Chapter 2: From the Idea to the Business Plan

Chapter 2
FROM THE IDEA TO THE BUSINESS PLAN
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 screenin system to aid in
determinin whether an idea should be discarded or pursued. We conclude the chapter with an
overview of a business plan.
LEARNING OB1ECTIVES
!. "escribe the process of movin from an idea to a business plan
2. #nderstand the components of a sound business model
$. Identify some of the best practices for hih rowth% hih performance firms
&. #nderstand the importance of timin in venture success
'. "escribe the use of a (trenth)Wea*ness)+pportunity),hreats -(W+,. analysis as an
initial /litmus test0
1. Identify the types of 2uestions that a reasonable feasibility assessment addresses
3. Identify 2uantitative criteria that assist in assessin a new venture4s feasibility and its
ability to attract external financin
5. "escribe the primary components of a typical business plan
CHAPTER OUTLINE
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>. Component!: ,he Plan must :enerate 6evenues
B. Component 2: ,he Plan must <a*e Profits
C. Component $: ,he Plan must Produce Free Cash Flows
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>. Best <ar*etin Practices
B. Best Financial Practices
C. Best <anaement Practices
". Best Production or +perations Practices are also Important
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>. >n Interview with the Founder -7ntrepreneur. and <anaement ,eam: Aualitative
(creenin
B. (corin a Prospective 8ew ?enture: Auantitative (creenin
C. IndustryB<ar*et Considerations
". PricinBProfitability Considerations
!3
Chapter 2: From the Idea to the Business Plan
7. FinancialB=arvest Considerations
F. <anaement ,eam Considerations
:. +pportunity)(creenin Caveats
2.3 @79 7;7<78,( +F > B#(I87(( P;>8
>. Cover Pae% Confidentiality (tatement% and ,able of Contents
B. 7xecutive (ummary
C. Business "escription
". <ar*etin Plan and (tratey
7. +perations and (upport
F. <anaement ,eam
:. Financial Plans and ProCections
=. 6is*s and +pportunities
I. Business Plan >ppendix
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>PP78"ID >:
>pplyin the ?+( Indicator
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: >n 7xample
C(C Profile
<ar*et +pportunity
Products
<anaement ,eam
C(C >ssessment
DISCUSSION QUESTIONS AND ANSWERS
1. How do we know whether an idea has the potential to become a viable business opportunity?
,he answer is that we don4t *now with absolute certainty. While there is no infallible
screenin process% there are tools and techni2ues that can help examine similarities between a
new idea and previously successful ventures.
2. Identify three types of startup firms.
Salary-replacement firms are firms that provide their owners with income levels comparable
to what they could have earned wor*in for much larer firms.
Lifestyle firms are firms that allow owners to pursue specific lifestyles while bein paid for
doin what they li*e to do.
ntrepreneurial ventures are entrepreneurial firms that are flows and performance oriented as
reflected in rapid value creation over time.
!. "riefly describe the process involved in movin# from an idea to a business plan.
6efer to Fiure 2.! /From 7ntrepreneurial +pportunities to 8ew Businesses% Products% or
(ervices.0 (tart with /ideas%0 then assess the /feasibility0 -findin an unfilled need.% and
then develop a /business plan.0
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Chapter 2: From the Idea to the Business Plan
$. %hat are the components of a sound business model?
,he components of a sound business model are the abilities to enerate revenues% create a
profit% and produce free cash flow. ,hese components must be achieved within a reasonable
time frame as the venture proresses throuh the early staes of its life cycle.
&. 'escribe the differences between entrepreneurial ventures and other entrepreneurial firms.
7ntrepreneurial ventures are entrepreneurial firms that are flows and performance oriented as
reflected in rapid value creation over time. (uch ventures strive for hih rowth in revenues%
profits% and cash flows. In contrast% some small businesses may have some of the trauma and
rewards of the entrepreneurial lifestyle% but remain centered on a small)scale format with
limited rowth and employment opportunities.

(. Identify some of the best marketin# and mana#ement practices of hi#h #rowth) hi#h
performance firms.
(uccessful hih)rowth% hih)performance firms typically sell hih 2uality products or
provide hih 2uality services. (uch firms also enerally develop and introduce new products
or services considered the top or best in their industriesE they are product and service
innovation leaders. ,heir products typically command hiher prices and profit marins. In
summary% these firms4 /mar*etin profiles0 are characteriFed by hih 2uality% innovative
leadership% and pricin power.
Best manaement practices include: -!. assemble a manaement team that is balanced in
both functional area coverae and industryBmar*et *nowlede% -2. employ a decision)ma*in
style that is viewed as bein collaborative% -$. identify and develop functional area manaers
that support entrepreneurial endeavors% and -&. assemble a board of directors that is balanced
in terms of internal and external members.
*. 'escribe and discuss some of the best financial practices of hi#h #rowth) hi#h performance
firms. %hy is it also important to consider production or operations practices?
=ih)rowth% hih)performance firms consider their financial practices as important as their
mar*etin and operatin functions. ,o this end% they plan for future rowth and unexpected
continencies that may develop as the firm operates. ,hey prepare realistic monthly
financial plans for at least the comin year% and also may prepare annual financial plans for
the next three to five years. >s rapid rowth typically re2uires multiple rounds of financin%
successful ventures anticipate financin needs in advance and see* to obtain financin
commitments before the funds are actually needed. Financin sources that allow% whenever
possible% the entrepreneur to maintain control over the firm% are hihly desirable. (uccessful
hih rowth firms devote the necessary resources and effort to manae the firm4s assets%
financial resources% and operatin performance efficiently and effectively. ,hey also develop
preliminary harvest or exit strateies and may indicate potential li2uidity events in their
business plans.
