Entrepreneurial Finance
Leach and Melicher – fourth edition
Chapter 1: Background and Environment
The entrepreneurial process comprises: developing opportunities, gathering resources, and
managing and building operations, all with the goal of creating value. The second aspect of a
successful entrepreneurial process involves gathering the physical assets, intellectual
property, human resources, and financial capital necessary to move from opportunity to
entrepreneurial venture. The third piece of the entrepreneurial process is managing and
building the venture’s operations. An effective business model must generate revenues to
cover operating costs in the foreseeable future. An intersection of all three components is
creating value. Each of the components contributes to the overall value.
It is suggested that entrepreneurship is a way of thinking, reasoning, and acting that is
opportunity obsessed, holistic in approach, and leadership balanced for the purpose of value
creation and capture. A shorter definition would be: the process of changing ideas into
commercial opportunities and creating value. An entrepreneur is an individual who thinks,
reasons, and acts to convert ideas into commercial opportunities and to create value.
We want to avoid most generalizations about entrepreneurial traits or characteristics, but
there are three important to consider. First, successful entrepreneurs recognize and seize
commercial opportunities, frequently before others even have an inkling of their potential.
Second, successful entrepreneurs tend to be doggedly optimistic. Third, successful
entrepreneurs are not consumer entirely with the present.
Entrepreneurial opportunities are ideas that have the potential to create value through new,
repackaged, or repositioned products, markets, processes, or services. Megatrends are large
societal, demographic, or technological trends or changes that are slow in forming but, once
in place, continue for many years. In contrast, fads are not predictable, have short lives, and
do not involve macro changes. Of course, there are many degrees between fads and
megatrends that provide entrepreneurs with business opportunities.
We emphasize seven principles of entrepreneurial finance:
1. Real, human, and financial capital must be rented from owners.
2. Risk and expected reward go hand in hand.
3. While accounting is the language of business, cash is the currency.
4. New venture financing involves search, negotiation, and privacy.
5. A venture’s financial objective is to increase value.
6. It is dangerous to assume that people act against their own self-interests.
7. Venture character and reputation can be assets or liabilities.
The owner-manager (agency) conflict refers to the differences between manager’s self-
interest and that of the owners who hired him. Next, the owner-debt holder conflict is the
divergence of the owners’ and lenders’ self-interests as the firm gets close to bankruptcy.
,Entrepreneurial finance is the application and adaptation of financial tools, techniques, and
principles to the planning, funding, operations, and valuation of an entrepreneurial venture.
Entrepreneurial finance focuses on the financial management of a venture as it moves through
the entrepreneurial process. Financial distress occurs when cash flow is insufficient to meet
current liability obligations. Anticipating and avoiding financial distress is one of the main
reasons to study and apply entrepreneurial finance.
Successful ventures frequently follow a maturation process known as a life cycle. The venture
life cycle begins in the development stage, has various growth stages, and ‘ends’ in a maturity
stage. The five life cycle stages are:
1. Development stage
2. Startup stage
3. Survival stage
4. Rapid-growth stage
5. Early-maturity stage
During the development stage, the venture progresses from an idea to a promising business
opportunity. The feasibility of an idea is first put on trial during the development stage. The
development stage is depicted as occurring during the period of -1.5 to -0.5 years prior to
market entry.
The second stage of a successful venture’s life cycle is the startup stage, when the venture is
organized, developed, and an initial revenue model is put in place. The startup stage as
typically occurring between years -0.5 and +0.5.
The survival stage occurs from about +0.5 to +1.5 years, although different ventures will
experience different timing. During the survival stage, revenues start to grow and help pay
some, but typically not all, of the expenses. The gap is covered by borrowing or by allowing
other to own a part of the venture. However, lenders and investors will provide financing only
if they expect the venture’s cash flows from operations to be large enough to repay their
investments and provide for additional returns. Consequently, ventures in the survival stage
begin to have serious concern about the financial impression they leave on outsiders.
The fourth stage of a successful venture’s life cycle is the rapid-growth stage, when revenues
and cash inflows grow very rapidly. Cash flows from operations grow much more quickly than
do cash outflows, resulting in a large appreciation in the venture’s value. This rapid growth
often coincides with years +1.5 through +4.5.
The fifth stage in a successful venture’s life cycle is the early-maturity stage, when the growth
of revenue and cash flow continues, but at much slower rates than in the rapid-growth stage.
Although value continues to increase modestly, most venture value has already been created
and recognized during the rapid-growth stage. The stage occurs around years +4 and +5.
Major types of financing include:
• Seed financing
• Startup financing
• First-round financing
, • Second-round, mezzanine, and liquidity-stage financing
• Seasoned financing
During the development stage of a venture’s life cycle, the primary source of funds is in the
form of seed financing to determine whether the idea can be converted into a viable business
opportunity. The primary
source of funds at the
development stage is the
entrepreneurs own assets. As
a supplement to this limited
source, most new ventures will
also resort to financial
bootstrapping, that is, creative
methods, including barter, to
minimize the cash needed to
fund the venture.
Startup financing coincides
with the startup stage of the
venture’s life cycle; this is
financing that takes the
venture from a viable business
opportunity to the point of
initial production and sales. Most startup-stage ventures need external equity financing. This
source of equity capital is referred to as venture capital, which is early-staged financial capital
that often involves a substantial risk of total loss. Business angels are wealthy individuals,
operating as informal or private investors, who provide venture financing from small business.
Venture capitalists (VCs) are individuals who join in formal, organized venture capital firms to
raise and distribute capital to new and fast-growing ventures.
The survival stage of a venture’s life cycle is critical to whether the venture will succeed and
create value or be closed and liquidated. First-round financing is external equity financing,
typically provided by venture investors during the venture’s survival stage to cover the cash
shortfalls when expenses and investments exceed revenues.
Second-round financing is the financing for ventures in their rapid-growth stage to support
investments in working capital. It typically takes the form of venture capital needed to back
working capital expansion. During a venture’s rapid-growth stage, mezzanine financing
provides funds for plant expansion, marketing expenditures, working capital, and product or
service improvements. This is often done in the form of warrants – rights or options to
purchase the venture’s stock at a specific price within a set time period.
If additional funds are needed, seasoned financing can be obtained in the form of loans from
commercial banks or through new issues of bonds and stocks, usually with the aid of
investment bankers. A mature firm with previously issued publicity traded securities can
obtain debt and equity capital by selling additional securities through seasoned securities
offerings to the public.
