"COURSE TEXTBOOK:Title: Entrepreneurship, Tenth EditionPrint: ISBN 978-0-07-811284-3 Author(s): Hisrich, Peters & Shepherd Publisher:McGraw-Hill Education Copyright year: © 2017 ? Chapter Ten:Pages 266 to 288 > The Financial Plan? Chapter Eleven:Pages 290 to 311 > Sources of Capital? Chapter Twelve:Pages 312 to 354 >Compare and contrast the benefits and costs of using private financing,commercial bank loans, government grants, and R&D limited partnerships. Mini Project:Within an industry or market segment . . . your potential venture, identify a pioneering firm that successfully built long-termsuccess around a new product or service in a new market.10THE FINANCIAL PLANLEARNING OBJECTIVES1To understand the role of budgets in preparing pro forma statements.2To understand why positive profits can still result in a negative cash flow.3To learn how to prepare monthly pro forma cash flow, income, balance sheet, and sources and applications offunds statements for the first year of operation.4To explain the application and calculation of the break-even point for the new venture.5To illustrate the alternative software packages that can be used for preparing financial statements.266OPENING PROFILETONY HSIEHwww.zappos.comNot too many entrepreneurs have the goal of reaching a billion dollars in sales. At the age of 35, Tony Hsieh(pronounced ?Shay?) has reached this goal as the CEO and entrepreneurial brain behind Zappos.com. Hisserious entrepreneurial endeavors began after graduation from Harvard University at the age of 23. He and hisclassmate Sanjay Madan saw opportunities for advertisers who wanted to consolidate large ad buys into a singlepackage and subsequently launched LinkExchange in the early 1990s. LinkExchange offered small sites freeadvertising on a 2-to-1 basis. What this meant was that for every two ads a member displayed on their site, theywould be granted one free ad on another member’s site. The excess ad credits not used were then sold byLinkExchange to nonmembers, resulting in a substantial revenue stream. After getting investment capital in1997, the company was seen as a serious player in the Internet advertising market and was subsequentlypurchased by Microsoft for $265 million in 1998. After this success, Hsieh co-founded Venture Frogs, whichinvested in Internet start-ups such as Ask Jeeves, Tellme Networks, and Zappos.com. In 1999, as an investor, hebegan to look more seriously at the long-term potential of Zappos.com. Initially, he was an advisor andconsultant to Zappos.com, but eventually he joined the company full time in 2000 as co-CEO. He later tookover the reins completely and moved the operation to Las Vegas because of the lower real estate rates and abundance of call-center workers. Under his leadership, the company grew from $1.6 million in sales in 2000 tomore than $1 billion in sales in 2008. In fact, the company doubled its sales every year from 1999 to 2008.Hsieh realized when he joined Zappos.com that the Internet had not become a major player as a shoppingchoice for consumers. He discovered that the footwear industry, at $40 billion per year, was mostly a result ofretail store sales and that only 5 percent of the sales came from mail-order catalogs. He saw this as a hugeopportunity for the company, particularly since he believed that the Web would surpass mail-order business as apercentage of total sales. Thus, he saw 5 percent of $40 billion as a reasonable goal for his business.267Hsieh’s business model was unique and to some retailers costly, yet it has been extremely successful. Part ofHsieh’s approach is to focus on customer service. Zappos offers free shipping, fast delivery, and a 365-dayreturn policy. He even relocated his warehouse to Kentucky to be nearer to the UPS hub and to ensure the fastdelivery of the products offered, which has recently expanded to clothing, handbags, and accessories. Thecompany’s focus on customer service is designed to make sure the customer has a quality experience frombeginning to end. In addition, all employees once hired must complete a four-week customer loyalty trainingprogram to make sure they understand the culture that has made the company so successful. To ensure that thehires are serious, Hsieh makes a visit during the second week and offers anyone $2,000 if they would like todrop out and quit the program. Only 1 percent of the hires have taken him up on the offer. In addition, in April2015, Hsieh changed his customer service dedication by eliminating people managers. His new system involvesself-management. According to Hsieh, this system will make Zappos a fully self-organized, self-managedorganization by combining a variety of different tools and processes referred to as a Teal organization. Thepurpose of this change is to be able to answer 80 percent of customer inquiries within 20 seconds. Formermanagers will reinvent themselves with new roles in the organization or they will be asked to leave. He feelsthat this structure will improve customer service effectiveness and also improve long-term profits for the firm.Once Zappos wins over a customer (75 percent of the customers are