Nov 142012
 
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Should I Start A Business?  Probably Not.

Some people ask themselves this question quite often:  Should I start a business?  For most people, in my opinion and experience, the answer is,  “Probably not, at least not yet”.

The fact is that many startups have little chance of success from the outset.  They are ill conceived and often based solely on the entrepreneur’s desire to have their own business.  That is, they are not created to address a market need that the entrepreneur has identified; they are created in more of a hopeful, “if you build it, they will come” kind of way.

I’m not saying that such businesses can’t succeed, just as I’m not saying that people don’t win the lottery; they do, but the odds definitely are not in favor of such an outcome.

Many of the most successful entrepreneurs I know will not consider starting a business until someone comes to them and tells them that they have a need that is not being adequately served by the marketplace.  Since most of these entrepreneurs are not really passive types, they don’t sit around waiting for people to come to them with this news.  Rather, they constantly have feelers out for where businesses and consumers are experiencing frustration.

Successful entrepreneurs then sift through those frustrations to identify which ones are true business opportunities – the ones where customers are willing to pay sufficient sums of money to solve their problems.  Sufficient, in this case, is defined as “enough to make selling the product or service profitable to a level that it is worth making the investment and taking the risk to start and run the business”.

How many businesses do you know of that were started in this manner?  How many businesses have you started this way?  Again, I’m not saying you can’t be successful by just starting up and “course-correcting” along the way.  I’m just saying that you can do yourself a favor and increase your odds of success by identifying potentially profitable products and services before you invest the (serious) time, effort and many times, capital, necessary to get a business off the ground.

Understand, too, that it is not as though you are going to have a monopoly on the solution to a particular problem or frustration that the market is facing.  If you do, congratulations, but that would be highly unusual.  In most cases, once a particular business comes up on the radar as a decent profit opportunity, a lot of new entrants will come onto the scene.  At that time, in most cases, you can expect competition to increase significantly, which usually means there will be pressure on prices and profit margins.  That’s one of the reasons that it’s so important that the margins you expect at the beginning of the venture be very healthy; that way, they can take a hit and you can still have an attractive business.  Ideally, you should be looking for initial gross margins in excess of 60%.  Such businesses are not easy to find, but they’re out there.

Do yourself a favor and don’t put yourself behind the eight ball from the get-go by selecting a business that has weak margins from the outset, or worse yet, by selecting a business that has weak margins and does not address an identified market frustration / opportunity.  Entrepreneurship can be challenging in its own right, so don’t make it more challenging, or even impossible to succeed, by selecting a “dog” from the start.

I look forward to your thoughts!  Please leave a comment (“response”) below or in the upper right corner of this post.

Paul Morin

paul@companyfounder.com

www.companyfounder.com

 

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Oct 102011
 
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business plan

What Is A Business Plan For?

You always hear that you need a business plan, but is it true?  If you talk to ten experts, it’s likely that five will tell you “yes,” and five will tell you “no”.  At the end of the day though, even if you don’t “need” a business plan, that is, a written document titled “Business Plan,” the exercise of putting one together will benefit you and your company in a wide variety of ways.

As you’re no doubt aware, business plans are typically associated with raising capital, particularly when they are discussed in the context of startups and other early-stage businesses.  Once you move into the realm of more established companies, you’ll often hear business plan and “strategic plan” used interchangeably.  The bottom line is, regardless of what you call the document, in order to create it, unless you’re going to sit in a back room and “business plan in a vacuum” on your own, you will work with your team to research and write the plan.  In this work with your team, you will discuss the past, the present, and the anticipated future of your business.  These discussions will force you to consider issues and scenarios that may otherwise not come to light in the absence of such a planning process.  This alone has tremendous value.

So, if it’s a good idea to develop a business plan, what should the plan contain and what will be the collateral benefits of developing each section of the plan?

The contents of a business plan are somewhat subjective and what is considered essential will vary based on the expected audience for your plan.  Even so, there are some elements of a business plan that are required, regardless of whom the audience will be.  Those essential components include the following:

Executive Summary:  all plans should have a brief executive summary at the beginning.  Creating the executive summary will force you to boil your business down to its most important elements, offerings and benefits.  This is always a useful exercise.

Problem Description:  this section must make very clear the problem that your products and services will solve.  It is very useful to push yourself and your team to think about your business and your offerings in terms of the problems you are solving for your customers.  This forces you to move away from an inward-focused perspective that can be very dangerous.

Overall Market Description:  here you will want to provide as much pertinent information as you can about the market.  In addition to forcing you to get a good handle on the demographics of your market, this section will push you to assess the size and growth of your market.  You should describe your market in terms of number of customers and total sales, as well as how you anticipate these figures to look in the future.  No one can predict the future, at least not consistently, however making an effort to anticipate your market’s growth, based on all available sales data and other relevant metrics, will help you to develop a better understanding of the true opportunity and how to take advantage of it.

Market Niche(s):  Now that you’ve provided an overview of the market, it’s time to talk about the various segments or niches in the market and those you expect to target.  Again, going through this exercise will require analysis and assessment of the attractiveness of the relevant segments in your market.  As a small company, you don’t have the resources to go after the market as a whole, and even if you did, it wouldn’t likely be a good idea, so it’s very important to do this market segment analysis.  In the absence of a business planning process, it may be tempting not to do adequate analysis of the segments in your market and instead, take a “wait and see attitude,” likely biting off more than you could chew in the beginning.