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Chapter 2: From the Idea to the Business Plan
It is the production or operations area that carries the responsibility of deliverin hih)2uality
products or services on time. Customers want their products or services delivered when they are
promised. ,hus% the production or operations area is e2ually important to successful hih)rowth%
hih)performance firms.

+. ,ime to market is #enerally important) but bein# first to market does not necessarily ensure
success. -plain.
/,ime)to)mar*et0 is particularly critical when ideas involve information technoloy% as a few
months miht determine success or failure. 7Bay4s rapid proression from concept to mar*et
dominance provides an example of the advantaes of actin 2uic*ly in a technoloy mar*et.
/First to mar*et%0 does not always result in success% as 2uite often companies enterin the
mar*et later may achieve sinificant competitive advantaes such as more efficient
production% distribution% and service% superior product desin% and a more sound financial
position. ,he portable computer% first sold by +sborne% provides an example of a technoloy
product that failed to achieve success by bein /first to mar*et.0
.. %hat is meant by a viable venture opportunity?
> viable venture opportunity is one that creates or meets a customer need% provides an initial
competitive advantae% is timely in terms of time)to)mar*et% and offers the expectation of
added value to investors.
1/. 'escribe how a S%0, analysis can be used to conduct a first-pass assessment of whether an
idea is likely to become a viable business opportunity.
> S%0, analysis is an examination of strenths% wea*nesses% opportunities% and threats to
determine the business opportunity viability of an idea. +ne typically /beins0 by as*in
whether there is an unfilled customer need. +ther considerations that could be potential
strenths or wea*nesses include: intellectual property rihts% first mover% lower costs andBor
hiher 2uality% experienceBexpertise% and reputation value. >reas to consider as potential
opportunities or threats include: existin competition% mar*et siFeBmar*et share potential%
substitute products or services% possibility of new technoloies% recent or potential reulatory
chanes% and international mar*et possibilities.
11. 'escribe the meanin# of venture opportunity screenin#.
1enture opportunity screenin# is the assessment of an idea4s commercial potential to produce
revenue rowth% financial performance% and value.
12. 2n analo#y used relatin# to venture opportunity screenin# makes reference to 3caterpillars4
and 3butterflies.4 "riefly describe the use of this analo#y.
Caterpillars are ideas that are li*ely to become butterflies which are successful business or
venture opportunities.
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Chapter 2: From the Idea to the Business Plan
1!. %hen conductin# a 5ualitative screenin# of a venture opportunity) whom should you
interview? %hat topics should you cover?
It is most important to interview the entrepreneur or founder. 9ou miht also want to
interview the mar*etin manaer% the operations manaer% and the financial manaer. In the
event that a manaement team is not in place at the time of the 2ualitative screenin% the
entrepreneur or founder may have to play all of the roles.
,he interviewin process with the entrepreneur should include 2uestions aimed at
understandin the bi picture. Information should be souht reardin the intended
customers% possible competition% intellectual property% challenes to be faced% etc.
,he mar*etin manaer interview see*s information on who ma*es the purchase decision for
the venture4s product or service% and who pays for the purchase. +thers 2uestions focus on
mar*et siFe and rowth% channel and distribution challenes% and mar*etin and promotion
needs.
,he operations manaer interview see*s information on the state of the idea in terms of
prototypes and whether they have been tested. +ne should also attempt to assess what ris*s
remain between now and successful mar*et delivery and whether potential development or
production concerns exist.
,he financial manaer interview see*s information on what lenth of time is proCected before
the venture will achieve brea*even% how will the venture be financed% and how much and
when will outside financin be neededI
1$. 'escribe the characteristics of a viable venture opportunity. %hat is a 10S Indicator?
> viable venture opportunity will meet a customer need% have a competitive advantae% be
able to be brouht to mar*et 2uic*ly% and offer attractive investment returns compared to the
ris* associated with it. > ?+( Indicator is a uide to help investors and entrepreneurs screen
business opportunities. It contains a chec*list for indicatin the potential attractiveness of a
proposed venture.
1&. 'escribe the factor cate#ories used by venture capitalists and other venture investors when
they screen venture opportunities for the purpose of decidin# to invest.
,he cateories used by venture investors to screen are the industry or mar*et% pricin and
profitability% the manaement team% and financial harvest indicators. The market size of the
industry% now or expected in the future% is a critical factor in the li*elihood that a venture can
become hih rowth% with potential sales or revenues of more than J!HH million bein
re2uired to scorin a /hih0 in terms of potential attractiveness.
Profitability% indicated by the ross profit marin% is one of the most important metrics for
Cudin the potential for a viable business opportunity% with a lare ross profit marin
providin a cushion for coverin related business expenses while still providin sufficient
2!
Chapter 2: From the Idea to the Business Plan
return for investors. In eneral% a ross profit marin reater than 'H percent indicates that a
venture has the potential to be a hih rowth% hih performance opportunity. ,he net profit
marin may also be used to evaluate ventures% with after)tax reater marins reater than 2H
percent suestin the potential for a hih rowth% hih performance venture.
?enture screenin usually beins with an assessment of the management team`s experience
and expertise% with a hih score bein iven to a manaement team havin both expertise and
experience in the proposed business opportunity4s industry or mar*et. Finally% venture
investors ive hih scores to entrepreneurs who have iven some thouht in relation to
providin investors with an exit from their venture investment.
