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[glossaryBu]
William A. Sahlman
ew areas of business attract as much attention as new ventures, and few aspects
of new-venture creation attract as much attention as the business plan.
Countless books and articles in the popular press dissect the topic. A growing
number of annual business-plan contests are springing up across the United
States and, increasingly, in other countries. Both graduate and undergraduate
schools devote entire courses to the subject. Indeed, judging by all the hoopla
surrounding business plans, you would think that the only things standing
between a would-be entrepreneur and spectacular success are glossy five-color
charts, a bundle of meticulous-looking spreadsheets, and a decade of
month-by-month financial projections.
Nothing could be further from the truth. In my experience with hundreds of
entrepreneurial startups, business plans rank no higher than 2 on a scale from
1 to 10 as a predictor of a new venture s success. And sometimes, in fact, the
more elaborately crafted the document, the more likely the venture is to, well,
flop, for lack of a more euphemistic word.
What s wrong with most business plans? The answer is relatively
straightforward. Most waste too much ink on numbers and devote too little to
the information that really matters to intelligent investors. As every seasoned
investor knows, financial projections for a new company especially detailed,
month-by-month projections that stretch out for more than a year are an act of
imagination. An entrepreneurial venture faces far too many unknowns to predict
revenues, let alone profits. Moreover, few if any entrepreneurs correctly
anticipate how much capital and time will be required to accomplish their
objectives. Typically, they are wildly optimistic, padding their projections.
Investors know about the padding effect and therefore discount the figures in
business plans. These maneuvers create a vicious circle of inaccuracy that
benefits no one.
Don t misunderstand me: business plans should include some numbers. But those
numbers should appear mainly in the form of a business model that shows the
entrepreneurial team has thought through the key drivers of the venture s
success or failure. In manufacturing, such a driver might be the yield on a
production process; in magazine publishing, the anticipated renewal rate; or in
software, the impact of using various distribution channels. The model should
also address the break-even issue: At what level of sales does the business
begin to make a profit? And even more important, When does cash flow turn
positive? Without a doubt, these questions deserve a few pages in any business
plan. Near the back.
What goes at the front? What information does a good business plan contain?
If you want to speak the language of investors and also make sure you have
asked yourself the right questions before setting out on the most daunting
journey of a businessperson s career I recommend basing your business plan on
the framework that follows. It does not provide the kind of winning formula
touted by some current how-to books and software programs for entrepreneurs.
Nor is it a guide to brain surgery. Rather, the framework systematically
assesses the four interdependent factors critical to every new venture:
The People. The men and women starting and running the venture, as well as the
outside parties providing key services or important resources for it, such as
its lawyers, accountants, and suppliers.
The Opportunity. A profile of the business itself what it will sell and to
whom, whether the business can grow and how fast, what its economics are, who
and what stand in the way of success.
The Context. The big picture the regulatory environment, interest rates,
demographic trends, inflation, and the like basically, factors that inevitably
change but cannot be controlled by the entrepreneur.
Risk and Reward. An assessment of everything that can go wrong and right, and a
discussion of how the entrepreneurial team can respond.
---
Business Plans: For Entrepreneurs Only?
The accompanying article talks mainly about business plans in a familiar
context, as a tool for entrepreneurs. But quite often, start-ups are launched
within established companies. Do those new ventures require business plans? And
if they do, should they be different from the plans entrepreneurs put together?
The answer to the first question is an emphatic yes; the answer to the second,
an equally emphatic no. All new ventures whether they are funded by venture
capitalists or, as is the case with intrapreneurial businesses, by shareholders
need to pass the same acid tests. After all, the marketplace does not
differentiate between products or services based on who is pouring money into
them behind the scenes.
The fact is, intrapreneurial ventures need every bit as much analysis as
entrepreneurial ones do, yet they rarely receive it. Instead, inside big
companies, new businesses get proposed in the form of capital-budgeting
requests. These faceless documents are subject to detailed financial scrutiny
and a consensus-building process, as the project wends its way through the
chain of command, what I call the neutron bomb model of project governance.
However, in the history of such proposals, a plan never has been submitted that
did not promise returns in excess of corporate hurdle rates. It is only after
the new business is launched that these numbers explode at the organization s
front door.