Products/Services:  It’s critical that, based on the market research you do, particularly the analysis of the niches you will go after, you develop your products and services in a way that will have strong appeal to your target market.  Doing the necessary research and analysis in the business planning process will force you to consider all key aspects of your offerings, from features and benefits, to pricing and distribution.  Again, in the absence of a structured business plan and planning process, you may be tempted to just “wing it” unnecessarily on some of these issues.

Competition:   The first key point to make regarding competition is that as you think through and develop this section, remember that there is always competition.  In my experience, in the absence of a formal business plan and planning process, analysis of competition is the first thing to be overlooked.  Many entrepreneurs like to think and say that there’s “no real competition,” when in reality, that is hardly ever the case.  A structured planning process ensures that you will not just pay “lip service” to the existence of relevant competitors and substitutes.

Marketing Strategy/Tactics:  What will be your marketing strategies and tactics for selling your products and services to your target market?  It is very important to consider and budget for the marketing approach you will use in your business.  As in other areas of your business, no one is expecting you to be a fortune-teller here, however it is useful to consider your strategic options, start testing your chosen approach, then make adjustments based on the results you are achieving.  The alternative is to go in with no plan and just “shoot from the hip”.  While this may work in some circumstances, typically you will see better results if you know where you are trying to go, get started, then course correct as necessary.

Management Team:  It has been said many times that a potential investor cares more about having a good management team than about having the perfect product or service offering.  It is considered a truism among most experienced entrepreneurs and investors I know.  Yet this is an area where entrepreneurs in early stage and mature businesses alike don’t tend to spend much time thinking and strategizing.  A lot of times, the entrepreneur has the mindset that they’ll take the lead on all important projects, so it doesn’t really matter who comprises the rest of their team.  I’ve yet to see this mindset pay off in situations where a business achieves any real growth.  Worse yet, it’s often the case that businesses are impeded from achieving their growth potential due to not having the right leadership team in place.  A structured business plan and planning process will force you to at least consider the composition of the optimal management team for your business.  In so doing, you likely will identify current and potential future management team deficiencies that you will need to address.

Financial Summary:  This is the section of the plan that gives non-financial and non-quantitative people the most pause.  In fact, in my observation, this is the section that causes many to not even bother starting the business plan.  They don’t understand it and they realize that it will not be an easy road to understand it.  That said, if you are starting a business or currently running a business, you must have a basic understanding of break-even, profitability, and financial statements if you want to increase your probability of having a successful business.  It is very difficult to effectively run an enterprise, if you do not at least understand the basics of how to “keep score”.

The essential elements that you’ll want to include in your Financial Summary include the following:

Break-even Analysis:  a calculation of the point at which the company covers all its fixed and variable costs.  Although it may look and sound daunting, it is a very simple calculation, especially when you’re just “thumbnailing” it.

Key Assumptions:  a description and quantification of those elements about which you don’t have certainty that will play a role in your financial model.  Unless you possess supernatural powers to know the unknown and predict the future, you will not be certain about the values of all the variables that will go into your financial projections.

Projected Financials:  here, based on your assumptions, you will project the three major financial statements:  the Income Statement, the Balance Sheet, and the Cashflow Statement.  The Income Statement provides the reader with a window into the expected revenues, costs and profitability of the company.  The Balance Sheet provides a snapshot of the company’s assets, liabilities and equity at a particular point in time.  The Cashflow Statement does exactly what its name implies – it provides the reader with a window into the cashflows based on the company’s operating, investing and financing activities.  The three financial statements are inextricably linked and you’ll need to project all three to provide a full understanding of the expected financial performance of the venture.

Key Financial Indicators:  Based on the projected financial statements, in this section you will provide the reader with financial ratios that can yield insights into the potential financial strengths and weaknesses of the venture.  These ratios indicate such things as liquidity, profitability, return on equity and asset utilization, among others, and are important for gaining an understanding of the likely financial attractiveness of the venture.

Capital Requirements:  One of the reasons you’re creating a business plan may be to raise money from equity investors or get a loan from a bank.  Any potential investor will be very interested in the projected financial statements you created above.  They will also want to see a more specific breakdown of the capital requirements you see for the venture, into the future.  The relevant time horizon will vary, but you’ll want to project this for at least five years.  These capital requirements can result from several potential factors, but the largest chunks are likely related to expenditures on equipment and facilities, startup costs, including the hiring of key senior and technical staff beyond the founders, and working capital.

Conclusion

At the end of the day, even if you don’t believe it’s important to create a document called “Business Plan” or “Strategic Plan,” hopefully I’ve convinced you that the business planning process almost always has value.  The majority of that value usually derives from the insights you gain into the potential opportunities and pitfalls of growing your business.  Further, the process of business planning allows you and your team to “get on the same page” and develop a common “language” and understanding of the issues of your particular business, its target markets, growth potential, and so on.  Having your team aware of the same goals, risks and opportunities, is invaluable as you navigate your business toward achieving its full potential.

I look forward to your thoughts and questions.  Please leave a comment (“response”) below or in the upper right corner of this post.

Paul Morin

paul@companyfounder.com

www.companyfounder.com

 

Don’t miss an issue of Company Founder! Subscribe today.  It’s free.  It’s private.  It’s practical information for entrepreneurs and leaders interested in taking it to the next level.