Financial harvest indicators such as operatin cash flow brea*even% free cash flow to
e2uity% and internal rate of return -I66. provide indications that a venture will be able to
achieve an exit stratey% and returns to investors% in an acceptably short period of time.
1(. 'escribe 602. 'escribe the two ma7or ratio components that comprise the venture8s 602
model.

,he return on assets is a metric calculated by dividin the venture4s net after)tax profit by
its venture total assets and it represents a measure of the firm4s performance relative to its
invested assets. ,he return on assets measure can also be viewed in terms of the return on
assets -ROA) model that expresses the return on assets as the product of the net profit
marin and the assets turnover metrics or ratios. ,his relationship is depicted as follows:
6eturn on >ssets K 8et Profit <arin x >ssets ,urnover
,his also can be represented as:
8et ProfitB,otal >ssets K 8et ProfitB6evenues x 6evenuesB,otal >ssets.

,hus% the 6+> of a venture is e2ual to its profit marin times its asset intensity.
1*. How do the concepts operatin# cash flow and free cash flow to e5uity differ?
Operating cash flow is a measure of the cash enerated by the daily operations of sellin the
company4s product or serviceE it represents the fiure that remains after the cost of oods
sold and other business expenses -primarily eneral and administrative expenses alon with
mar*etin expenses or /(:L>0. are subtracted from revenues. It approximates the
operatin cash flows over a specified time period% such as a year.
Free cash flow to equity is the cash available to the entrepreneur and venture investors after
operatin cash outflows% financin and tax cash flows% re2uired investment in assets needed
to sustain the venture4s rowth% and net increases in debt capital. Free cash flow to e2uity is
calculated as the venture4s revenues minus operatin expenses% minus financin costs and tax
payments% after adCustment for chanes in net wor*in capital -8WC.% physical capital
22
Chapter 2: From the Idea to the Business Plan
expenditures -C>P7D. needed to sustain and row the venture% and net additional debt issues
to support the venture4s rowth. In short: Free cash flow to e2uity K
net profit M depreciation chares ) 8WC N C>P7D M net new debt.
1+. %hat is a business plan? %hy is it important to prepare a business plan?
> business plan is a written document that describes the proposed venture in terms of the
product or service opportunity% current resources% and financial proCections. <ore formal
business plan development is common in ventures movin from the development stae to the
startup stae. ,he process of business plannin is beneficial to the entrepreneur% who must
be the first to believe the plan is reasonable. ,he entrepreneur must be convinced that
startin this business is the riht thin to do personally and professionallyE the business plan
reflects the excitement% opportunity% and reasonableness of the business idea to the members
of the manaement team% potential investors% and other sta*eholders.
1.. %hat are the ma7or elements of a typical business plan?
> typical business plan contains% in its Introduction% a cover pae% confidentiality statement%
table of contents% and executive summary. ,he Business "escription section presents some
of the considerations related to the venture opportunity)screenin phase on industryBmar*et
factors. ,he <ar*etin Plan and (tratey section addresses the taret mar*et and customers%
competition and mar*et share% pricin stratey% and promotion and distribution. ,he
+perations and (upport section discusses how production methods or services will be
delivered. ,he <anaement ,eam section presents the experience and expertise
characteristics of the manaement team. In the Financial Plans and ProCections% the business
plan typically includes financial proCections in the form of income statements% balance sheets%
and statements of cash flows. ,hese proCections provide the basis for how the venture is
expected to start up and operate over the next several years. ,he business plan should
include a discussion of possible Problems or 6is*s.
,he >ppendix should contain the detailed assumptions underlyin the proCected financial
statements in the Financial Plans and ProCections section. It should also include a timeline
with milestones indicatin the amount and siFe of expected financin needs.
2/. %hat are real options? %hat types of real option opportunities are available to
entrepreneurs?
Real options are real or non)financial options available to a venture4s manaers as the
venture proresses throuh its life cycle. 7xamples of real options include rowth options%
flexibility options% learnin options% and even exit options. :rowth options represent the
possibility that% if the venture4s mar*et beins to row rapidly% an initial toehold position in a
scalable technoloy or service may provide a platform for 2uic* expansion to capture mar*et
share. Flexibility or learnin options may develop when an investment in new technoloy
has multiple potential applications and revenue streams. 7xit options relate to the venture4s
ability to provide a return in a variety of ways other than remainin as a free)standin
venture. ,he venture4s intellectual property can be licensed or purchased by other firms% the
2$
Chapter 2: From the Idea to the Business Plan
venture can be absorbed into another public or private entity or the venture can remain
independent and use its cash flow to provide a return for the investors.
21. 9rom the Headlines--"rooklyn "rew Shop: briefly describe how the idea of a small s5uare
foota#e apartment-based brewin# device became a startup enterprise.
>nswers will vary: (tephen ?aland and 7rica (hea% after notin that home brewin in hih
rent apartments would re2uire a reduced footprint and e2uipment that would most li*ely be
visible to uests% desined their own home brewin *its and started to sell them at the
Broo*lyn Flea <ar*et. >s demand rew% they introduced a hiher volume *it and
established a presence in stores and on the internet. ,hey used J!H%HHH in personal savins
and the revenue from the flea mar*et sales to cover costs and rowth reinvestments while
see*in startup assistance where they could find it% includin a local university4s law clinic.
INTERNET ACTIVITIES
1. 2ccess the Inc. ma#a;ine %eb 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
discussin# why venture investors chose not to invest in potential business opportunities.