That problem could be avoided in large part if intrapreneurial ventures
followed the guidelines set out in the accompanying article. For instance,
business plans for such a venture should begin with the r sum s of all the
people involved. What has the team done in the past that would suggest it would
be successful in the future, and so on? In addition, the new venture s product
or service should be fully analyzed in terms of its opportunity and context.
Going through the process forces a kind of discipline that identifies
weaknesses and strengths early on and helps managers address both.
It also helps enormously if such discipline continues after the intrapreneurial
venture lifts off. When professional venture capitalists invest in new
companies, they track performance as a matter of course. But in large
companies, scrutiny of a new venture is often inconsistent. That shouldn t or
needn t be the case. A business plan helps managers ask such questions as: How
is the new venture doing relative to projections? What decisions has the team
made in response to new information? Have changes in the context made
additional funding necessary? How could the team have predicted those changes?
Such questions not only keep a new venture running smoothly but also help an
organization learn from its mistakes and triumphs.
Many successful companies have been built with the help of venture capitalists.
Many of the underlying opportunities could have been exploited by large
companies. Why weren t they? Perhaps useful lessons can be learned by studying
the world of independent ventures, one lesson being: Write a great business
plan.
---
The assumption behind the framework is that great businesses have attributes
that are easy to identify but hard to assemble. They have an experienced,
energetic managerial team from the top to the bottom. The team s members have
skills and experiences directly relevant to the opportunity they are pursuing.
Ideally, they will have worked successfully together in the past. The
opportunity has an attractive, sustainable business model; it is possible to
create a competitive edge and defend it. Many options exist for expanding the
scale and scope of the business, and these options are unique to the enterprise
and its team. Value can be extracted from the business in a number of ways
either through a positive harvest event a sale or by scaling down or
liquidating. The context is favorable with respect to both the regulatory and
the macro-economic environments. Risk is understood, and the team has
considered ways to mitigate the impact of difficult events. In short, great
businesses have the four parts of the framework completely covered. If only
reality were so neat.
The People
When I receive a business plan, I always read the r sum section first. Not
because the people part of the new venture is the most important, but because
without the right team, none of the other parts really matters.
I read the r sum s of the venture s team with a list of questions in mind. (See
the insert Who Are These People, Anyway? ) All these questions get at the same
three issues about the venture s team members: What do they know? Whom do they
know? and How well are they known?
---
Who Are These People, Anyway?
Fourteen Personal Questions Every Business Plan Should Answer
Where are the founders from?
Where have they been educated?
Where have they worked and for whom?
What have they accomplished professionally and personally in the past?
What is their reputation within the business community?
What experience do they have that is directly relevant to the opportunity they
are pursuing?
What skills, abilities, and knowledge do they have?
How realistic are they about the venture s chances for success and the
tribulations it will face?
Who else needs to be on the team?
Are they prepared to recruit high-quality people?
How will they respond to adversity?
Do they have the mettle to make the inevitable hard choices that have to be
made?
How committed are they to this venture?
What are their motivations?
---
What and whom they know are matters of insight and experience. How familiar are
the team members with industry players and dynamics? Investors, not
surprisingly, value managers who have been around the block a few times. A
business plan should candidly describe each team member s knowledge of the new
venture s type of product or service; its production processes; and the market
itself, from competitors to customers. It also helps to indicate whether the
team members have worked together before. Not played as in roomed together in
college but worked.
Investors also look favorably on a team that is known because the real world
often prefers not to deal with start-ups. They re too unpredictable. That
changes, however, when the new company is run by people well known to
suppliers, customers, and employees. Their enterprise may be brand new, but
they aren t. The surprise element of working with a start-up is somewhat
ameliorated.
Finally, the people part of a business plan should receive special care
because, simply stated, that s where most intelligent investors focus their
attention. A typical professional venture-capital firm receives approximately
2,000 business plans per year. These plans are filled with tantalizing ideas
for new products and services that will change the world and reap billions in
the process or so they say. But the fact is, most venture capitalists believe
that ideas are a dime a dozen: only execution skills count. As Arthur Rock, a
venture capital legend associated with the formation of such companies as
Apple, Intel, and Teledyne, states, I invest in people, not ideas. Rock also
has said, If you can find good people, if they re wrong about the product,
they ll make a switch, so what good is it to understand the product that they
re talking about in the first place?