repeaters), the company tries to ensure theircontinued interest by keeping them engaged in various online and social media outlets. Customers are invited tosubmit reviews and to share their experience with others. This not only enhances each customer’s loyalty butalso attracts new customers.In 2005, the Amazon.com founder visited Zappos headquarters looking to buy the company. At that time, Hsiehturned them down thinking that the company would probably reach profitability and about $1 billion in sales.However, by 2009, the company began to feel the cash flow crunch because of the poor economy. In addition,the line of credit from the bank was asset-backed at about 50 percent of the value of the inventory, which gavethe company little flexibility with cash flow. With the credit crunch and a board that wanted to see more profits,Hsieh felt that he could be forced out as CEO unless he made some drastic decisions to improve profitability. Atthis point, Amazon.com came calling again and offered to buy the company but let it operate as an independententity with Hsieh still at the helm. With a $1.2 billion buyout, the company now would have the resources toexpand its marketing efforts and increase its sales and profits. A new board was formed and the company nowhad the cash resources to move on. The company continues to grow as an independent company and TonyHsieh continues to introduce new-age entrepreneurial strategies and structures to make the company even more1 successful than it has been.268The financial plan provides the entrepreneur with a complete picture of how much and when funds are cominginto the organization, where funds are going, how much cash is available, and the projected financial position ofthe firm. It provides the short-term basis for budgeting control and helps prevent one of the most commonproblems for new ventures—lack of cash. We can see from the preceding example how important it is tounderstand the role of the financial plan. Without careful financial planning, in its early stages, especially in light of the costly customer services, Zappos.com could have suffered serious cash flow problems. Eventually,growth capital cash flow for Zappos did become an issue but now as an independent part of Amazon.com, andwith its newly enforced organizational structure, Zappos will continue to strive to meet its financial goals.The financial plan must explain to any potential investor how the entrepreneur plans to meet all financialobligations and maintain the venture’s liquidity in order to either pay off debt or provide a good return oninvestment. In general, the financial plan will need three years of projected financial data to satisfy any outsideinvestors. The first year should reflect monthly data.This chapter discusses each of the major financial items that should be included in the financial plan: pro formaincome statements, pro forma cash flow, pro forma balance sheets, and break-even analysis. As we saw in theZappos.com example, Internet start-ups have some unique financial characteristics, which are included in thediscussion that follows.OPERATING AND CAPITAL BUDGETSBefore developing the pro forma income statement, the entrepreneur should prepare operating and capitalbudgets. If the entrepreneur is a sole proprietor, then he or she is responsible for the budgeting decisions. In thecase of a partnership, or where employees exist, the initial budgeting process may begin with one of theseindividuals, depending on his or her role in the venture. For example, a sales budget may be prepared by a salesmanager, a manufacturing budget by the production manager, and so on. Final determination of these budgetswill ultimately rest with the owners or entrepreneurs.As can be seen in the following, in the preparation of the pro forma income statement, the entrepreneur mustfirst develop a sales budget that is an estimate of the expected volume of sales by month. The key element in thebudget is projected sales. There are a number of different approaches that can be used to forecast sales fromvery quantitative methods to more qualitative approaches. Techniques such as regression, time series analysis,and exponential smoothing are beyond the scope of this text. In many instances, the entrepreneur can rely onmore qualitative techniques to estimate sales. Some of these are discussed below. From the sales forecasts, theentrepreneur will then determine the cost of these sales. In a manufacturing venture, the entrepreneur couldcompare the costs of producing these internally or subcontracting them to another manufacturer. Also includedwill be the estimated ending inventory needed as a buffer against possible fluctuations in demand and the costsof direct labor and materials.Table 10.1 illustrates a simple format for a production or manufacturing budget for the first three months ofoperation. This provides an important basis for projecting cash flows for the cost of goods produced, whichincludes units in inventory. The important information from this budget is the actual production required eachmonth and the inventory that is necessary to allow for sudden changes in