Web)researched results vary due to constant updatin of the related web sites.
2. 2ccess the =enter for "usiness >lannin# %eb site at www.businessplans.or#. ,he site
provides e-amples of business plans prepared by ?"2 students from top business schools
and presented to panels of investors at recent ?oot =orp. competitions hosted by the
@niversity of ,e-as at 2ustin. 6eview one of the business plans. %rite a brief summary
comparin# the se#ments 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 updatin of the related web sites.
!. 2ccess the =enter for business >lannin# %eb site at: www.businessplans.or#. 9ind the
reference to >lan%rite which is desi#ned to help an entrepreneur to create a business plan.
Identify and briefly describe what this software product provides.
Web)researched results vary due to constant updatin of the related web sites.
EXERCISES/PROBLEMS AND ANSWERS
1. [Basic Financial Ratios] A venture recorded revenues of $1 million last year and net profit
of $100,000. Total assets were $800,000 at the end of last year.

A. Calculate the ventures net profit margin.
Net Profit Margin: net profit/revenues = $100,000/$1,000,000 = 10.0%
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Chapter 2: From the Idea to the Business Plan
B. Calculate the ventures asset turnover.
Asset Turnover: revenues/total assets = $1,000,000/$800,000 = 1.25 times

C. Calculate the ventures return on total assets.
Return on Total Assets: net profit/total assets = $100,000/$800,000 = 12.5%
2. A9inancial 6atios and >erformanceB 9ollowin# is financial information for three ventures:
1enture CC 1enture DD 1enture EE
2fter-ta- >rofit ?ar#ins &F 1&F 2&F
2sset ,urnover 2./ times 1./ times !./ times
2. =alculate the return on assets for each firm.
?enture DD: 'O x 2.H K !HO
?enture 99: !'O x !.H K !'O
?enture PP: 2'O x $.H K 3'O
". %hich venture is indicative of a stron# entrepreneurial venture opportunity?
?enture PP seems to represent a stron entrepreneurial venture opportunity based on a
very hih return on assets financial measure.
=. %hich venture seems to be more of a commodity type business?
?enture DD seems to be more of a commodity type of business as indicated by a
relatively low return on assets.
'. How would you place these three ventures on a #raph similar to 9i#ure 2.1/?
?enture PP would be a Case ! type of venture opportunity -very hih profit marin..
=owever% ?enture PP4s also hih turnover would place the venture above the 6+> curve
-with an 6+> of 3'O as calculated in Part >... ?enture DD would be a Case 2 type of
venture opportunity -low profit marin with a moderate asset turnover. resultin in a
6+> of !HO -see Part >.. ?enture 99 would fall between the other two ventures -a
relatively hih profit marin and a low asset turnover ratio. resultin in an 6+> of !'O
-see Part >..
. @se the information in 9i#ure 2.. relatin# to pricin#<profitability) and 3score4 each
venture in terms of potential attractiveness.
PricinBProfitability ?enture DD ?enture 99 ?enture PP
:ross marins 8> 8> 8>
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Chapter 2: From the Idea to the Business Plan
>fter)tax marins ! 2 $
>sset intensity 2 2 2
6eturn on assets 2 2 $
,otal points ' 1 5
!. A6evenues) =osts) and >rofitsB In early 2/1/) Gennifer HGenI Liu and Larry ?estas founded
Gen and Larry8s 9ro;en Do#urt =ompany) which was based on the idea of applyin# the
microbrew or microbatch strate#y to the production and sale of fro;en yo#urt. ,hey be#an
producin# small 5uantities of uni5ue flavors and blends in limited editions. 6evenues were
J(//)/// in 2/1/ and were estimated at J1.2 million in 2/11. "ecause Gen and Larry were
sellin# premium fro;en yo#urt containin# premium in#redients) each small cup of yo#urt sold
for J! and the cost of producin# the fro;en yo#urt avera#ed J1.&/ per cup. 0ther e-penses
plus ta-es avera#ed an additional J1 per cup of fro;en yo#urt in 2/1/ and were estimated at
J1.2/ per cup in 2/11.
2. 'etermine the number of cups of fro;en yo#urt sold each year.
6evenue K Price per unit x units sold% and 6evenue B Price per unit K units sold:
#nits (old for 2HH5 K 1HH%HHHB$ K 2HH%HHH units
#nits (old for 2HHG K !%2HH%HHHB$ K &HH%HHH units
". stimate the dollar amounts of #ross profit and net profit for Gen and Larry8s venture in
2/1/ and 2/11.
2H!H 2H!!
6evenue J 1HH%HHH J !%2HH%HHH
C+:( -#nits x C+:( per #nit. $HH%HHH 1HH%HHH
:ross Profit $HH%HHH 1HH%HHH
+7 M ,ax 2HH%HHH &5H%HHH
8et Profit J!HH%HHH J!2H%HHH
=. =alculate the #ross profit mar#ins and net profit mar#ins in 2/1/ and 2/11.
:ross Profit <arin K :ross ProfitB6evenues
8et Profit <arin K 8et ProfitB6evenues
:ross Profit <arin in 2H!H K :ross ProfitB(ales K $HH%HHHB1HH%HHH K 'HO
8et Profit <arin in 2H!H K 8et ProfitB(ales K !HH%HHHB1HH%HHH K !1.3O
:ross Profit <arin in 2H!! K :ross ProfitB(ales K 1HH%HHHB!%2HH%HHH K 'HO
8et Profit <arin in 2H!! K 8et ProfitB(ales K !2H%HHHB!%2HH%HHH K !HO
'. "riefly describe what has occurred between the two years.