Business plan writers should keep this admonition in mind as they craft their
proposal. Talk about the people exhaustively. And if there is nothing solid
about their experience and abilities to herald, then the entrepreneurial team
should think again about launching the venture.
The Opportunity
When it comes to the opportunity itself, a good business plan begins by
focusing on two questions: Is the total market for the venture s product or
service large, rapidly growing, or both? Is the industry now, or can it become,
structurally attractive? Entrepreneurs and investors look for large or rapidly
growing markets mainly because it is often easier to obtain a share of a
growing market than to fight with entrenched competitors for a share of a
mature or stagnant market. Smart investors, in fact, try hard to identify
high-growth-potential markets early in their evolution: that s where the big
payoffs are. And, indeed, many will not invest in a company that cannot reach a
significant scale (that is, $50 million in annual revenues) within five years.
As for attractiveness, investors are obviously looking for markets that
actually allow businesses to make some money. But that s not the no-brainer it
seems. In the late 1970s, the computer disk-drive business looked very
attractive. The technology was new and exciting. Dozens of companies jumped
into the fray, aided by an army of professional investors. Twenty years later,
however, the thrill is gone for managers and investors alike. Disk drive
companies must design products to meet the perceived needs of original
equipment manufacturers (OEMs) and end users. Selling a product to OEMs is
complicated. The customers are large relative to most of their suppliers. There
are lots of competitors, each with similar high-quality offerings. Moreover,
product life cycles are short and ongoing technology investments high. The
industry is subject to major shifts in technology and customer needs. Intense
rivalry leads to lower prices and, hence, lower margins. In short, the disk
drive industry is simply not set up to make people a lot of money; it s a
structural disaster area.
The information services industry, by contrast, is paradise. Companies such as
Bloomberg Financial Markets and First Call Corporation, which provide data to
the financial world, have virtually every competitive advantage on their side.
First, they can assemble or create proprietary content content that, by the
way, is like life s blood to thousands of money managers and stock analysts
around the world. And although it is often expensive to develop the service and
to acquire initial customers, once up and running, these companies can deliver
content to customers very cheaply. Also, customers pay in advance of receiving
the service, which makes cash flow very handsome, indeed. In short, the
structure of the information services industry is beyond attractive: it s
gorgeous. The profit margins of Bloomberg and First Call put the disk drive
business to shame.
---
The Opportunity of a Lifetime or Is It?
Nine Questions About the Business Every Business Plan Should Answer
Who is the new venture s customer?
How does the customer make decisions about buying this product or service?
To what degree is the product or service a compelling purchase for the
customer?
How will the product or service be priced?
How will the venture reach all the identified customer segments?
How much does it cost (in time and resources) to acquire a customer?
How much does it cost to produce and deliver the product or service?
How much does it cost to support a customer?
How easy is it to retain a customer?
---
Thus, the first step for entrepreneurs is to make sure they are entering an
industry that is large and/or growing, and one that s structurally attractive.
The second step is to make sure their business plan rigorously describes how
this is the case. And if it isn t the case, their business plan needs to
specify how the venture will still manage to make enough of a profit that
investors (or potential employees or suppliers, for that matter) will want to
participate.
Once it examines the new venture s industry, a business plan must describe in
detail how the company will build and launch its product or service into the
marketplace. Again, a series of questions should guide the discussion. (See the
insert The Opportunity of a Lifetime or Is It? )
Often the answers to these questions reveal a fatal flaw in the business. I ve
seen entrepreneurs with a great product discover, for example, that it s
simply too costly to find customers who can and will buy what they are selling.
Economically viable access to customers is the key to business, yet many
entrepreneurs take the Field of Dreams approach to this notion: build it, and
they will come. That strategy works in the movies but is not very sensible in
the real world.
It is not always easy to answer questions about the likely consumer response to
new products or services. The market is as fickle as it is unpredictable. (Who
would have guessed that plug-in room deodorizers would sell?) One entrepreneur
I know proposed to introduce an electronic news-clipping service. He made his
pitch to a prospective venture-capital investor who rejected the plan, stating,
I just don t think the dogs will eat the dog food. Later, when the
entrepreneur s company went public, he sent the venture capitalist an anonymous
package containing an empty can of dog food and a copy of his prospectus. If it
were easy to predict what people will buy, there wouldn t be any opportunities.