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Sep 122011
 
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How to write a bad business plan

How To Write A Bad Business Plan

You’ve heard you need to have a business plan, so you figure you’ll throw one together and get it over with, right?  This article talks about how to write a “bad” business plan.  It also explains how to avoid these common errors.  Well, it explains a bit.  Really, it would be best if you’re good with irony and inference, as this article is mainly about what’s to be found in bad business plans.  Note: for anyone thinking about quoting from this article or following its advice verbatim, as I point out below, hopefully you’ll pick up on the irony and can infer what to do from what not to do.  For everyone else, see Business Plan Basics – The Essential Elements of a Good Plan.

The contents of the business plan typically should vary based on the expected audience for your plan.  However, given that this is how not to write a good business plan, we won’t differentiate for particular audiences.  They’re all the same, right?

Here’s what a bad business plan would include and a few suggestions to avoid being “bad”.  Please note that many experts don’t believe a business plan is necessary, so think twice before putting massive effort into writing one.  By the way, while I don’t think a full business plan is the first step you should take in launching your business, the planning process should help you to gain many insights into the venture you are considering launching.  So, even if you’re not big on the plan itself, in my experience, the process of putting it together can bring a lot of risks and opportunities to the surface.

So, here we go.  Make sure your bad business plan includes the following (remember, it’s “opposite day”):

Executive Summary:  Most people who read your plan won’t be very busy, so don’t bother with a summary.  Better yet, if you do include a summary, make it ten pages long, or somewhere around twenty-five percent of the document.

Problem Description:  Be sure not to discuss any specifics in this section.  Speak in generalities.  Talk about how there is a big problem and it’s likely to keep getting bigger, given that no one is really doing anything about it.

Overall Market Description:  Again, speak in generalities.  Be sure to use older data about the market and explain how the market really hasn’t changed that much in the last ten years, so the older data should be a pretty solid indicator of the current opportunity.  Be sure to describe the expected tremendous growth over the next several years.

Market Niche(s):  Pick a couple of market segments that you think will pique the interest of the readers of your plan.  Again, don’t get into too many details about their size, but talk about how great they are and how all the best buyers are in those segments.  Be sure to point out how those buyers are not particularly price sensitive, so the niche you’re targeting should therefore be a lot more profitable than the rest of the market.

Products/Services:  Describe how your products and services perfectly solve the problems of the market and especially of the price-insensitive segments you are targeting.  Be sure to refer to your offerings as “world beaters” and highly innovative.  It also helps to use the word “revolutionary” wherever possible.  Explain how nothing has come along like this in a long time, really since sliced bread.

Competition:   The first thing you should point out is that you really don’t have any competitors.  Not only are there no competitors, there are really no substitute solutions that do exactly what yours does for the market.  Be sure to hit this point very hard, as investors and other consumers of business plans love to hear that no one else has paid any attention to this tremendous need you’ve identified in the market.

Marketing Strategy/Tactics:  Here is where you talk about how you’ll let your target market and the rest of the world know about the great solutions you’re bringing to the marketplace.  This section won’t require a lot of work, as given the quality of your products and services, you likely won’t need to market and sell a lot.  Word should travel and “word of mouth” marketing should take over, creating a “viral” spread of praise regarding your company and its offerings.

Management Team:  It has been said many times that a potential investor cares more about having a great management team than about having the perfect product or service offering.  It’s just a saying though, right?  You’re just starting out.  Don’t worry too much about what your management team will look like.  Given all your talents, you should be able to do most everything yourself, at least at the beginning.  In this section, just include a large bio for yourself and reference a few other people who may join the business if all goes well.

Financial Summary:  This is the section of the plan that gives non-financial and non-quantitative people the most pause.  It’s not easy to put together a good financial summary, as in order to do so, you need to do a bunch of financial analysis in the background.  It’s not possible to predict the future, so why try, right?  Just include a bit about how fast you think the sales will grow and how profitable you think the company will be.

Break-even Analysis:  this is a calculation of the point at which the company covers all its fixed and variable costs.  Since you will not be doing financial analysis, don’t worry about this.

Key Assumptions:  in an ideal world, you’d try to do as much research as possible to justify your assumptions on both the cost and revenue side.  That would be a lot of work though!  Go ahead and just take some guesses based on your experience.  Don’t worry; everyone does it!

Projected Financials:  here, based on your assumptions, you may want to project the three major financial statements:  the Income Statement, the Balance Sheet, and the Cashflow Statement.  But that too would be a lot of work.   Just focus on the Income Statement.  Don’t worry about using a spreadsheet, as you won’t be using any formulas.  You can just type the info into a Word table.

Key Financial Indicators:  Don’t worry about this.  It’s too much detail.

Capital Requirements:  One of the reasons you’re creating a business plan may be to raise money from equity investors or get a loan from a bank.  While most potential investors will be very interested in what you expect to do with the investment, don’t worry about it.  That’s not your issue.  They’re professionals.  They should be able to figure it out, right?

