Entrepreneurial Ventures Valuation

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Successful entrepreneurs tend to have one thing in common; they have developed an uncanny ability to separate the opportunities from the chaotic sea of ideas. Entrepreneurial success depends on identifying the right opportunity and seizing it at the right time.
Entrepreneurs have to look at opportunities in a little different light. Rather than seeing an opportunity as a single entity, entrepreneurs have to look at it to see if it can be seen as a number or series of opportunities.

Some of today’s most successful firms illustrate the merit in being first into a market and then exploring growth opportunities. Dell found that selling custom-made computers directly to individual consumers could be a springboard for selling printers, monitors, and servers. eBay found out that established firms, not just individual consumers, would use its online auction system to buy and sell products. Amazon.com found that it did not have to change its DNA when it realized that it was a very effective vehicle for selling music and movies.
Although the preceding examples illustrate that capturing a large part of a large opportunity can be lucrative, they also indicate how difficult it can be to estimate the size, nature, longevity, and profitability for an emerging market. Michael Dell, Pierre Omidyar, and Jeff Bezos believed there was an opportunity for each of their ventures, but none of them perceived how big their markets would be or how large their firms would become.

These three examples illustrate another interesting point: Sensing an opportunity is of little value unless you can capitalize on it. Each firm sensed a wave (market opportunity) as it was beginning to form, caught the wave early (established brand identity), established good systems, and evolved by positioning themselves (by keeping their eyes open to customer needs) so they could catch related waves as they began to form.
Each of these examples illustrates two other critical ingredients for new venture success.
All three firms developed strategies that were designed to give their firms a competitive advantage and they executed the strategies well. Finding the right window of opportunity is important—but being able to gain a sustainable competitive advantage may be equally important. It’s like being given the opportunity to be a designated hitter in baseball. Standing in the batter’s box is of little value unless you are able to hit the pitch!

WINDOW OF OPPORTUNITY
The window of opportunity concept captures the relationship between timing and opportunities. From a timing perspective, if you get to the window well before it opens, then you have to wait. If you get there after it has been open for a while, then you may find yourself competing with numerous other firms. You also run the risk of entering as the window is closing. From an opportunity perspective, you do not want to pursue an opportunity with limited potential or that will only be open for a brief period of time. Your analysis must be directed to identifying windows of opportunity where you can have a decided timing advantage and that have the potential to open wide enough and long enough for your venture to create and maintain customers for a profit.

The ability to recognize a potential opportunity when it appears and the sense of timing to seize it as the window is opening, rather than slamming shut, is critical. “Another way to think of the process of creating and seizing an opportunity in real time is to think of it as a process of selecting objects (opportunities) from a conveyor belt moving through an open window, the window of opportunity. The speed of the conveyor belt changes, and the window through which it moves is constantly opening and closing. That the window is continually opening and closing and that the speed of the conveyor belt is constantly changing represent the volatile nature of the marketplace and the importance of timing.”

Entrepreneurs need to recognize that the window is unique. The size of the window and the speed at which it opens and closes will vary with each opportunity. The extent the window is visible in advance will also vary. The window for some opportunities will open wide and stay open for an extended period of time. Other windows remain open for a brief period of time. If you get to the window before it opens, then you will have committed resources and tipped your hand about what you plan to offer the market to potential competitors. A number of ventures died on the vine because they had too little capital to hold them over until the window opened and provided them with a revenue stream to cover their outlays. Being late also has its consequences. If the new venture tries to enter after more perceptive firms have established their competitive positions and market share, then that firm will have an uphill battle. Its revenue stream will be contingent on the firm’s ability to take customers from the other firms.

Being first to market is important for new ventures because it means you have the whole market to yourself. In a sense, you have a temporary legal monopoly. Being first to market requires considerable skill. It is like trying to hit the bull’s eye of a target when the target is barely visible. You have to see the opportunity before other firms. You have to sense what the market wants before the market even knows exactly what it wants. You must have the people and resources in place before the window opens. You have to develop the goods, services, processes, and distribution capabilities before the window opens.

Entrepreneurs need to determine if the opportunity is real and lasting or if it is nothing more than a passing fad. Some opportunities are as perishable as fruit. Although they may garner a lot of attention like the Y2K info-tech crisis, they are short-lived. Some opportunities may stick around for a while and then fade. You need to determine if the opportunity is here to stay. Your analysis of the windows of opportunity should also include an analysis of the potential for substitute products or services to leapfrog the need for your product or service. The development of substitute products can make even a relatively new product obsolete.