demand. As can be seen, theproduction required in the month of January is greater than the projected sales because of the need to retain 100units in inventory. In February, the actual production will take into consideration the inventory from January aswell as the desired number of units needed in inventory for that month. This continues for each month, withinventory needs likely increasing as sales increase. Thus, this budget is a real determination of how much willbe spent and for what purpose money will be used. The pro forma income statement discussed later in thischapter does not include the cost of inventory as an expense until it is actually sold (reflected on statement ascost of goods). Thus, in those ventures in which high levels of inventory are necessary or where demandfluctuates significantly because of seasonality, this budget can be a very valuable tool to assess cash needs.TABLE 10.1 A Sample Manufacturing Budget for First Three Months Jan. Feb. Mar.Projected sales (units) 5,000 8,000 12,000Jan. Feb. Mar.Desired ending inventory100200300Available for sale 5,100 8,200 12,300Less: beginning inventory0100200Total production required 5,100 8,100 12,100269ETHICSETHICAL DILEMMAA dilemma all professionals face is deciding whether to look beyond their immediate organization and applytheir professional skills for external benefits. Accountants have long helped nonprofits, including churches andgovernments, in their drive for accurate financial reporting and adequate controls. Some professions, such aslaw, have developed a tradition of pro bono service. The individual who has unique talents that can serve abroader society can work on an idea and establish a venture on their own. However, the process of idea-to- venture is a long process and they may directly or indirectly use the resources of their current employer. Thisgives rise to several ethical questions ranging from sharing the idea to using the current company’s resources.The employee faces the following questions while working with his or her plan:? When do I have to tell my boss that I am working on an idea?? When do I have to tell my boss that I am leaving on a certain date?? Does my current employer have to know about my plans to start a new venture? Do I have to describewhat my venture is about?? The new venture will compete directly with my current company. How does this change my obligationsto my current company?? The exit survey asks if I am starting a new venture. Do I have to tell the truth?The following questions arise about using the resources and contacts of the company:? Can I ask my current customers to follow me in my new business? Can I take my client list? I’m the onewho built those relationships, not the company, right?? I’d like to use a supplier from my old company. Can I contact them? Can I take my supplier contact listwith me when I leave?? I’m not taking any documents, but I do remember a great deal about my current company, its products,and customers. Can I use this information in my new venture?? I’ve used my company email for work and personal matters and may need access for my records. Can Idownload and take all my emails when I leave?These questions take into account the nature of a contract existing between the employer and employee. Inaddition the employee may be asked to sign a non-compete agreement which may limit his or her efforts to starta competing business. These dilemmas are common when someone leaves a position to start their own business.Before attempting to answer any of these questions it is advised to seek legal counsel.Source: ?The Six Ethical Dilemmas Every Professional Faces,? Kirk O. Hanson, February 3, 2014, Center forBusiness Ethics, Bentley College (www.bentley.edu) and ?The Unavoidable Ethical Dilemmas ThatEntrepreneurs Face,? Markkula Center for Applied Ethics, Santa Clara University(www.scu.edu/practicing/ethical/dilemmas). 270After completing the sales budget, the entrepreneur can then focus on operating costs. First, a list of fixedexpenses (these are expenses that are incurred regardless of sales volume) such as rent, utilities, salaries,advertising, depreciation, and insurance should be completed. Estimated costs for many of these items can beascertained from personal experience or industry benchmarks, or through direct contact with real estate brokers,insurance agents, and consultants. Industry benchmarks for preparing financial pro forma statements werediscussed in the Financial Plan section of Chapter 7 (see Table 7.2 for a list of financial benchmark sources).Anticipation of the addition of space, new employees, and increased advertising can also be inserted in theseprojections as deemed appropriate. There are also expenses that vary from month to month based on salesactivity or changes in marketing strategy. Examples might include labor, materials, transportation, orentertainment. These variable expenses must be linked to strategy in the business plan. Table 10.2 provides anexample of an operating budget. In this example, we can see that salaries increase in month 3 because of theaddition of a shipper, advertising increases because the