Conclusion

So in the end, the business plan is not so complicated.  It’s particularly easy if you follow the advice in this article for how to create a bad business plan.  Whatever you do, don’t follow the advice of this article verbatim.  This article highlights everything you should not do in a business plan, or in any kind of document or presentation where you are trying to convince others that you have a compelling business opportunity and you’re the one to take advantage of it.  This article was written in this contrarian mode in the hope that it will startle some folks into reality.  Without exaggeration, I have seen thousands of business plans and investor pitches in my career.  I can tell you that a large percentage of them commit some, if not most, of the errors described above.  Don’t write the next bad business plan.  For more advice on what you should include in a business plan, see the following article on the CompanyFounder.com blog:

Business Plan Basics – The Essential Elements of a Good Plan

I look forward to your thoughts and questions.  Please leave a comment (“response”) below or in the upper right corner of this post.

Paul Morin

paul@companyfounder.com

www.companyfounder.com

 

Don’t miss an issue of Company Founder! Subscribe today.  It’s free.  It’s private.  It’s practical information for entrepreneurs and leaders interested in taking it to the next level.

Go to the right-hand navigation bar near the top of the page, enter your email and click subscribe.  We respect your privacy and will not sell your email address.  Note:  once you subscribe, if the confirmation email doesn’t arrive, check your spam filter.  It usually makes it through, but we’ve had a few get caught up in the filter..

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Sep 012011
 
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7 Deadly Sins of Startups From a Valuation Perspective

7 Deadly Sins of Startups From A Valuation Perspective

With unemployment high and good job opportunities scarce, many displaced workers are taking the entrepreneurial route and starting their own businesses.  They are hoping their skills from years of employment, often at large companies, will translate into successful small business ownership.  Many are purchasing franchises or existing businesses, while others are using their own ideas or hobbies to start their own unique businesses.  As a result, Small Business Administration (SBA) guaranteed loan applications have soared and ROBS (Rollovers as Business Startups) plans that enable workers to rollover funds from 401k retirement plans to purchase or start a business without adverse tax consequences, have flourished.  The valuation analysis required by both these funding mechanisms has revealed common flaws in these new businesses.  As a result of our active participation in the valuation of businesses for these purposes, we have identified seven common “sins” of business startups from a valuation perspective. For a perspective more oriented toward what venture capitalists and high-end “angel investors” focus on, see 11 Things Venture Capitalists Look For.

1.       The First Deadly Sin—No Financial Projections

The value of most businesses is the sum of the present value of the cash flows expected to be generated in the future.  Amazingly, many entrepreneurs and new business owners are unable to provide a set of financial projections or budgets and the underlying assumptions.  Many believe that growth of the business will just happen and that they will react to that growth by paying the bills, making purchases, etc.  The most successful small business owners prepare, in advance, a forecasted income statement (or budget) and balance sheet that detail: expected revenue growth over the next three to five years, cost of goods sold, fixed costs or overhead, profitability, and how this translates into cash flow, the need for additional asset purchases, etc.  The financial projections may show, for example, that the business will not reach break-even in the first year and that the business will incur financial losses that will use cash on hand or require additional cash infusions to continue operations and pay the bills.  The financial projections may also reveal that the company is unable to service any debt or generate sufficient cash flow to enable the owner to take a salary.  All of these are significant problems that a relatively simple set of financial projections should reveal to the new business owner.

On the flip side, many startup business owners do create a set of financial projections, but they are based on underlying assumptions that are unrealistic.  For example, some startups may be expected to experience rapid growth in the first few years; however, there is a limit to that growth and the ability of the business to sustain that growth.  With growth of a startup come certain expenses that should be anticipated, such as the need for additional staffing, supplies, purchases of raw materials, etc.  Failure to plan and anticipate this can lead to cash flow problems.  Cash is king for any business.  Lack of cash or lack of access to funds to support operations can quickly lead to bankruptcy and closure of the business.

From a valuation perspective, the lack of financial projections, or providing unrealistic financial projections without supporting assumptions, suggests to the business appraiser that the entrepreneur is “wet behind the ears” or fails to understand the implications and necessity of financial planning.  Typically, this has a negative effect on the likelihood of success and therefore, on the current and projected value of the business.

2.       The Second Deadly Sin—No Formal Business Plan

Along the lines of the first deadly sin, the lack of a formal business plan is also common among small businesses and startups.  New entrepreneurs often mistakenly believe that opening a business and putting a sign outside is enough.  It is usually the business plan that segregates viable businesses from an entrepreneur’s hobby that they hope to make into a business.  In some cases the hobby may be a viable business.  Successful entrepreneurs create a thoughtful and realistic business plan prior to opening the business to determine if the business is feasible both financially and operationally.  The business plan includes aspects such as how the business is going to market itself and generate revenues, its target market, operational plans such as staffing requirements, supplier analysis, capital budgeting or expectations regarding the need for fixed assets to start the business or maintain operations and meet growth demands, etc.  The business plan is the roadmap for the entrepreneur, telling where they are going, how they are going to get there, and what resources they need to get there.  A business plan that is well thought out and researched does not necessarily have to be a one hundred page document, but it should be sufficiently long to provide insight into the expected operations and “path” of the business.

The lack of a formal business plan in the valuation process once again suggests that the entrepreneur may not understand the importance of planning for various aspects of the business.  Just as the absence of a business plan bodes poorly for the value of the business, an unrealistic or haphazardly prepared business plan also instills little confidence in the business appraiser with regards to the entrepreneur’s ability to be successful.  A similar statement can be made about the likely confidence level of prospective investors.