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Chapter 2: From the Idea to the Business Plan
,he ross profit marins are the same in the two years because the /cost of oods sold
per unit0 stays the same. =owever% 2H!!4s net profit marin declines because of the
increase in the other expenses cateory.
$. A6eturns on 2ssetsB Gen and Larry8s fro;en yo#urt venture described in >roblem ! re5uired
some investment in bricks and mortar. Initial specialty e5uipment and the renovation of an
old warehouse buildin# in Lower 'owntown) referred to as Lo'o) cost J$&/)/// at the
be#innin# of 2/1/. 2t the same time) J&/)/// was invested in inventories. In early 2/11) an
additional J1//)/// was spent on e5uipment to support the increased fro;en yo#urt sales in
2/11. @se information from >roblem ! and this problem to answer the followin# 5uestions.
2. =alculate the return on assets in both 2/1/ and 2/11.
,otal >ssets 2H!H K Warehouse M Inventory K J&'H%HHH M J'H%HHH K J'HH%HHH
,otal >ssets 2H!! K Warehouse M Inventory M >dditional Capital 7xpenditure
K J&'H%HHH M J'H%HHH M J!HH%HHH K J1HH%HHH
6eturn on >ssets -6+>. K 8et ProfitB,otal >ssets
6+> for 2H!H K !HH%HHHB'HH%HHH K 2HO
6+> for 2H!! K !2H%HHHB1HH%HHH K 2HO
". =alculate the asset intensity or asset turnover ratios for 2/1/ and 2/11.
>sset Intensity K >ssets ,urnover K 6evenuesB,otal >ssets
>sset ,urnover 6atio for 2H!H K 1HH%HHHB'HH%HHH K !.2H
>sset ,urnover 6atio for 2H!! K !%2HH%HHHB1HH%HHH K 2.HH
=. 2pply the 602 "usiness ?odel to Gen and Larry8s fro;en yo#urt venture.
6+> Business <odel K 8et Profit <arin x >sset ,urnover 6atio
6+> for 2H!H K !1.13O x !.2 K 2HO
6+> for 2H!! K !HO x 2.H K 2HO
'. "riefly describe what has occurred between the two years.
,he 6eturns on >ssets were the same in the two years because the company4s 8et Profit
<arins went down due to the increased operation expenses while >sset Intensity went
up due to additional capital expenditure on e2uipment.
. Show how you would position Gen and Larry8s fro;en yo#urt venture in terms of the
relationship between net profit mar#ins and asset turnovers depicted in 9i#ure 2.1/.
In relation to Fiure 2.!H% one should position Qen and ;arry4s froFen yourt venture in
Case ! where the company has hih profit marin and low assets turnover.
23
Chapter 2: From the Idea to the Business Plan
In Case 2% companies compete on price% have very low profit marin and hih assets turnover.
If the company is incapable of becomin a mar*et leader% it will be s2ueeFed out as the industry
rows.
&. A10S Indicator
,?
Screenin#B Gen Liu and Larry ?estas are seekin# venture investors to help
fund the e-pected #rowth in their 9ro;en Do#urt venture described in >roblems ! and $. @se
the 10S Indicator #uidelines presented in 9i#ures 2.+ and 2.. to score Gen and Larry8s fro;en
yo#urt venture in terms of the items in the pricin#<profitability factor cate#ory. =omment on the
likely attractiveness of this business opportunity to venture investors.
:ross <arin: 'HO% 'HO -/=ih0.
>fter),ax <arin: !1.3O% !HO -/>verae0.
>sset Intensity: !.2% 2 -/>verae0.
6+>: 2HO% 2HO -/>verae0.
,his is an />verae0 opportunity.
(. Athical IssuesB 2ssume that you have 7ust 3run-out-of-money4 and are unable to move your
3idea4 from its development sta#e to production and the startup sta#e. However) you remain
convinced that with a reasonable amount of additional financial capital you will be a successful
entrepreneur. %hile your e-pectations are low) you are meetin# with a loan officer of the local
bank in the hope that you can #et a personal loan in order to continue your venture.
2. 2s you are about to enter the bank) you see a bank money ba# lyin# on the street. Ko one
is around to claim the ba#. %hat would you do?
<any entrepreneurs state that hih ethical standards are one of a venture4s most important
assets and are critical to lon)term success and value. =ih ethical standards involve
followin laws% reulations% and treatin others honestly and fairly. ,he money% if any% in the
money ba does not belon to youRit is someone else4s property. <ost people would aree
that you should turn the money ba in to the ban* immediately.
It is possible% but should not be expected and thus should not be part of your decision% that
your hih ethical standards miht have an indirect impact on your bein able to obtain a
personal loan from the ban* to continue your venture.
". Kow) let8s assume that what you found lyin# on the street was a J1// bill. ,he thou#ht
crosses your mind that it would be nice to take your si#nificant other out for a nice dinnerL
somethin# that you have not had for several months. %hat would you do?
#nless you see someone drop the J!HH bill it will be very difficult to identify the owner of
the bill. =owever% the money does not belon to you. <ost people would aree that you
should not Cust /poc*et0 the J!HH bill but should ma*e an attempt to find its owner. (ince
you are outside the ban*% you miht enter the ban*% indicate that you found a J!HH bill
outside the ban*% and en2uire whether someone has reported losin a J!HH bill.
25
Chapter 2: From the Idea to the Business Plan
=. Kow) instead of J1// you 3find4 a J1 bill on the street. ,he thou#ht crosses your mind that
you could buy a lottery ticket with the dollar. %innin# the lottery would certainly solve all
your financin# needs to start and run your venture. %hat would you do?