The market is as fickle as it is unpredictable. Who would have guessed that
plug-in room deodorizers would sell?
Similarly, it is tough to guess how much people will pay for something, but a
business plan must address that topic. Sometimes, the dogs will eat the dog
food, but only at a price less than cost. Investors always look for
opportunities for value pricing that is, markets in which the costs to produce
the product are low, but consumers will still pay a lot for it. No one is dying
to invest in a company when margins are skinny. Still, there is money to be
made in inexpensive products and services even in commodities. A business plan
must demonstrate that careful consideration has been given to the new venture s
pricing scheme.
The list of questions about the new venture s opportunity focuses on the direct
revenues and the costs of producing and marketing a product. That s fine, as
far as it goes. A sensible proposal, however, also involves assessing the
business model from a perspective that takes into account the investment
required that is, the balance sheet side of the equation. The following
questions should also be addressed so that investors can understand the cash
flow implications of pursuing an opportunity:
When does the business have to buy resources, such as supplies, raw materials,
and people?
When does the business have to pay for them?
How long does it take to acquire a customer?
How long before the customer sends the business a check?
How much capital equipment is required to support a dollar of sales?
Investors, of course, are looking for businesses in which management can buy
low, sell high, collect early, and pay late. The business plan needs to spell
out how close to that ideal the new venture is expected to come. Even if the
answer is not very and it usually is at least the truth is out there to
discuss.
The opportunity section of a business plan must also bring a few other issues
to the surface. First, it must demonstrate and analyze how an opportunity can
grow in other words, how the new venture can expand its range of products or
services, customer base, or geographic scope. Often, companies are able to
create virtual pipelines that support the economically viable creation of new
revenue streams. In the publishing business, for example, Inc. magazine has
expanded its product line to include seminars, books, and videos about
entrepreneurship. Similarly, building on the success of its personal-finance
software program Quicken, Intuit now sells software for electronic banking,
small-business accounting, and tax preparation, as well as personal-printing
supplies and on-line information services to name just a few of its highly
profitable ancillary spin-offs.
Now, lots of business plans runneth over on the subject of the new venture s
potential for growth and expansion. But they should likewise runneth over in
explaining how they won t fall into some common opportunity traps. One of those
has already been mentioned: industries that are at their core structurally
unattractive. But there are others. The world of invention, for example, is
fraught with danger. Over the past 15 years, I have seen scores of individuals
who have devised a better mousetrap newfangled creations from inflatable
pillows for use on airplanes to automated car-parking systems. Few of these
idea-driven companies have really taken off, however. I m not entirely sure
why. Sometimes, the inventor refuses to spend the money required by or share
the rewards sufficiently with the business side of the company. Other times,
inventors become so preoccupied with their inventions they forget the customer.
Whatever the reason, better-mousetrap businesses have an uncanny way of
malfunctioning.
Another opportunity trap that business plans and entrepreneurs in general need
to pay attention to is the tricky business of arbitrage. Basically, arbitrage
ventures are created to take advantage of some pricing disparity in the
marketplace. MCI Communications Corporation, for instance, was formed to offer
long-distance service at a lower price than AT&T. Some of the industry
consolidations going on today reflect a different kind of arbitrage the ability
to buy small businesses at a wholesale price, roll them up together into a
larger package, and take them public at a retail price, all without necessarily
adding value in the process.
Whatever the reason, better-mousetrap businesses have an uncanny way of
malfunctioning.
Taking advantage of arbitrage opportunities is a viable and potentially
profitable way to enter a business. In the final analysis, however, all
arbitrage opportunities evaporate. It is not a question of whether, only when.
The trick in these businesses is to use the arbitrage profits to build a more
enduring business model, and business plans must explain how and when that will
occur.
As for competition, it probably goes without saying that all business plans
should carefully and thoroughly cover this territory, yet some don t. That is a
glaring omission. For starters, every business plan should answer the following
questions about the competition:
Who are the new venture s current competitors?
What resources do they control? What are their strengths and weaknesses?
How will they respond to the new venture s decision to enter the business?
How can the new venture respond to its competitors response?
Who else might be able to observe and exploit the same opportunity?
Are there ways to co-opt potential or actual competitors by forming alliances?