3.       The Third Deadly Sin—No Break-even Analysis

A key part of the financial projections and business plan is for the entrepreneur to conduct a break-even analysis.  The traditional break-even analysis reveals what level of sales a business must achieve to cover both the variable costs (cost of goods sold) and the fixed costs (overhead), resulting in $0 profitability.  Beyond the break-even point, the business should be generating profits.  Until the company reaches its break-even point, the business must have adequate financial resources to pay the bills and fund ongoing operations.  Conducting a break-even analysis should enable the entrepreneur to test the reasonability of the business plan and financial projections.  For example, if the business needs to produce and sell 5,000 widgets per month to reach break-even but the capacity is only 4,000 widgets per month, the entrepreneur has a significant problem and will either need to cut costs to lower the break-even point or increase capacity to produce more products.  In addition to traditional break-even analysis, an entrepreneur may conduct a cash flow break-even, which shows how much must be sold for the business to begin generating positive cash flow.

A business appraiser will often consider the startup’s break-even point in the analysis of future returns and risk.  The break-even analysis can make the difference between the business having a value of $0, implying the business won’t survive, and a positive value and future prospects.

4.       The Fourth Deadly Sin—Operating On Shoestring Budget/No Working Capital

Too often, entrepreneurs believe the business will quickly generate enough cashflow to sustain operations and, thus, enter into the new business with insufficient financial resources.  They may try to operate on a shoestring budget until the business reaches cashflow break-even out of necessity due to a lack of access to additional financial resources.  This may involve getting behind on paying bills, which could hurt the business’s credit and relationships with suppliers and vendors.  Obviously, in the absence of access to additional funding sources or lines of credit, the lack of cash also can quickly result in the closure of a business.  Unexpected or unanticipated expenses can quickly lead to financial problems and growth constraints for shoestring operations.  For example, the need for an additional employee to accommodate demand, but not having the funds to hire, can constrict the business’s growth and profitability.

But just as important, business growth changes a business’s working capital.  For example, more sales create more accounts receivable and accounts payable.  The payables can’t be paid until the receivables are converted to cash without using other cash resources.  This lag can create cash flow problems for any business, particularly a startup whose financial resources often are more limited.  Adequate business planning and financial analysis at the outset can help identify potential working capital needs at various critical points in the company’s growth, enabling the entrepreneur to make arrangements for lines of credit, additional capital, etc.

From a valuation perspective, businesses that operate on a shoestring budget have high operating risk, which tends to increase overall risk and lower overall value.  In addition, inadequate working capital or lack of planning for working capital needs tends to increase the financial risk profile of a business and lower the value as well.

5.       The Fifth Deadly Sin—Lack of Startup Managerial Experience

While many startup entrepreneurs have experience in a corporate setting, few have had experience actually running an entire operation on their own.  In a corporate setting, there are already established relationships, financial resources, and managerial depth across other key functional areas of the business.  Usually, in a corporate setting, the functional areas are also managed by different people.  For example, human resources handles hiring and staffing issues, accounting handles the financial aspects and bill paying, the marketing department handles the marketing, and so on.  The entrepreneur who has come from the corporate world has likely been predominantly working in their own functional area with their unique and specialized responsibilities (except in some instances when they have been a high-level executive with full P&L responsibility).  In the entrepreneurial setting, however, they typically must wear several different hats, handling and overseeing sales staff, the accounting function, marketing, etc.  Those entrepreneurs who do not have significant cross-functional experience are often starting their business at a disadvantage, which may be evident in the lack of a business plan, financial projections, and other factors as previously discussed.  While startup ventures often require the entrepreneur to be the “chief cook and bottle washer,” no one can do it all; in most cases, it cannot be a one man show (with the exception being some professional services).  The most successful entrepreneurs have a solid understanding of all functional areas, but also surround themselves with other individuals who may have more experience in particular key aspects of business operations.  For example, a restaurant owner who is also a chef may have a mastery of back of the house operations but limited experience with front of the house operations, necessitating an individual with a skill set to fill that gap.

The business appraiser will typically consider the entrepreneur’s experience or lack thereof in valuing the business.  Individuals with little or no experience are usually considered much more risky than individuals with extensive business backgrounds, particularly if their experience is in the same industry of the new startup.  A higher entrepreneurial risk profile stemming from lack of experience will likely result in a lower value for the business.  While it is not always the case, a more extensive background and level of experience may tend to reduce the risk profile of the startup and increase the value, all else being equal.

6.       The Sixth Deadly Sin—Unrealistic Growth Expectations

Planning for too little growth and trying to play catch up when growth exceeds expectations creates a number of challenges, such as the need to expand operations and capacity and the resulting requirement for capital expenditures and potentially, additional financial resources.  However, planning for too much growth is just as bad, if not worse, in that overinvestment in equipment and materials reduces asset efficiency and return.  As mentioned before, some startup businesses are likely to experience extremely rapid growth in the first few years of operations.  However, the growth of a startup is not limitless and is bound by, among other factors, the business’s capacity to produce its goods and services.   It is easy for an entrepreneur to exhibit “irrational exuberance” when it comes to growth.  In creating growth expectations, the entrepreneur should first consider the maximum potential output of its goods or services based on available equipment, human capital, etc.  Growth over and beyond that level will require additional capital investment, as well as more financial and human resources.  In forecasting growth, the entrepreneur should, of course, also take a close look at the potential demand for its goods and services by considering the markets being served, the competition, and the potential market share that the company may gain given the size, scope, and competitive landscape.

