expenses
plus taxes averaged an additional $1 per cup of frozen yogurt in 2013 and were estimated at
$1.20 per cup in 2014.
A. Determine the number of cups of frozen yogurt sold each year.
B. Estimate the dollar amounts of gross profit and net profit for Jen and Larry’s venture in
2013 and 2014.
2013 2014
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C. Calculate the gross profit margins and net profit margins in 2013 and 2014.
Gross Profit Margin = Gross Profit/Revenues
D. Briefly describe what has occurred between the two years.
4. [Returns on Assets] Jen and Larry’s frozen yogurt venture described in Problem 3 required
some investment in bricks and mortar. Initial specialty equipment and the renovation of an
old warehouse building in Lower Downtown, referred to as LoDo, cost $450,000 at the
beginning of 2013. At the same time, $50,000 was invested in inventories. In early 2014, an
additional $100,000 was spent on equipment to support the increased frozen yogurt sales in
2014. Use information from Problem 3 and this problem to answer the following questions.
A. Calculate the return on assets in both 2013 and 2014.
B. Calculate the asset intensity or asset turnover ratios for 2013 and 2014.
Asset Intensity = Total Assets/Revenues
C. Apply the ROA Business Model to Jen and Larry’s frozen yogurt venture.
ROA Business Model = Net Profit Margin x Asset Turnover Ratio
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D. Briefly describe what has occurred between the two years.
E. Show how you would position Jen and Larry’s frozen yogurt venture in terms of the
relationship between net profit margins and asset turnovers depicted in Figure 2.10.
5. [VOS IndicatorTM Screening] Jen Liu and Larry Mestas are seeking venture investors to help
fund the expected growth in their Frozen Yogurt venture described in Problems 3 and 4. Use
the VOS Indicator
guidelines presented in Figures 2.8 and 2.9 to score Jen and Larry’s
frozen yogurt venture in terms of the items in the pricing/profitability factor category.
Comment on the likely attractiveness of this business opportunity to venture investors.
6. [Ethical Issues] Assume that you have just “run-out-of-money” and are unable to move your
“idea” from its development stage to production and the startup stage. However, you remain
convinced that with a reasonable amount of additional financial capital you will be a successful
entrepreneur. While your expectations are low, you are meeting with a loan officer of the local
bank in the hope that you can get a personal loan in order to continue your venture.
A. As you are about to enter the bank, you see a bank money bag lying on the street. No one is
around to claim the bag. What would you do?
Many entrepreneurs state that high ethical standards are one of a venture’s most important
Chapter 2: Developing the Business Idea
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It is possible, but should not be expected and thus should not be part of your decision, that
B. Now, let’s assume that what you found lying on the street was a $100 bill. The thought
crosses your mind that it would be nice to take your significant other out for a nice dinner—
something that you have not had for several months. What would you do?
C. Now, instead of $100 you “find” a $1 bill on the street. The thought crosses your mind that
you could buy a lottery ticket with the dollar. Winning the lottery would certainly solve all
your financing needs to start and run your venture. What would you do?
When the amount of money “found” is very small, such as $1, people often behave
differently than when the amount of money is large. First, it is virtually impossible to
SUPPLEMENTAL EXERCISES/PROBLEMS AND ANSWERS
[Note: These activities are for readers with an existing understanding of financial statements (i.e.,
income statements and balance sheets). For other readers, these exercises/problems can be
worked after covering Chapter 4.]
7. [Revenues, Profits, and Assets] Refer to the information on the three ventures in Problem 2.
A. If each venture had net sales of $10 million, calculate the dollar amount of net profit and
total assets for Venture XX, Venture YY, and Venture ZZ.
Net Profit Total Assets
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B. Which venture would have the largest dollar amount of net profit?
C. Which venture would have to largest dollar amount of total assets?
Venture ZZ would have the largest total assets at $10,000,000.
8. [Ratio Calculations from Financial Statements] Ricardo Martinez has prepared the
following financial statement projections as part of his business plan for starting the
Martinez Products Corporation. The venture is to manufacture and sell electronic
components that make standard overhead projectors “smart.” In essence, through voice
commands a projector can be turned on or off, and the brightness of the projection altered.
This will allow the user to avoid audience annoyances associated with a bright projection
light during periods when no overhead transparency is being used. Venture investors usually
screen prospective venture opportunities in terms of projected profitability and financial
performance.
A. Use the following projected financial statements for Martinez Products and calculate
financial ratios showing the venture’s projected: (a) gross profit margin, (b) net profit
margin, (c) asset intensity, and (d) return on assets.
Gross Profit Margin = Gross Profit/Sales = 100,000/200,000 = 50%
B. The ratios calculated in Part A are found in the venture opportunity screening guide
discussed in the chapter. Rate the potential attractiveness of the Martinez Products
venture using the guidelines for the pricing/profitability factor category for the VOS
Indicator.
The VOS Indicator shows that three of the pricing/profitability indicators are average
while after-tax margins are low in attractiveness. The scoring suggests a low-to-average
appraisal of this venture opportunity.
__________________________________
Martinez Products Corporation
Projected Income Statement for Year 1
__________________________________
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Martinez Products Corporation
Projected Balance Sheet for End of Year 1
9. [Ratio Calculations] Ricardo Martinez, the founder of the Martinez Products Corporation
(see Problem 8), projects sales to double to $400,000 in the second year of operation.
A. If the financial ratios calculated for Year 1 in Problem 8 remain the same in Year 2, what
would be Martinez’s dollar amount projections in his business plan for: (a) gross profit,
(b) net profit or income, and (c) total assets?