Business is like chess: to be successful, you must anticipate several moves in
advance. A business plan that describes an insuperable lead or a proprietary
market position is by definition written by na ve people. That goes not just
for the competition section of the business plan but for the entire discussion
of the opportunity. All opportunities have promise; all have vulnerabilities. A
good business plan doesn t whitewash the latter. Rather, it proves that the
entrepreneurial team knows the good, the bad, and the ugly that the venture
faces ahead.
The Context
Opportunities exist in a context. At one level is the macroeconomic
environment, including the level of economic activity, inflation, exchange
rates, and interest rates. At another level are the wide range of government
rules and regulations that affect the opportunity and how resources are
marshaled to exploit it. Examples extend from tax policy to the rules about
raising capital for a private or public company. And at yet another level are
factors like technology that define the limits of what a business or its
competitors can accomplish.
Context often has a tremendous impact on every aspect of the entrepreneurial
process, from identification of opportunity to harvest. In some cases, changes
in some contextual factor create opportunity. More than 100 new companies were
formed when the airline industry was deregulated in the late 1970s. The context
for financing was also favorable, enabling new entrants like People Express to
go to the public market for capital even before starting operations.
Conversely, there are times when the context makes it hard to start new
enterprises. The recession of the early 1990s combined with a difficult
financing environment for new companies: venture capital disbursements were
low, as was the amount of capital raised in the public markets. (Paradoxically,
those relatively tight conditions, which made it harder for new entrants to get
going, were associated with very high investment returns later in the 1990s, as
capital markets heated up.)
Sometimes, a shift in context turns an unattractive business into an attractive
one, and vice versa. Consider the case of a packaging company some years ago
that was performing so poorly it was about to be put on the block. Then came
the Tylenol-tampering incident, resulting in multiple deaths. The packaging
company happened to have an efficient mechanism for installing tamper-proof
seals, and in a matter of weeks its financial performance could have been
called spectacular. Conversely, U.S. tax reforms enacted in 1986 created havoc
for companies in the real estate business, eliminating almost every positive
incentive to invest. Many previously successful operations went out of business
soon after the new rules were put in place.
Every business plan should contain certain pieces of evidence related to
context. First, the entrepreneurs should show a heightened awareness of the new
venture s context and how it helps or hinders their specific proposal. Second,
and more important, they should demonstrate that they know the venture s
context will inevitably change and describe how those changes might affect the
business. Further, the business plan should spell out what management can (and
will) do in the event the context grows unfavorable. Finally, the business plan
should explain the ways (if any) in which management can affect context in a
positive way. For example, management might be able to have an impact on
regulations or on industry standards through lobbying efforts.
Risk and Reward
The concept that context is fluid leads directly to the fourth leg of the
framework I propose: a discussion of risk and how to manage it. I ve come to
think of a good business plan as a snapshot of an event in the future. That s
quite a feat to begin with taking a picture of the unknown. But the best
business plans go beyond that; they are like movies of the future. They show
the people, the opportunity, and the context from multiple angles. They offer a
plausible, coherent story of what lies ahead. They unfold possibilities of
action and reaction.
Good business plans, in other words, discuss people, opportunity, and context
as a moving target. All three factors (and the relationship among them) are
likely to change over time as a company evolves from start-up to ongoing
enterprise. Therefore, any business plan worth the time it takes to write or
read needs to focus attention on the dynamic aspects of the entrepreneurial
process.
---
Visualizing Risk and Reward
When it comes to the matter of risk and reward in a new venture, a business
plan benefits enormously from the inclusion of two graphs. Perhaps graphs is
the wrong word; these are really just schematic pictures that illustrate the
most likely relationship between risk and reward, that is, the relationship
between the opportunity and its economics. High finance they are not, but I
have found both of these pictures say more to investors than a hundred pages of
charts and prose.
The first picture depicts the amount of money needed to launch the new venture,
time to positive cash flow, and the expected magnitude of the payoff.
This image helps the investor understand the depth and duration of negative
cash flow, as well as the relationship between the investment and the possible
return. The ideal, needless to say, is to have cash flow early and often. But
most investors are intrigued by the picture even when the cash outflow is high
and long as long as the cash inflow is more so.