Unrealistic growth expectations typically are easily spotted.  For example, a maker of gourmet marinades has initially good growth potential.  However, its facility can only produce enough cases annually to equal a 1% total market share.  Based on the competitive landscape, the company would need significant investment in advertising to build brand awareness in order to potentially increase its market share to 5%.  However, the revenue expectations as expressed in the company’s financial projections suggest production in the second year that is beyond the facility’s capacity and the financial projections do not account for additional capital expenditures or advertising campaigns.  Fixed costs grow by only 2% in the financial projections, yet by the fifth year, revenues for the company imply a market share of over 15%!

Based on these inconsistencies, the growth expectations obviously are “pie in the sky”.  The business appraiser will likely notice this glaring error, which tends to undermine the integrity of the financial projections as well as the credibility of the entrepreneur.  As a result, the value is likely to be negatively impacted.

7.       The Seventh Deadly Sin—No Risk/Return Analysis

One of the most difficult considerations for an entrepreneur is the risk/return analysis of the potential business venture.  An incomplete or poorly-reasoned risk/return analysis on the part of the entrepreneur may lead a savvy financial investor to turn down a potential investment in the business in favor of an apparently less risky opportunity.

Even in a world with the global financial system and markets turned upside down, there is a relatively clear relationship between risk and return.  An investor in a higher risk investment should be compensated with a higher return.  For example, an investor in a risk free asset such as US Treasury bonds would expect a return of roughly 4%.  An investor in a publicly-traded, blue chip company (a utility company, for example) may expect a dividend yield of 5-6%.  Corporate bonds have returns of 5% and higher.  A well diversified investment portfolio may have a return in the 6-12% range.  “Junk bonds” have returns of 12% or higher.  Venture capitalists expect annual compounded returns anywhere from 30% and up for “risky” equity investments in startup ventures.  Entrepreneurs should recognize that owning their own business involves significant risks.  As such, any investor (whether it is themselves or a financial buyer under the fair market value standard in business valuation) would expect a return significantly higher than that on Treasury bonds, a diversified portfolio of publicly-traded stocks, etc.

For example, suppose an entrepreneur invests $500,000 of his or her own money into their business.  For the first two years, they expect losses which they finance with external debt.  After three years, they are projecting a net cash flow to equity of $20,000, representing actual cash available for distribution as a dividend at year end.  The return in this case is only 4%, which is hardly enough to compensate for the level of risk.  A financial investor would likely opt for any one of a number of other potential investments that offer a higher projected return for an apparently lower level of risk.  For the entrepreneur, however, the investment in the business only makes sense if they factor in their $20,000 net cash flow along with their projected salary and benefits of $50,000, for a total return of $70,000 or 14%, in year three.  The financial investor will receive no salary, so the return calculation is not as attractive for them.

Many entrepreneurs are new to the business world and are overwhelmed with emotions that may tend to cloud their investment decisions.  The most successful entrepreneurs are those who proactively address the seven deadly “valuation sins” of business startups prior to starting operations.  Business owners who are reactive in dealing with these “sins” generally find themselves at a disadvantage, which can often lead to failure.  Entrepreneurs should seek to maximize the value of their business.  To do so, they must address these seven deadly sins or be prepared to face the negative valuation ramifications.

This article was written by Robert M. Clinger III and Paul Morin.  For more information on Robert M. Clinger III and Highland Global (HG), see www.HighlandGlobal.com.  For more information on Paul Morin, see HG and www.CompanyFounder.com/about.

Please leave your comments and questions below or in the top right corner of this post.

Paul Morin

paul@companyfounder.com

www.companyfounder.com

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Jul 242011
 
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How To Start A Business

Even though these days I often deal with entrepreneurs and senior-level managers who are much further along in their entrepreneurial careers, I still frequently get asked how to start a business.  Amazingly it’s often these further along and usually successful entrepreneurs or larger corporations who are asking me how to start a business correctly!  How can this be?!  Didn’t I just get done saying that they’re experienced and usually quite successful already?

As it turns out, many folks who have been in entrepreneurship their whole lives and have attained some significant success have never really thought through how to start a business.  Instead, they have subscribed to the “just do it” mentality.  In my experience, while this approach can frequently lead to success, it a can much more often lead to failure.  Granted, in any large group of people just “throwing it against the wall and seeing if it sticks,” there will be successes, some of them notable.  That said, just because there some successes with that approach doesn’t mean it is the way to go.

In my experience and observation, the best answer to “how to start a business” is carefully and deliberately, but with a great deal of confidence and belief.  Just because you take a meticulous, well-thought-out approach does not mean that you’re not an entrepreneur!  In fact, the best entrepreneurs do just that.  They take a measured, deliberate approach to assessing and starting up each business they get into.  They are willing to take risks, but they greatly prefer to take calculated risks and they are willing to constantly update their approach based on the ongoing feedback they receive from their target market(s).

These days, when I’m asked how to start a business, I provide the following steps.  While it is not intended to be an exhaustive list of what needs to be done, and the order of the steps may change slightly depending on the particular situation, I have used and seen this approach used successfully many times.  As one of my mentors told me early in my career, “you want have a powerful plan that can change”.  You must be willing to adapt to changing circumstances and feedback.  You must not be rigid in your behavior.  You must believe that you can succeed, but you must be flexible.

