The Spreadsheet Mirage

It is hard to imagine any entrepreneur who would not want ready answers to many financial vigilance questions. (See Exhibit 4.1.) Until now, however, getting the answers to these questions was a rarity. If the capacity and information are there to do the necessary analysis (and fre­quently they are not), it can take up to several weeks to get a response. In this era of spreadsheet mania, more often than not, the answers will come in the form of a lengthy report with innumerable scenarios, pages of numbers, backup exhibits, and possibly a stand-up presentation by a staff financial analyst, controller, or chief financial officer.

Yet, all too often the barrage of spreadsheet exhibits is really a mirage. What is missing? Traditional spreadsheets can only report and manip­ulate the data. The numbers may be there, the trends may be identified, but the connections and interdepend encies between financial structure and business decisions inherent in key financial questions may be missed. As a result, gaining true insights and getting to creative alternatives and new solutions may be painfully slow, if not interminable. By themselves, spreadsheets cannot model the more complex financial and strategic interrelationships that entrepreneurs need to grasp. And for the board of directors, delays or failures to get this information can be disastrous. Such a weakness in financial know-how becomes life-threatening for entrepreneurs (such as those noted earlier) when it comes to anticipat­ing the financial and risk-reward consequences of their business deci­sions. During a period of financial crisis, such a weakness can make an already dismal situation even worse.

Time and again, financially fluent and skillful entrepreneurs push what would otherwise be an average company toward greatness. What many entrepreneurs may fail to consider is the acumen of competitorExhibit 4.1 The Crux of It: Anticipation and Financial Vigilance

To avoid some of the greatest tar pits, entrepreneurs need answers to questions that link strategic business decisions to financial plans and choices. The crux of it is anticipation: What is most likely to happen? When? What can go right along the way? What can go wrong? What has to happen to achieve our business objectives and to increase or to preserve our options? Financially savvy entrepreneurs know that such questions trigger a process that can lead to creative solutions to their financial challenges and problems. At a practical level, financially astute entrepreneurs and managers maintain vigilance over numerous key strategic and financial questions:

What are the financial consequences and implications of crucial business decisions such as pricing, volume, and policy changes affecting the balance sheet, income statement, and cash flow? How will these change over time?

How can we measure and monitor changes in our financial strategy and structure from a management, not just a GAAP,* perspective?

What does it mean to grow too fast in our industry? How fast can we grow without requiring outside debt or equity? How much capital is required if we increase or decrease our growth byx percent?

What will happen to our cash flow, profitability, return on assets, and shareholder equity if we grow faster or slower byx percent?

How much capital will this require? How much can be financed internally and how much will have to come from external sources? What is a reasonable mix of debt and equity?

What if we are 20 percent less profitable than our plan calls for? Or 20 percent more profitable?

What should be our focus and priorities! What are the cash flow and net income break­even points for each of our product lines? For our company? For our business unit?

What about our pricing volume, and costs? How sensitive is our cash flow and net income to increases or decreases in price, volume, or variable costs? What price-volume mix will enable us to achieve the same cash flow and net income?

How will these changes in pricing, volume, and costs affect our key financial ratios, and how will we stack up against others in our industry? How will our lenders view this?

At each stage - rapidly growing, stagnating, or mature company - how should we be thinking about these questions and issues?

*GAAP is an acronym for generally accepted accounting principles. Basic financial ratio formulas can be found at

CEOs. They will move faster, more nimbly, and with less risk because they understand the language and nuance of the finance world. Such adversaries enjoy a secret competitive weapon that can yield a decisive edge over less financially skilled entrepreneurs.

Critical Financing Issues

Exhibit 4.2 illustrates the central issues in entrepreneurial finance. These include the creation of value, how the value pie is sliced and

divided among those who have a stake or have participated in the ven­ture, and the handling of the risks inherent in the venture. Developing financing and fund-raising strategies, knowing what alternatives are available, and obtaining funding are tasks vital to the survival and suc­cess of most higher-potential ventures.

As a result, entrepreneurs face certain critical issues and problems that bear on the financing of entrepreneurial ventures:

• Creating value. Who are the constituencies for whom value must be created or added to achieve a positive cash flow and to develop harvest options?

Exhibit 4.2 Central Issues in Entrepreneurial Finance

>m Customers

Value creation

Shareholders

Employees

Slicing the value pie

Covering risk

f*

S

t^

S

Allocating risks and returns

Cash-risk-time

Debt: take control

Equity: staged commitments

• Slicing the value pie:

- How are deals, both for start-ups and for the purchases of existing ventures, structured and valued, and what are the critical tax consequences of different venture structures?

- What is the legal process, and what are the key issues involved in raising outside risk capital?

- How do entrepreneurs make effective presentations of their business plans to financing and other sources?

- What are some of the nastier pitfalls, minefields, and hazards that need to be anticipated, prepared for, and responded to?

- How critical and sensitive is timing in each of these areas?

• Covering risk:

- How much money is needed to start, acquire, or expand the business, and when, where, and how can it be obtained on acceptable terms?

- What sources of risk and venture capital financing - equity debt and other innovative types - are available, and how is appropriate financing negotiated and obtained?

- Who are the financial contacts and networks that need to be accessed and developed?

- How do successful entrepreneurs marshal the necessary financial resources and other financial equivalents to seize and execute opportunities? What pitfalls do they manage to avoid, and how? Can a staged approach to resource acquisition mitigate risk and increase return?

A clear understanding of the financing requirements is especially vital for new and emerging companies, because new ventures go through the torturous and heated competition for capital, compared to existing firms, both smaller and larger, that have a customer base and revenue stream. In the early going, new firms are gluttons for capital, yet are usually not very debt-worthy. To make matters worse, the faster they grow, the more gluttonous is their appetite for cash.

This phenomenon is best illustrated in Exhibit 4.3, where loss as a percentage of initial equity is plotted against time. The shaded area rep­resents the cumulative cash flow of 157 companies from their inception.

For these firms, it took thirty months to achieve operating breakeven and seventy-five months (or going into the seventh year) to recover the initial equity. As can be seen from the illustration, cash goes out for a long time before it starts to come in. This phenomenon is at the heart of the financing challenges facing new and emerging companies.

More thematic eBooks are located at : capital basics