Of course, since the world of new ventures is populated by wild-eyed optimists,
you might expect the picture to display a shallower hole and a steeper reward
slope than it should. It usually does. But to be honest, even that kind of
picture belongs in the business plan because it is a fair warning to investors
that the new venture s team is completely out of touch with reality and should
be avoided at all costs.
The second picture complements the first. It shows investors the range of
possible returns and the likelihood of achieving them. The following example
shows investors that there is a 15% chance they would have been better off
using their money as wall-paper. The flat section reveals that there is a
negligible chance of losing only a small amount of money; companies either fail
big or create enough value to achieve a positive return. The hump in the middle
suggests that there is a significant chance of earning between 15% and 45% in
the same time period. And finally, there is a small chance that the initial
outlay of cash will spawn a 200% internal rate of return, which might have
occurred if you had happened to invest in Microsoft when it was a private
company.
Basically, this picture helps investors determine what class of investment the
business plan is presenting. Is the new venture drilling for North Sea oil
highly risky with potentially big payoffs or is it digging development wells in
Texas, which happens to be less of a geological gamble and probably less
lucrative, too? This image answers that kind of question. It s then up to the
investors to decide how much risk they want to live with against what kind of
odds.
Again, the people who write business plans might be inclined to skew the
picture to make it look as if the probability of a significant return is
downright huge and the possibility of loss is negligible. And, again, I would
say therein lies the picture s beauty. What it claims, checked against the
investor s sense of reality and experience, should serve as a simple pictorial
caveat emptor.
---
Of course, the future is hard to predict. Still, it is possible to give
potential investors a sense of the kind and class of risk and reward they are
assuming with a new venture. All it takes is a pencil and two simple drawings.
(See the insert Visualizing Risk and Reward. ) But even with these drawings,
risk is, well, risky. In reality, there are no immutable distributions of
outcomes. It is ultimately the responsibility of management to change the
distribution, to increase the likelihood and consequences of success, and to
decrease the likelihood and implications of problems.
One of the great myths about entrepreneurs is that they are risk seekers. All
sane people want to avoid risk. As Harvard Business School professor (and
venture capitalist) Howard Stevenson says, true entrepreneurs want to capture
all the reward and give all the risk to others. The best business is a post
office box to which people send cashier s checks. Yet risk is unavoidable. So
what does that mean for a business plan?
It means that the plan must unflinchingly confront the risks ahead in terms of
people, opportunity, and context. What happens if one of the new venture s
leaders leaves? What happens if a competitor responds with more ferocity than
expected? What happens if there is a revolution in Namibia, the source of a key
raw material? What will management actually do?
Those are hard questions for an entrepreneur to pose, especially when seeking
capital. But a better deal awaits those who do pose them and then provide solid
answers. A new venture, for example, might be highly leveraged and therefore
very sensitive to interest rates. Its business plan would benefit enormously by
stating that management intends to hedge its exposure through the
financial-futures market by purchasing a contract that does well when interest
rates go up. That is the equivalent of offering investors insurance. (It also
makes sense for the business itself.)
Finally, one important area in the realm of risk/reward management relates to
harvesting. Venture capitalists often ask if a company is IPOable, by which
they mean, Can the company be taken public at some point in the future? Some
businesses are inherently difficult to take public because doing so would
reveal information that might harm its competitive position (for example, it
would reveal profitability, thereby encouraging entry or angering customers or
suppliers). Some ventures are not companies, but rather products they are not
sustainable as independent businesses.
One of the greatest myths about entrepreneurs is that they are risk seekers.
All sane people want to avoid risk.
Therefore, the business plan should talk candidly about the end of the process.
How will the investor eventually get money out of the business, assuming it is
successful, even if only marginally so? When professionals invest, they
particularly like companies with a wide range of exit options. They like
companies that work hard to preserve and enhance those options along the way,
companies that don t, for example, unthinkingly form alliances with big
corporations that could someday actually buy them. Investors feel a lot better
about risk if the venture s endgame is discussed up front. There is an old
saying, If you don t know where you are going, any road will get you there.
In crafting sensible entrepreneurial strategies, just the opposite is true: you
had better know where you might end up and have a map for getting there. A
business plan should be the place where that map is drawn, for, as every
traveler knows, a journey is a lot less risky when you have directions.
The Deal and Beyond
Once a business plan is written, of course, the goal is to land a deal. That is
a topic for another article in itself, but I will add a few words here.