Here are the “how to start a business” steps.  Posts elsewhere on this blog go into greater detail on most, if not all of the steps.

1.)    Understand profitability and break-even analysis — too many people go into business not understanding these basic concepts.

2.)    Understand upside goals and potential — what kind of business are you trying to create? Does the business you are starting right now match your objectives?

3.)    Screen and sort your ideas/opportunities using criteria that make sense.

4.)    Understand the psychology of markets and niches.

5.)    Develop products and/or services that meet a true market need.

6.)    Understand and select appropriate marketing strategies.

7.)    Deploy appropriate marketing tactics.

8.)    Create a full, formal business plan.

9.)    Strive for operational excellence.

10.)  Replace yourself/sell your “baby”.

It should also be noted that you may choose to raise capital at any point along this process.  However, I would suggest that you should not seek to raise capital from angel investors or venture capitalists until you’ve at least reached Step 5, where you are developing products or services based on a true market need.  Depending on how well you know the angel investors and/or venture capitalists, and depending on how much capital you are seeking to raise, you will also likely need to have a formal business plan completed before it makes sense to approach them.  As discussed elsewhere, angel investment and venture capital don’t make sense for a large percentage of start-ups, so before investing a great deal of time in approaching them, be sure you have a business with characteristics that make sense for that type of equity investor.

I look forward to your questions and comments.

Paul Morin

paul@CompanyFounder.com

www.CompanyFounder.com.

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Apr 162011
 
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business plan basicsIf you’re starting a business, everyone knows that you have to have a business plan, right? Well, you may be surprised to hear that many of the greatest businesses we know today were started without any business plan. In fact, in my opinion, writing a business plan is not the first, but the eighth step in starting a business. That being said, I do think it’s important to have a business plan, even if it’s not a fancy 100-page document. The process of putting the plan together, if not the physical plan itself, can have great value in how you think about and grow your business. So, if it’s a good idea to develop a business plan, what should the plan contain?

The contents of a business plan are somewhat subjective and what is considered essential will vary based on the expected audience for your plan. Even so, there are some elements of a business plan that are required, regardless of whom the audience will be. Those essential components include the following:

Executive Summary: all plans should have a brief executive summary at the beginning, and given that many readers will never make it past this section, it should be concise, well-written and full of key information that will pique the interest of the reader.

Problem Description: this section must make very clear the problem that your product and/or service will solve. It should leave no doubt that you are not speculating that such a problem exists, but rather have done sufficient primary and secondary market research to confirm that there is a real need in the market, and one that people or companies are willing to pay you to solve.

Overall Market Description: here you will want to provide as much pertinent information as you can about the market. It’s key to keep the information relevant to the problem you are solving. Try to get as much current data as you can and try to size the market, both in terms of the number of potential customers and the potential dollar volume per year. Provide an indication of expected growth or decline in the market over the next five to ten years.

Market Niche(s): Now that you’ve provided an overview of the market, it’s time to talk about the various segments or niches in the market and specifically, go into greater detail regarding those you expect to target. Discuss why these segments are most relevant and attractive from your perspective and indicate how you expect to go after them. It is also important here to provide an indication of the size of these segments and how they fit into the overall market that you described above.

Products/Services: While you may have touched briefly in Problem Description on the products and services you will be offering, this is where you’ll go into greater detail, including how they will solve market needs better/cheaper/faster than the solutions currently available. Here you will want to cover the important characteristics of the offering, as well as the various versions you expect to bring to the market, based on the unique needs and desires of the particular niches you will be targeting. It is in this section that you will also cover the pricing of your offering and why your intended price points make sense in the context of the existing market and its expected evolution.

Competition: The first key point to make regarding competition is that as you think through and develop this section, remember that there is always competition. While there may be no competitors do exactly what you are expecting to do in the market, if a need exists, without a doubt there are alternative or substitute solutions being proposed to the market by other providers. There are very few situations where this is not the case. So, do yourself a favor and acknowledge that there is competition, however minimal or ineffective it may be. You will want to describe the existing competitors and their offerings, including the pricing. You will also want to point out their strengths and their deficiencies and where you think your offering will be more appealing to the market. Base your statements on primary and secondary research, not foundationless assertions. Don’t business plan “in a vacuum”.

Marketing Strategy/Tactics: What will be your marketing strategies and tactics for selling your products and services to your target market? It is in this section that you will exhibit your market knowledge and insights into the buying habits of the target market. You will discuss the typical buying process/cycle for the products and services you are introducing and you will describe any innovations you expect to bring to this process. For example, does your target market respond best to being sold through the internet, or have they never bought anything in your space unless it was sold by a salesperson face-to-face? A lot of the answers here will of course depend on the complexity and price point of your offering. If you expect to take a very innovative approach to marketing and selling to your target market, your argument will be a lot more compelling if you have done tests and primary market research to prove that the market is open to such an approach. Human behavior is not easy to change, and this is not lost on potential investors.