primary season for this product is approaching, andpayroll taxes increase because of the additional employee. This budget, along with the manufacturing budgetillustrated in Table 10.1, provides the basis for the pro forma statements discussed in this chapter.TABLE 10.2 A Sample Operating Budget for First Three Months ($000s)Expense Jan. Feb. Mar.Salaries $23.2 $23.2 $26.2Rent222Utilities 0.9 0.9 0.9Advertising 13.5 13.5 17 Selling expenses111Insurance222Payroll taxes 2.1 2.1 2.5Depreciation 1.2 1.2 1.2Office expenses 1.5 1.5 1.5Total expenses $47.4 $47.4 $54.3 Capital budgets are intended to provide a basis for evaluating expenditures that will impact the business formore than one year. For example, a capital budget may project expenditures for new equipment, vehicles,computers, or even a new facility. It may also consider evaluating the costs of make or buy decisions inmanufacturing or a comparison of leasing, buying used, or buying new equipment. Because of the complexityof these decisions, which can include the computation of the cost of capital and the anticipated return on theinvestment using present value methods, it is recommended that the entrepreneur enlist the assistance of anaccountant.FORECASTING SALESAs stated earlier, there are many different methods for projecting sales, some very quantitative and some morequalitative. Most start-ups would not likely use any of the quantitative techniques but would rely on morequalitative methods. Our focus here will be to try to understand how to project sales simply and reasonablyusing more qualitative methods. To begin with, the entrepreneur should research everything he or she can findabout other 271start-ups in the same industry. Reviewing their experience can often provide reasonableexpectations for early sales. Local chambers of commerce, or any other business organization, may provide contacts and information on what might be expected in first year sales. No matter what approach entrepreneursuse, they must be aware that sales estimates may be wrong. As a result, it is sometimes beneficial for theentrepreneur to provide sales estimates at different levels of activity. For example, sales estimates may beshown at one level and also at levels such as 5 percent less or 10 percent less. Each sales estimate may reflectdifferent assumptions about the market and show costs and profits or losses with each sales forecast.Since the pro forma income statement requires monthly projections, it is important not to just make a salesforecast and divide by 12. Sales may vary each month depending on the seasonality of the product and need tobe reflected in the monthly projections. In addition, changes in strategy may also affect sales and would need tobe included in the estimates. Using as much information as possible to project sales can make the pro formastatements more meaningful.PRO FORMA INCOME STATEMENTSThe marketing plan discussed in Chapter 8 provides an estimate of sales for the next 12 months. Since sales arethe major source of revenue and since other operational activities and expenses relate to sales volume, it isusually the first item that must be defined.pro forma income Projected net profit calculated from projected revenue minus projected costs and expensesTable 10.3 summarizes all the profit data during the first year of operations for MPP Plastics. This companymakes plastic moldings for such customers as hard goods manufacturers, toy manufacturers, and appliancemanufacturers. As can be seen from the pro forma income statement in Table 10.3, the company begins to earna profit in the eleventh month. Cost of goods sold remains consistent at 50 percent of sales revenue.TABLE 10.3 MPP Plastics Inc., Pro Forma Income Statement, First Year by Month ($000s)*Added shipper in month 3.†Trade show.‡Plant and equipment of $72,000 depreciated straight line for five years. 272In preparation of the pro forma income statement, sales by month must be calculated first. As indicated above,sales may be projected using many different techniques. Again, it is important to try to estimate variations insales that may result from changes in such factors as marketing strategy or seasonality. As would be expected, itwill take a while for any new venture to build up sales. The costs for achieving these increases can bedisproportionately higher in some months, depending on the given situation in any particular period.Sales revenue for an Internet start-up is often more difficult to project since extensive advertising will benecessary to attract customers to the Web site (see Chapter 8 for information on how to build a Web site). Forexample, a giftware Internet company can anticipate no sales in the first few months until awareness of the Website has been created. Heavy advertising expenditures (discussed subsequently) also will be incurred to createthis awareness. Given existing data on the number of ?hits? by a similar type of Web site, a giftware Internetstart-up could project the number of average hits expected per day or month. From the number of hits, it is possible to project the number of consumers who will actually buy