B. How would your answers change in Part A if the gross profit margin in the second year
is projected to be 60%, the net profit margin 25%, and the asset intensity at a 5 times
turnover?
Gross Profit = 400,000 x 60% = 240,000
C. Use the projected ratio information in Part B in the return on assets (ROA) model to
determine the projected percentage rate of return on assets.
ROA = Net Profit Margin x Assets Turnover = 25% x 5.00 = 125%
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MINI CASE: LEARNRITE.COM CORPORATION
LearnRite.com offers e-commerce service for children’s “edutainment” products and
services. The word edutainment is used to describe software that combines “educational” and
“entertainment” components. Valuable product information and detailed editorial comments are
combined with a wide selection of products for purchase to help families make their kids’
edutainment decisions. A team of leading educators and journalists provide editorial comments
on the products sold by the firm. LearnRite targets highly educated, convenience oriented, and
value conscience families with children under the age of 12, estimated to be about 35 percent of
Internet users.
The firm’s warehouse-distribution model results in higher net margins, as well as greater
selection and convenience for customers, when compared to traditional retailers. Gross profit
margins are expected to average about 30 percent each year. Because of relatively high
marketing expenditures aimed at gaining market share, the firm is expected to suffer net losses
for two years. Marketing and other operating expenses are estimated to be $3 million in 2017
and $5 million in 2018, respectively. However, during the third year operating cash flow
breakeven should be reached. Net profit margins are expected to average 10 percent per year
beginning in year 3. Investment in bricks and mortar is largely in the form of warehouse
facilities and a computer system to handle orders and facilitate the distribution of inventories.
After considering the investment in inventories, the asset intensity or turnover is expected to
average about two times per year.
LearnRite estimates that venture investors should earn about a 40 percent average annual
compound rate of return and sees an opportunity for a possible initial public offering in about six
years. If industry consolidation occurs, a merger might occur even sooner.
The management team is headed by Srikant Kapoor who serves as President of
LearnRite.com and who personally controls about 35 percent of the ownership of the firm. Mr.
Kapoor has more than twelve years experience in high-tech industries including previous
positions with US West and Microsoft. He holds a B.S. degree in electrical engineering from an
Indian technology institute and an MBA from a major U.S. university. Sean Davidson, Director
of Technology has more than ten years of experience in software development and integration.
Walter Vu has almost ten years of experience in sales and business development in the software
industry including positions at Claris and Maxis. Mitch Feldman, Director of Marketing, was
responsible for six years for the marketing communications function and the Internet operations
of a large software company. Management strives for continual improvement in ease of user
interface, personalized services, and amount of information supplied to customers.
The total market for children’s entertainment is estimated to be $35 billion annually.
Toys account for about $20 billion in annual spending. Summer camps are estimated to generate
$6 billion annually. This is followed by children’s videos and video games at $4 billion each.
Children’s software sales currently generates about $1 billion per year in revenues and industry
sales are expected to grow at a 30 percent annual rate over the next several years.
LearnRite has made the following five-year revenue projections:
Year 2017 2018 2019 2020 2021
Revenues ($M) $1.0 $9.6 $30.1 $67.8 $121.4
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A. Project industry sales for children’s software through the year 2021based on the information
provided above.
2017 Market for Children’s Entertainment:
Industry
Year Forecasted Sales
B. Calculate the year-to-year annual sales growth rates for LearnRite. [Optional: Estimate the
compound growth rate over the 2017 through 2021 time period using a financial calculator
or computer software program.]
LearnRite
Year Forecasted Sales Sales Growth Rate
C. Estimate LearnRite’s expected market share in each year based on the above data.
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Year Industry Sales
D. Estimate the firm’s net income (loss) in each of the five years.
Year Net Income (Loss)
E. Estimate the firm’s return on assets beginning when the net or after-tax income is expected
to be positive.
Millions of Dollars: Return
Year Net Income / Forecasted Assets = on Assets
Note: Since the asset intensity or turnover is 2.00, total assets will be one-half of
forecasted sales. Alternatively, return on assets = net profit margin (10.0%) times
asset turnover (2.0 times) = 20.0%
F. Score LearnRite’s venture investor attractiveness in terms of the Industry/Market Factor
Category using the VOS Indicator
guide and criteria set out in Figures 2.8 and 2.9. If
you believe there are insufficient data, indicate that decision with an “N/A.”
Industry/Market Score
Chapter 2: Developing the Business Idea
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G. Score LearnRite’s venture investor attractiveness in terms of pricing/profitability factors.
Follow the instructions in Part F.
Pricing/Profitability Score
H. Score LearnRite’s venture investor attractiveness in terms of financial/harvest factors.
Follow the instructions in Part F.
Financial/Harvest Score
I. “Score” LearnRite’s venture investor attractiveness in terms of management team factors.
Follow the instructions in Part F.
Management Team Score
J. Determine overall total points and an average score for LearnRite as was done for the
Companion Systems Corporation in the Appendix. Items where information is judged to be
lacking and an NA is used should be excluded when calculating an average score.
The “labels” assigned in (F) through (I) for LearnRite can be summarized as follows:
Category Number x Points Per = Total Points
K. Provide a brief written summary indicating how you feel about LearnRite.com as a
business opportunity.
Chapter 2: Developing the Business Idea
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We have “scored” each of the 16 items. Of course, it could be argued that adequate
information might be lacking for one or more of the items and an NA could have been
We have assigned “average” scores to about two-thirds of the items, which accounts
for a score around 2. Of course, it is important we recognize that the venture