When I talk to young (and old) entrepreneurs looking to finance their ventures,
they obsess about the valuation and terms of the deal they will receive. Their
explicit goal seems to be to minimize the dilution they will suffer in raising
capital. Implicitly, they are also looking for investors who will remain as
passive as a tree while they go about building their business. On the food
chain of investors, it seems, doctors and dentists are best and venture
capitalists are worst because of the degree to which the latter group demands
control and a large share of the returns.
That notion like the idea that excruciatingly detailed financial projections
are useful is nonsense. From whom you raise capital is often more important
than the terms. New ventures are inherently risky, as I ve noted; what can go
wrong will. When that happens, unsophisticated investors panic, get angry, and
often refuse to advance the company more money. Sophisticated investors, by
contrast, roll up their sleeves and help the company solve its problems. Often,
they ve had lots of experience saving sinking ships. They are typically process
literate. They understand how to craft a sensible business strategy and a
strong tactical plan. They know how to recruit, compensate, and motivate team
members. They are also familiar with the Byzantine ins and outs of going public
an event most entrepreneurs face but once in a lifetime. This kind of know-how
is worth the money needed to buy it.
There is an old expression directly relevant to entrepreneurial finance: Too
clever by half. Often, deal makers get very creative, crafting all sorts of
payoff and option schemes. That usually backfires. My experience has proven
again and again that sensible deals have the following six characteristics:
They are simple.
They are fair.
They emphasize trust rather than legal ties.
They do not blow apart if actual differs slightly from plan.
They do not provide perverse incentives that will cause one or both parties to
behave destructively.
They are written on a pile of papers no greater than one-quarter inch thick.
But even these six simple rules miss an important point. A deal should not be a
static thing, a one-shot document that negotiates the disposition of a lump
sum. Instead, it is incumbent upon entrepreneurs, before they go searching for
funding, to think about capital acquisition as a dynamic process to figure out
how much money they will need and when they will need it.
How is that accomplished? The trick is for the entrepreneurial team to treat
the new venture as a series of experiments. Before launching the whole show,
launch a little piece of it. Convene a focus group to test the product, build a
prototype and watch it perform, conduct a regional or local rollout of a
service. Such an exercise reveals the true economics of the business and can
help enormously in determining how much money the new venture actually requires
and in what stages. Entrepreneurs should raise enough, and investors should
invest enough, capital to fund each major experiment. Experiments, of course,
can feel expensive and risky. But I ve seen them prevent disasters and help
create successes. I consider it a prerequisite of putting together a winning
deal.
Beware the Albatross
Among the many sins committed by business plan writers is arrogance. In today s
economy, few ideas are truly proprietary. Moreover, there has never been a time
in recorded history when the supply of capital did not outrace the supply of
opportunity. The true half-life of opportunity is decreasing with the passage
of time.
A business plan must not be an albatross that hangs around the neck of the
entrepreneurial team, dragging it into oblivion. Instead, a business plan must
be a call for action, one that recognizes management s responsibility to fix
what is broken proactively and in real time. Risk is inevitable, avoiding risk
impossible. Risk management is the key, always tilting the venture in favor of
reward and away from risk.
A plan must demonstrate mastery of the entire entrepreneurial process, from
identification of opportunity to harvest. It is not a way to separate
unsuspecting investors from their money by hiding the fatal flaw. For in the
final analysis, the only one being fooled is the entrepreneur.
We live today in the golden age of entrepreneurship. Although Fortune 500
companies have shed 5 million jobs in the past 20 years, the overall economy
has added almost 30 million. Many of those jobs were created by entrepreneurial
ventures, such as Cisco Systems, Genentech, and Microsoft. Each of those
companies started with a business plan. Is that why they succeeded? There is no
knowing for sure. But there is little doubt that crafting a business plan so
that it thoroughly and candidly addresses the ingredients of success people,
opportunity, context, and the risk/reward picture is vitally important. In the
absence of a crystal ball, in fact, a business plan built of the right
information and analysis can only be called indispensable.
A version of this article appeared in the July August 1997 issue of Harvard
Business Review.
William A. Sahlman is the Dimitri V. D Arbeloff-MBA Class of 1955 Professor of
Business Administration at the Harvard Business School.