Management Team: It has been said many times that a potential investor cares more about having a good management team than about having the perfect product or service offering. In fact, it has been said so much, that it is largely taken as a truism by those in the entrepreneurship field. Why would this be? Well, veteran entrepreneurs and investors know that very few successful businesses end up being successful based on the exact formulation on which they were founded. Typically there are many course corrections that need to take place – the business and the offering morph as the founders and their team get more feedback from the marketplace. Given this reality, no one expects a perfect formulation of the business at the outset, but most realize that if the management team is not apt, it will have a very hard time making the ongoing adjustments necessary to become successful. So, in this section, you must describe your management team and why you believe that in this particular marketplace, you think your team is the right one to make your company a success as the business grows and evolves.

Financial Summary: This is the section of the plan that gives non-financial and non-quantitative people the most pause. In fact, in my observation, this is the section that causes many to not even bother starting the business plan. They don’t understand it and they realize that it will not be an easy road to understand it. That said, if you are starting a business, you must have a basic understanding of break-even, profitability, and financial statements if you want to increase your probability of having a successful business. You don’t need to become a “numbers person” or a “quant jock” overnight, but you do need to be willing to step outside your comfort zone a bit, so you can understand how the world keeps score in business, which is by use of financial information. There are programs to help you put the financials together and there are also people out there who will help you put them together quite affordably. However you decide to approach it, make sure that you are not simply handing it off to someone else, without developing at least a basic understanding of the subject matter yourself. It is very difficult to effectively run an enterprise, if you do not at least understand the basics of how to “keep score”.

The essential elements that you’ll want to include in your Financial Summary include the following:

Break-even Analysis: a calculation of the point at which the company covers all its fixed and variable costs. Although it may look and sound daunting, it is a very simple calculation, especially when you’re just “thumbnailing” it. You’d do yourself and the readers of your plan an injustice if you didn’t do this calculation.

Key Assumptions: a description and quantification of those elements about which you don’t have certainty that will play a role in your financial model. Unless you possess supernatural powers to know the unknown and predict the future, you will not be certain about the values of all the variables that will go into your financial projections. For example, you will not know with certainty at what price or rate your offerings will sell in the marketplace, so you’ll need to make estimates or assumptions. You will have many assumptions, with some having a very important impact on your projections and others having a minimal impact. In this section you will want to focus on the important assumptions and describe them in as much detail as practical, to give yourself and the readers of your plan an indication of their variability and their importance in your financial projections.

Projected Financials: here, based on your assumptions, you will project the three major financial statements: the Income Statement, the Balance Sheet, and the Cashflow Statement. The Income Statement provides the reader with a window into the expected revenues, costs and profitability of the company. The Balance Sheet provides a snapshot of the company’s assets, liabilities and equity at a particular point in time. The Cashflow Statement does exactly what its name implies – it provides the reader with a window into the cashflows based on the company’s operating, investing and financing activities. The three financial statements are inextricably linked and you’ll need to project all three to provide a full understanding of the expected financial performance of the venture.

Key Financial Indicators: Based on the projected financial statements, in this section you will provide the reader with financial ratios that can yield insights into the potential financial strengths and weaknesses of the venture. These ratios indicate such things as liquidity, profitability, return on equity and asset utilization, among others, and are important for gaining an understanding of the likely financial attractiveness of the venture.

Capital Requirements: One of the reasons you’re creating a business plan may be to raise money from equity investors or get a loan from a bank. Any potential investor will be very interested in the projected finanical statements you created above. They will also want to see a more specific breakdown of the capital requirements you see for the venture, into the future. The relevant time horizon will vary, but you’ll want to project this for at least five years. These capital requirements can result from several potential factors, but the largest chunks are likely related to expenditures on equipment and facilities, startup costs, including the hiring of key senior and technical staff beyond the founders, and working capital.

Conclusion

So in the end, the business plan is not so complicated. It will however take a significant amount of time and effort to complete to a reasonable standard. Sure, you could take shortcuts and put a lot of guesswork into your plan, but that would serve neither you nor the readers of the plan. Particularly in the area of understanding the needs and behavior of the market, put the time in to do sufficient primary and secondary market research to establish that there is actually going to be demand at a profitable pricepoint for your offering. If there is no demand for what you bring to market, nothing else will matter and you will have wasted a great deal of time, effort and money.

We’d love to hear your comments and question about developing your business plan. Leave a comment below or in the top right hand corner of this post.

Paul Morin
CompanyFounder.com
paul@companyfounder.com
Twitter: @companyfounder.

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Oct 062010
 
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You must plan in the real world, with facts, not fiction.  In other words, don’t plan “in a vacuum”.  I can’t tell you the frequency with which I’ve seen this one – an entrepreneur with a “great idea” that he or she cooked up over coffee or drinks, entirely isolated from the target market.  Related to the “show me your first five customers” rule and the “don’t drink your own bath water” rule, this one is meant to strongly caution you against planning a business based on an unconfirmed reality (a fantasy).  We all say we won’t plan in a vacuum, but the reality is that correctly planning for a business is hard work – it takes a lot of time and resources, and it’s frustrating.  It’s so much easier just to make up your own facts and go from there.  Don’t be tempted – sure you can try to define your own reality – but just make sure that your reality is at least grounded in some facts.  First and foremost, make sure that your venture fills a legitimate need.  Next, make sure that there are people willing to pay for your solution.  Last but not least, make sure that you can make a solid return by providing your offering at a price the market is willing to pay – a sufficient return to make it worth the risk, time, effort, and other resources you will need to commit the venture..

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