products from the Web site and the averagedollar amount per transaction. Using a reasonable percentage of these ?hits? times, the average transaction willprovide an estimate of sales revenue for the Internet start-up.The pro forma income statements also provide projections of all operating expenses for each of the monthsduring the first year. As discussed earlier and illustrated in Table 10.2, each of the expenses should be listed and2 carefully assessed to make sure that any increases in expenses are added in the appropriate month. Forexample, selling expenses such as travel, commissions, and entertainment should be expected to increasesomewhat as territories are expanded and as new salespeople or representatives are hired by the firm. Sellingexpenses as a percentage of sales also may be expected to be higher initially since more sales calls will have tobe made to generate each sale, particularly when the firm is an unknown. The cost of goods sold expense can bedetermined either by directly computing the variable cost of producing a unit times the number of units sold orby using an industry standard percentage of sales. For example, for a restaurant, the National RestaurantAssociation or Food Marketing Institute publishes standard cost of goods as a percentage of sales. Thesepercentages are determined from members and studies completed on the restaurant industry. Other industriesalso publish standard cost ratios, which can be found in sources such as those listed in Table 7.2. Tradeassociations and trade magazines will also often quote these ratios in industry newsletters or trade articles.Salaries and wages for the company should reflect the number of personnel employed as well as their role in theorganization (see the organization plan in Chapter 9). As new personnel are hired to support the increasedbusiness, the costs will need to be included in the pro forma statement. In March, for example, a shipper isadded to the staff. Other increases in salaries and wages may also reflect raises in salary.The entrepreneur should also consider increasing selling expenses as sales increase, adjusting taxes because ofthe addition of new personnel or raises in salary, increasing office expenses relative to the increase in sales, andmodifying the advertising budget as a result of seasonality or simply because in the early months of start-up thebudget may need to be higher to increase visibility. These adjustments actually occur in our MPP Plasticsexample (Table 10.3) and are reflected in the month-by-month pro forma income statement for year 1. Anynoteworthy changes that are made in the pro forma income statement are also labeled, with explanationsprovided.273In addition to the monthly pro forma income statement for the first year, projections should be made for years 2and 3. Generally, investors prefer to see three years of income projections. Year 1 totals have already beencalculated in Table 10.3. Table 10.4 illustrates the yearly totals of income statement items for each of the threeyears. Calculation of the percent of sales of each of the expense items for year 1 can be used by the entrepreneuras a guide for determining projected sales and expenses for year 2; those percentages then can be considered inmaking the projections for year 3. In addition, the calculation of percent of sales for each year is useful as ameans of financial control so that the entrepreneur can ascertain whether any costs are too high relative to salesrevenue. In year 3, the firm expects to significantly increase its profits as compared with the first and secondyears. In some instances, the entrepreneur may find that the new venture does not begin to earn a profit untilsometime in year 2 or 3. This often depends on the nature of the business and start-up costs. For example, aservice-oriented business may take less time to reach a profitable stage than a high-tech company or one thatrequires a large investment in capital goods and equipment, which will take longer to recover. TABLE 10.4 MPP Plastics Inc., Pro Forma Income Statement, Three-Year Summary ($000s) *No taxes are incurred in profitable years 2 and 3 because of the carryover of losses in year 1. In the pro forma statements for MPP Plastics (Tables 10.3 and 10.4), we can see that the venture begins to earna profit in the eleventh month of year 1. In the second year, the company does not need to spend as much moneyon advertising and, with the sales increase, shows a modest profit of $16,300. However, in year 3, we see thatthe venture 274adds an additional employee and also incurs a 26 percent increase in sales, resulting in a netprofit of $127,900.In projecting the operating expenses for years 2 and 3, it is helpful to first look at those expenses that will likelyremain stable over time. Items like depreciation, utilities, rent, insurance, and interest are likely to remain steadyunless new equipment or additional space is purchased. Some utility expenses such as heat and power can becomputed by using industry standard costs per square foot of space that is utilized by the new venture. Sellingexpenses, advertising, salaries and wages, and