If the window is just opening, then it will need to stay open for a number of years so you can harvest it. The first year may provide revenue, but it could take two to three years before you earn a profit and generate positive cash flow. Hopefully the market will stay open for at least 5 to 10 years. Additional time will give you the opportunity to position your venture to harvest new segments as they emerge. Additional time may also give you the opportunity to find ways to increase the usage rate, to find new uses for your products and services, and to develop subsequent generations from them.

A new venture will be able to create and maintain customers for a profit only to the extent it is able to offer the market a compelling reason to buy its products and service. Its strategy must also keep current and potential competitors at bay. Numerous successful ventures entered an established, yet fragmented industry. They created and maintained customers by professionalizing their operations. Kindercare was successful when it entered the child daycare marketplace because it professionalized what had traditionally been a mom-and-pop type of business. Firms that use incremental and continuous improvement strategies try to be at least a little better than their competitors on a number of dimensions.
High-growth ventures, however, utilize a much bolder strategy for creating and maintaining customers for a profit. They try to capture the market through major innovation. They come in with a bang and they try to keep competitors out by leaving little room for them.

Although it might be possible to create a successful venture by offering products or services that are slightly better than the firms already serving that target market or by having business processes that give your venture a competitive advantage by being a little faster, more convenient, or less costly, the more your venture is able to provide a significant value proposition, the greater its potential to be an exceptional enterprise. Exceptional enterprises seem to have at least two things in common. First, they identify markets where customers are dissatisfied with the current state of affairs. They focus their attention on target-rich environments. Second, they wow the market by providing a superior offering.

FINANCIAL DIMENSIONS
New ventures will be successful to the extent they create and maintain customers for a profit. The window of opportunity, target market, competitive situation, and market offering will affect the new venture’s revenue stream. The revenue stream is not an end in itself. A number of firms sell themselves into bankruptcy each year. The income statement’s top line is important, but its bottom line will determine whether the firm fulfills its investors’ expectations and its obligations to its creditors. Profits are the fuel for paying off loans, paying dividends, investing in new product development, improving the firm’s processes, rewarding the firm’s human resources, and for building the value of the firm.

Each opportunity needs to be evaluated in terms of its profitability, cash flow, and return on investment. Although a threshold may be established for the overall level of attractiveness, the threshold for the market gap and financial attractiveness may vary with each opportunity. Opportunities that require a substantial investment may have a higher threshold than opportunities that place fewer resources at risk.

Scalability may be an important factor when evaluating ventures. It describes the extent the venture can be started on a small scale and then expanded in manageable increments. Bhidé noted that entrepreneurs who have limited funds should favor ventures that aren’t capital intensive and have profit margins to sustain rapid growth with internally generated funds. In a similar fashion, entrepreneurs should look for ventures with a high margin for error, simple operations, and low fixed costs that are less likely to face a cash crunch because of factors such as technical delays, cost overruns, and slow buildup of sales. Fred DeLuca, cofounder of Subway Restaurants, captures the nature of scalability in the title of his book, Start Small, Finish Big.

Entrepreneurs who want to get a significant return on their investments should direct their attention to creating ventures that have the potential to provide a lucrative return on their investments. Sweet spot/jewel opportunities may be the most appealing opportunities. They provide high yields yet require a minimal investment. Sweet spot/jewel opportunities, however, may have two relative drawbacks. First, if they do not take a significant investment, then there may be few barriers to entry for potential competitors. If you have a proprietary position that prohibits competitors, then you may be in a very enviable position. Second, there may be situations when the return on investment may be high in percentage terms, but the yield in absolute dollars may not be enough in real dollars to satisfy your overall yield objectives. For example, a venture that generates a 1,500 percent return on a $1,000 investment will only yield a $15,000 profit. That would be a great return if it was an investment in a stock, but it may not be enough return in absolute dollars to justify all the time and effort you will devote to starting and running a business. Opportunities that have sweet spot/jewel potential that can generate lucrative returns in relative and absolute dollars should be sought.
The next big thing type of opportunities can also be appealing, but they usually have a substantial initial capital requirement. They may also require a regular infusion of capital to get them to the point where they dominate a substantial market.

Lifestyle ventures have merit for people who are looking for an alternative to working for someone else and who are not ambitious from a financial standpoint. Hole-in-theground ventures are to be avoided. They require substantial investment but provide minimal, if any, return on investment. They are like pleasure boats. Most people who have owned a boat describe their boats as a hole in the water that you pour money into. Many boat owners consider the term pleasure boat to be an oxymoron!