When the amount of money /found0 is very small% such as J!% people often behave
differently than when the amount of money is lare. First% it is virtually impossible to
identify the owner unless you saw a specific person drop the J! bill. (econd% the time and
enery involved in tryin to find the rihtful owner li*ely will outweih the value of the
money. >ain% the money is not rihtfully yours. <ost people would probably say that if
you can4t immediately identify the rihtful owner% the J! becomes /yours.0
It is up to you to decide whether *eepin the J! bill CeopardiFes your own personal hih
ethical standards. Purchasin a lottery tic*et with the dollar represents another personal
decision.
SUPPLEMENTAL EXERCISES/PROBLEMS AND ANSWERS
S8ote: ,hese activities are for readers with an existin understandin of financial statements -i.e..
income statements and balance sheets.. For other readers% these exercisesBproblems can be
wor*ed after coverin Chapter &.T
*. A6evenues) >rofits) and 2ssetsB 6efer to the information on the three ventures in >roblem 2.
2. If each venture had net sales of J1/ million) calculate the dollar amount of net profit and
total assets for 1enture CC) 1enture DD) and 1enture EE.
8et Profit ,otal >ssets
?enture DD J!H%HHH%HHH x .H' K J'HH%HHH J!H%HHH%HHHB2.H K J'%HHH%HHH
?enture 99 J!H%HHH%HHH x .2' K J2%'HH%HHH J!H%HHH%HHHB$.H K J$%$$$%$$$
?enture PP J!H%HHH%HHH x .!' K J!%'HH%HHH J!H%HHH%HHHB!.H K J!H%HHH%HHH
". %hich venture would have the lar#est dollar amount of net profit?
?enture 99 would have the larest net profit at J2%'HH%HHH.
=. %hich venture would have to lar#est dollar amount of total assets?
?enture PP would have the larest total assets at J!H%HHH%HHH.
+. A6atio =alculations from 9inancial StatementsB 6icardo ?artine; has prepared the
followin# financial statement pro7ections as part of his business plan for startin# the
?artine; >roducts =orporation. ,he venture is to manufacture and sell electronic
components that make standard overhead pro7ectors 3smart.4 In essence) throu#h voice
commands a pro7ector can be turned on or off) and the bri#htness of the pro7ection altered.
,his will allow the user to avoid audience annoyances associated with a bri#ht pro7ection
2G
Chapter 2: From the Idea to the Business Plan
li#ht durin# periods when no overhead transparency is bein# used. 1enture investors usually
screen prospective venture opportunities in terms of pro7ected profitability and financial
performance.
2. @se the followin# pro7ected financial statements for ?artine; >roducts and calculate
financial ratios showin# the venture8s pro7ected: HaI #ross profit mar#in) HbI net profit
mar#in) HcI asset intensity) and HdI return on assets.
:ross Profit <arin K :ross ProfitB(ales K !HH%HHHB2HH%HHH K 'HO
8et Profit <arin K 8et IncomeB(ales K !'%HHHB2HH%HHH K 3.'O
>sset Intensity K (alesB,otal >ssets 2HH%HHHB!HH%HHH K 2.H
6eturn on >ssets K 8et IncomeB,otal >ssets K !'%HHHB!HH%HHH K !'O
". ,he ratios calculated in >art 2 are found in the venture opportunity screenin# #uide
discussed in the chapter. 6ate the potential attractiveness of the ?artine; >roducts
venture usin# the #uidelines for the pricin#<profitability factor cate#ory for the 10S
Indicator.
,he ?+( Indicator shows that three of the pricinBprofitability indicators are averae
while after)tax marins are low in attractiveness. ,he scorin suests a low)to)averae
appraisal of this venture opportunity.
UUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUU
<artineF Products Corporation
ProCected Income (tatement for 9ear !
UUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUU
(ales J2HH%HHH
Cost of oods sold )!HH%HHH
:ross profit !HH%HHH
+peratin expenses )3'%HHH
"epreciation )&%HHH
7arnins before interest L taxes 2!%HHH
Interest )!HHH
7arnins before taxes 2H%HHH
,axes -2'O. )'%HHH
8et income J!'%HHH
<artineF Products Corporation
ProCected Balance (heet for 7nd of 9ear !
Cash J !H%HHH >ccounts payable J !'%HHH
>ccounts receivable 2H%HHH >ccrued liabilities !H%HHH
Inventories 2H%HHH Ban* loan !H%HHH
,otal current assets 'H%HHH ,otal current liabilities $'%HHH
:ross fixed assets '&%HHH Common stoc* '$%HHH
>ccumulated depreciation &HHH 6etained earnins !2%HHH
8et fixed assets 'H%HHH ,otal e2uity 1'%HHH
,otal assets !HH%HHH ,otal liabilities L e2uity J!HH%HHH
$H
Chapter 2: From the Idea to the Business Plan
.. A6atio =alculationsB 6icardo ?artine;) the founder of the ?artine; >roducts =orporation
Hsee >roblem +I) pro7ects sales to double to J$//)/// in the second year of operation.
2. If the financial ratios calculated for Dear 1 in >roblem + remain the same in Dear 2) what
would be ?artine;8s dollar amount pro7ections in his business plan for: HaI #ross profit)
HbI net profit or income) and HcI total assets?