The classic return on investment formula divides the level of profit by the investment. The formula permits different opportunities to be compared to one another. It also provides a good basis for establishing a threshold for evaluating opportunities. You will need to determine the appropriate threshold for your new venture. The most common financial threshold is the rate you could get for an investment with a moderate risk. If you believe you could get a 10 percent return in a relatively risk-free investment, then why should you risk your whole investment in a new venture that would provide a lower return? If you will be seeking additional investors, then the threshold must be high enough to attract their attention.

The threshold is usually a few points above the rate you could get for a safe investment. The threshold may be anywhere from 12 to 15 percent. If bond yields are high or the stock market is climbing, then the threshold may need to be higher to cover the opportunity cost of investing in the venture and to attract outside investors. When the threshold is raised, opportunities that do not generate a higher level of profit per dollar invested are dropped from consideration.
Profit margin is actually the result of two margins. The first margin is gross margin.
Gross margin is determined by subtracting the cost of the goods sold from sales. The cost of goods sold includes what you paid for the products you sold or the payroll expenses for the people who provided the services if you are in a service business. The gross margin is influenced by your firm’s cost structure. It is also influenced by its ability to charge what the market is willing to pay. As noted earlier, the ideal situation is for a new venture to have a temporary legal monopoly. This gives the firm considerable latitude in pricing its products or services.
Kenneth Olm and George Eddy noted, “Profit margin potential depends on a number of factors. The first and most critical is the existence of a strong market for the product/service.

The second is the ability to differentiate the product in the mind of the consumer so that intense competition is not encountered. Another important consideration is the ability to isolate yourself from intense competition by patents, copyrights, or geography.” Having a temporary legal monopoly or even a significant competitive advantage does not mean you should skim the market by charging an outrageous price. Such a strategy could generate considerable ill will from consumers. It would also invite competition.

The operating expenses also affect the firm’s profit margin. If you do not control regular operating expenses (salaries, rent, advertising, etc.), then the profit margin will be reduced. Perceptive marketing can enhance your gross margin, but it will take savvy management to keep the other expenses in line. This is why the skills and experience of the entrepreneur and the management team are so important. Their skills and experience will help them know where money should be spent and where it must be controlled. Managing growth is like having your foot on the accelerator. Successful entrepreneurs are able to differentiate between too little, too much, and just the right amount of selling and administrative expenses.

It would be time and cost prohibitive to do an in-depth analysis of the financials for every opportunity under review. You need to come up with estimates of the level of sales, the associated expenses, the resulting profit, and the corresponding investment for each opportunity. You do not need to develop full-blown projections; ballpark figures will be sufficient to determine if the opportunity exceeds the threshold. If you are reviewing just a couple of opportunities at this stage, then you may consider running three different sales scenarios for each opportunity. You would run best-case, most-likely, and worst-case sales projections for the first five years. The sales projections serve as the foundation for the corresponding profit and return on investment estimates. Each of the opportunities would then be ranked to determine their financial strength. This approach may also be helpful in determining the degree of risk for each opportunity. Opportunities that exceed the threshold with even their worst-case scenario are particularly noteworthy. Robert Morris Associates’ (RMA’s) Annual Statement Studies and numerous business magazines provide useful financial benchmarks for profitability and return on investment. Service businesses that usually require small capital investments usually generate higher profit margins.

The following questions provide valuable insights when evaluating the financial worthiness of each opportunity:
• What is the return on investment threshold?
• What is the initial capital requirement?
• What is the projected return on investment?
• How much money do I have available to invest?
• Are there areas where I can reduce costs constructively via the learning curve?
• What is the assets-to-sales ratio? (This indicates how much money will be required to support growth.)
• What is the gross margin to sales ratio?
• What is the net profit margin to sales ratio?
• What is the break-even point?
• What is the burn rate? (daily cash outlay to keep the business running)
• What is the cash flow?
• How soon will the firm achieve positive cash flow?
• Is the financial side of the firm easy for bankers and investors to understand?
• What are the financial risks?
• How forgiving are the financials?
• How easy is it to cash out of the business?

Each opportunity should be evaluated for at least its first five years of operation. Profitability in the first year is not as critical as cash flow. Few firms make a profit in the first year. Cash flow is critical from the beginning, however, because it is the lifeblood of the new venture. Too many new ventures die on the vine because they run out of cash. The ideal situation would be for the new venture to have a hockey-stick or J-shaped growth curve and substantial margins. Opportunities that can maintain a 20+ percent annual growth rate, have at least a 10 to 15 percent profit on sales after tax, and generate a 20 to 25 percent return on investment will help justify risking your time and money.