:ross Profit K :ross Profit <arin x 6evenue K 'HO x &HH%HHH K 2HH%HHH
8et Profit K 8et Profit <arin x 6evenue K 3.'O x &HH%HHH K $H%HHH
,otal >ssets K ,otal 6evenueB>sset Intensity K &HH%HHHB2.HH K 2HH%HHH
". How would your answers chan#e in >art 2 if the #ross profit mar#in in the second year is
pro7ected to be (/F) the net profit mar#in 2&F) and the asset intensity at a & times
turnover?
:ross Profit K &HH%HHH x 1HO K 2&H%HHH
8et Profit K &HH%HHH x 2'O K !HH%HHH
,otal >ssets K &HH%HHHB'.HH K 5H%HHH
=. @se the pro7ected ratio information in >art " in the return on assets H602I model to
determine the pro7ected percenta#e rate of return on assets.
6+> K 8et Profit <arin x >ssets ,urnover K 2'O x '.HH K !2'O
-8ote that !2'O is an unusually hih 6+>% but not necessarily uncommon iven the
optimism in many business plans..
MINI CASE: LEARNRITE.COM CORPORATION
;earn6ite.com offers e)commerce service for children4s /edutainment0 products and
services. ,he word edutainment is used to describe software that combines /educational0 and
/entertainment0 components. ?aluable product information and detailed editorial comments are
combined with a wide selection of products for purchase to help families ma*e their *ids4
edutainment decisions. > team of leadin educators and Cournalists provide editorial comments
on the products sold by the firm. ;earn6ite tarets hihly educated% convenience oriented% and
value conscience families with children under the ae of !2% estimated to be about $' percent of
Internet users.
,he firm4s warehouse)distribution model results in hiher net marins% as well as reater
selection and convenience for customers% when compared to traditional retailers. :ross profit
marins are expected to averae about $H percent each year. Because of relatively hih
mar*etin expenditures aimed at ainin mar*et share% the firm is expected to suffer net losses
for two years. <ar*etin and other operatin expenses are estimated to be J$ million in 2H!!
and J' million in 2H!2% respectively. =owever% durin the third year operatin cash flow
brea*even should be reached. 8et profit marins are expected to averae !H percent per year
$!
Chapter 2: From the Idea to the Business Plan
beinnin in year $. Investment in bric*s and mortar is larely in the form of warehouse
facilities and a computer system to handle orders and facilitate the distribution of inventories.
>fter considerin the investment in inventories% the asset intensity or turnover is expected to
averae about two times per year.
;earn6ite estimates that venture investors should earn about a &H percent averae annual
compound rate of return and sees an opportunity for a possible initial public offerin in about six
years. If industry consolidation occurs% a merer miht occur even sooner.
,he manaement team is headed by (ri*ant @apoor who serves as President of
;earn6ite.com and who personally controls about $' percent of the ownership of the firm. <r.
@apoor has more than twelve years experience in hih)tech industries includin previous
positions with #( West and <icrosoft. =e holds a B.(. deree in electrical enineerin from an
Indian technoloy institute and an <B> from a maCor #.(. university. (ean "avidson% "irector
of ,echnoloy has more than ten years of experience in software development and interation.
Walter ?u has almost ten years of experience in sales and business development in the software
industry includin positions at Claris and <axis. <itch Feldman% "irector of <ar*etin% was
responsible for six years for the mar*etin communications function and the Internet operations
of a lare software company. <anaement strives for continual improvement in ease of user
interface% personaliFed services% and amount of information supplied to customers.
,he total mar*et for children entertainment is estimated to be J$' billion annually. ,oys
account for about J2H billion in annual spendin. (ummer camps are estimated to enerate J1
billion annually. ,his is followed by *ids4 videos and video ames at J& billion each. @ids4
software sales currently enerates about J! billion per year in revenues and industry sales are
expected to row at a $H percent annual rate over the next several years.
;earn6ite has made the followin five)year revenue proCections:
9ear 2H!! 2H!2 2H!$ 2H!& 2H!'
6evenues -J<. J!.H JG.1 J$H.! J13.5 J!2!.&
2. >ro7ect industry sales for kids8 software throu#h the year 2/1&.
2H!! <ar*et for Children 7ntertainment:
,oys J2H billion
(ummer camps 1 billion
@ids4 videosBames & billion
@ids4 software sales ! billion
<iscellaneous & billion
,otal <ar*et J$' billion
@ids4 (oftware (ales :rowin at $HO annually:
9ear 2H!2 (ales K 9ear 2H!H (ales x !.$HE and so forth.
Industry
9ear Forecasted (ales
2H!! J!.HH billion
2H!2 !.$H billion
2H!$ !.1G billion
$2
Chapter 2: From the Idea to the Business Plan
2H!& 2.2H billion
2H!' 2.51 billion
". =alculate the year-to-year annual sales #rowth rates for Learn6ite. A0ptional: stimate the
compound #rowth rate over the 2/11 throu#h 2/1& time period usin# a financial calculator
or computer software pro#ram.B
:rowth 6ate K S-8ext 9ear (ales N Current 9ear (ales.BCurrent 9ear (alesT x !HH
;earn6ite
9ear Forecasted (ales (ales :rowth 6ate
2H!! J!.HH million
2H!2 G.1H million 51HO
2H!$ $H.!H million 2!&O
2H!& 13.5H million !2'O
2H!' !2!.&H million 3GO
>rithmetic averae K -51HO M 2!&O M !2'O M 3GO.B& K $2HO
Compound averae -usin a financial calculator and point)to)point estimate
between 2H!! and 2H!'. K 2$2O
S7nter: present value K )!.HHE future value K !2!.&HE number of periods K &E
then solve for OiT
:eometric averae K S-! M 51H. x -! M 2!&. x -! M !2'. x -! M 3G.T
!B&
K 2H5O
=. stimate Learn6ite8s e-pected market share in each year based on the above data.