Veteran entrepreneurs frequently reflect on what would be the ideal situation from a financial perspective when starting a new venture. They list such factors as the ability to make an extraordinary return on a minimal investment, the ability to generate positive cash flow and profitability right away, minimal loss if things do not work out, ease of cashing out, and a steady stream of people who want to buy the venture that will give you an incredible gain.

It was once noted that it takes seven years to find out if the venture is truly successful and less than two years to find out if it is a loser. The time to reach profitability and positive cash flow is important because it reduces your financial vulnerability. The ability to generate a favorable position is also important because it makes it easier to sell the venture if you find your talent and interests are more in starting ventures than managing them. The longer it takes the venture to generate solid financial returns, the greater the risk. Patrick Duffeler, who founded Williamsburg Winery, started his venture with the prospect of going seven years before it would generate any sales revenue. He noted, however, that if the venture did not generate a profit, at least he could spend the rest of his life liquidating the inventory!

The time frame and return on investment are important for another reason. Both factors will influence how much time and money you may be willing to commit to the venture. If your goal is to build an exceptional enterprise and own it for some time, then you will look at the financial worthiness of various opportunities from a long-term perspective. If you want to cash out within a few years, then you will need to direct your attention to opportunities that generate favorable financials right away. The time frame and the amount of money required for the venture may also affect your evaluation of various opportunities. Kathleen Allen, author of Bringing New Technology to Market, noted that if you have developed a highly innovative product or service and are not committed to the long haul and/or have limited funds, then you should consider licensing or selling it to another firm rather than doing it all yourself.

RANKING THE OPPORTUNITIES
Let’s assume that a few opportunities have made it through the screening process. If resources are available and the entrepreneur and team have the necessary skills and capabilities, then the evaluation process comes down to (1) financial attractiveness, (2) projected risk, and (3) personal preference. The remaining opportunities can be rated on a 10-point scale for each of these three criteria. Each type of stakeholder may place a different weight on each of the factors. Sophisticated investors place little value on the emotional appeal of the opportunity. They look at each opportunity’s financial worthiness and how it fits their overall investment portfolio.

Investors look for opportunities that will provide significant capital appreciation with an acceptable risk. Less sophisticated investors may place a personal preference fudge factor on opportunities that are in their zone of familiarity. Although they may not admit it, most people would rather invest in something that has emotional appeal such as a minor league baseball franchise, rather than a worm farm or a medical waste disposal business.

Bankers look at the degree of risk in their evaluation of a loan application. Each loan request is reviewed to determine inherent risk and ability to pay off the note. Although bankers do not focus their attention on the opportunity’s ability to generate considerable wealth, they do place a premium on business opportunities that will borrow larger amounts of money to finance additional growth.

The entrepreneur’s personal preference is rarely left out of the evaluation equation and the final decision. Personal preference should be considered at this stage. Personal preference can be weighted to reflect how important it may be to the entrepreneur. Most entrepreneurs place a high weight on personal preference. Because they will be investing their blood, sweat, and tears in the venture as well as their own money, they tend to place a premium on opportunities that fit their personal interests. If they like to travel, entertain, and products that make a difference in people’s lives, then they may place a premium on opportunities that supplement financial rewards with nonfinancial rewards.

The desire to do something that fits the entrepreneur’s interests and desires may far outweigh their concern for wealth and aversion to risk. Steve Schussler, who created Rainforest Café, may be one of the best examples of the role that passion plays for an entrepreneur who is driven to see his dream for creating a Disney-like family restaurant realized. His passion for his venture gave him the resilience needed to face all the challenges and to bounce back from all the setbacks associated with turning his concept into reality. Most people would have thrown in the towel when faced with just a fraction of the situations he encountered in the years he devoted to developing his innovative restaurant.
Risk, financial worthiness, and personal preference may vary from industry to industry. The rate of technological change and obsolescence place most firms in a very precarious position. Some industries can be lucrative for the firms that are in sync with market realities. Some industries allow some leeway for firms that seem to have questionable standards and practices. You should step back and ask yourself if you are willing to take that level of risk, commit the level of resources to capture lucrative gains, and whether you want to put yourself in a situation where the firms you may be competing with or the customers you may be serving may have questionable standards.

Your analysis may reveal that the challenges associated with the targeted opportunity may not be formidable. You may find that the opportunity is not as complicated as it appeared when it was originally identified. You may find that it actually appeals to your interests and that when you learned the jargon, you were able to learn about the technology and market conditions. You might find that a trade association offers a wealth of information and services for people who plan to start a business in that industry. You might find that professional organizations have departments to help their clients. Some accounting firms, legal practices, staffing firms, banks and other financial institutions have specialists in certain industries. You might also find that key technical people that need to be hired are readily available.