8ote: use data for the *id4s software industry from ->. and for ;earn6ite from -B..
Percent of
9ear Industry (ales
2H!! H.!O
2H!2 H.3O
2H!$ !.5O
2H!& $.!O
2H!' &.2O
'. stimate the firm8s net income HlossI in each of the five years.
9ear 8et Income -;oss.
2H!! J)2.3H million
2H!2 )2.!2 million
2H!$ $.H! million
2H!& 1.35 million
2H!' !2.!& million
9ear 2H!!: :ross profit is JH.$H million -J!.H million sales x .$H marin. less
mar*etin expenses of J$ million produces a loss of J2.3H million
$$
Chapter 2: From the Idea to the Business Plan
9ear 2H!2: :ross profit is J2.55 million -JG.1 million sales x .$H marin. less
mar*etin expenses of J' million produces a loss of J2.!2 million
9ears 2H!$)2H!': 8et profit is !HO of that year4s forecasted sales
. stimate the firm8s return on assets be#innin# when the net or after-ta- income is e-pected
to be positive.
<illions of "ollars: 6eturn
9ear 8et Income B Forecasted >ssets K on >ssets
2H!! J)2.3H B JH.'H K )'&H.HO
2H!2 )2.!2 B &.5H K )&&.2O
2H!$ $.H! B !'.H' K 2H.HO
2H!& 1.35 B $$.GH K 2H.HO
2H!' !2.!& B 1H.3H K 2H.HO
8ote: (ince the asset intensity or turnover is 2.HH% total assets will be one)half of
forecasted sales. >lternatively% return on assets K net profit marin -!H.HO. times
asset turnover -2.H times. K 2H.HO
9. Score Learn6ite8s venture investor attractiveness in terms of the Industry<?arket 9actor
=ate#ory usin# the 10S Indicator #uide and criteria set out in 9i#ures 2.+ and 2... If
you believe there are insufficient data) indicate that decision with an 3K<2.4
IndustryB<ar*et (core
<ar*et (iFe Potential: *id4s software sales K J! billion =ih
?enture :rowth 6ate: reater than $HO annually =ih
<ar*et (hare -9ear $.: !.5O of industry sales ;ow
7ntry Barriers: possible timin barriers >verae
M. Score Learn6ite8s venture investor attractiveness in terms of pricin#<profitability factors.
9ollow the instructions in >art 9.
PricinBProfitability (core
:ross <arins: $HO marins are estimated >verae
>fter),ax <arins: !HO marins are estimated >verae
>sset Intensity: 2.H asset turnovers are estimated >verae
6eturn on >ssets: 2HO returns are estimated >verae
H. Score Learn6ite8s venture investor attractiveness in terms of financial<harvest factors.
9ollow the instructions in >art 9.
FinancialB=arvest (core
Cash Flow Brea*even: estimated to occur in 9ear $ >verae
6ates of 6eturn: 2HO investor returns are estimated >verae
IP+ Potential: estimated in 9ear 1 ;ow
Founder4s Control: $'O ownership by founder >verae
$&
Chapter 2: From the Idea to the Business Plan
I. 3Score4 Learn6ite8s venture investor attractiveness in terms of mana#ement team
factors. 9ollow the instructions in >art 9.
<anaement ,eam (core
7xperienceB7xpertise: very ood in softwareBtech industries =ih
Functional >reas: ood except for finance >verae
FlexibilityB>daptability: experience suests flexibility >verae
7ntrepreneurial Focus: startup ris*s accepted by founderBteam >verae
G. 'etermine overall total points and an avera#e score for Learn6ite as was done for the
=ompanion Systems =orporation in the 2ppendi-. Items where information is 7ud#ed to be
lackin# and an K2 is used should be e-cluded when calculatin# an avera#e score.
,he /labels0 assined in -F. throuh -I. for ;earn6ite can be summariFed as follows:
Cateory 8umber x Points Per K ,otal Points
=ih $ $ G
>verae !! 2 22
;ow 2 ! 2
,otals !1 $$
>verae score K $$B!1 K 2.H1
N. >rovide a brief written summary indicatin# how you feel about Learn6ite.com as a
business opportunity.
We have /scored0 each of the !1 items. +f course% it could be arued that ade2uate
information miht be lac*in for one or more of the items and an 8> could have been
assined until the information was ac2uired. =owever% even after substantial due
dilience efforts are completed% scorin /Cudments0 will still have to be made. SWe
note that differences in industry *nowlede% attitudes towards ris* preferences% etc.
miht lead individual instructors andBor students to /score0 certain items differently
than we have. (uch differences in opinion should help enliven the discussion of the
mini case and provide reconition that decidin to become an entrepreneur is not for
everyone.T
We have assined /averae0 scores to about two)thirds of the items% which accounts
for a score around 2. +f course% it is important we reconiFe that the venture
opportunity)screenin uide we are employin is very demandin due to its focus on
venture investor expectations. While an ideaBopportunity with an averae score -!.13
to 2.$$. may find it somewhat difficult to attract venture capital% it may still constitute
a viable business opportunity. ,he ris*s associated with the ;earn6ite venture are
potentially hih% but the rewards are also potentially lare. >s a result% ;earn6ite
could be very successful and enerate substantial wealth for the founder and the
manaement team.
$'