taxes may be represented as a percentage of the projected netsales. When calculating the projected operating expenses, it is most important to be conservative for initialplanning purposes. A reasonable profit that is earned with conservative estimates lends credibility to thepotential success of the new venture.For the Internet start-up, capital budgeting and operating expenses will tend to be consumed by equipmentpurchasing or leasing, inventory, and advertising expenses. For example, the giftware Internet companyintroduced earlier would need to purchase or lease an extensive amount of computer equipment toaccommodate the potential buyers from the Web site. Inventory costs would be based on the projected salesrevenue just as would be the case for any retail store. Advertising costs, however, would need to be extensive tocreate awareness for the giftware Web site. These expenses would typically involve a selection of searchengines such as Yahoo!, Bing, and Google; links from the Web sites of magazines such as Woman’s Day,Family Circle, and Better Homes and Gardens; and extensive media advertising in magazines, television, radio,and print—all selected because of their link to the target market.PRO FORMA CASH FLOWCash flow is not the same as profit. Profit is the result of subtracting expenses from sales, whereas cash flowresults from the difference between actual cash receipts and cash payments. Cash flows only when actualpayments are received or made. For example, if someone owes you $100 for work you completed you haveearned that amount as income. If you wanted to spend this $100 at the supermarket you would have to get themto let you buy on credit (you would owe them the amount of the groceries) or you would pay with a credit card.The fact is that at that point you have income of $100 (no cash yet) and expenses of $100 (not yet paid in cash).Similarly, for a business, sales may not be regarded as cash since it is common for buyers to have at least 30days to make the payment. In addition, not all bills are paid immediately. Just as your buyer has at least 30 daysto make payment, you would likely do the same for any of your purchases. These purchases on credit, however,3 would still be counted as expenses on your income statement. On the other hand, cash payments to reduce theprincipal on a loan do not constitute a business expense but do constitute a reduction of cash. Only the intereston the loan would be considered an expense. Also, depreciation on capital assets is an expense, which reducesprofits, not a cash outlay.For an Internet start-up such as our giftware company discussed earlier, the sales transaction would involve theuse of a credit card in which a percentage of the sale would be paid as a fee to the credit card company. This isusually between 1 and 3 percent depending on the credit card. Thus, for each sale, only 97 to 99 percent of therevenue would be net revenue because of this fee. As stated at the beginning of this chapter, one of the major problems that new ventures face is cash flow. Onmany occasions, profitable firms fail because of lack of cash. Thus, using profit as a measure of success for anew venture may be deceiving if there is a significant negative cash flow.275For strict accounting purposes, there are two standard methods used to project cash flow, the indirect and thedirect method. The most popular of these is the indirect method, which is illustrated in Table 10.5. In thismethod, the objective is not to repeat what is in the income statement but to understand there are someadjustments that need to be made to the net income based on the fact that actual cash may or may not haveactually been received or disbursed. For example, a sales transaction of $1,000 may be included in net income,but if the amount has not yet been paid, no cash has been received. Thus, for cash flow purposes, there is nocash available from the sales transaction. For simplification and internal monitoring of cash flow purposes,many entrepreneurs prefer a simple determination of cash in less cash out. This method provides a fastindication of the cash position of the new venture at a point in time and is sometimes easier to understand.TABLE 10.5 Statement of Cash Flows: The Indirect MethodCash Flow from Operating Activities (+ or - Reflects Addition or Subtraction from Net Income)Net income XXXAdjustments to net income: Noncash nonoperating items+ depreciation and amortization XXXCash provided by changes in current assets or liabilities: Increase(+) or decrease(-) in accounts receivable XXX Increase(+) or decrease(-) in inventory XXX Increase(+) or decrease(-) in prepaid expenses XXX Increase(+) or decrease(-) in accounts payable XXXNet cash provided by operating activities XX,XXXCash Flow from Other Activities Capital expenditures (-) (XXX) Payments of debt (-) (XXX) Dividends paid (-) (XXX) Sale of stock (+) XXXNet cash provided by other activities (XXX)Increase (Decrease) in Cash XXX It is important for the entrepreneur to make monthly projections of cash like the monthly projections made forprofits. The numbers in the cash flow projections are constituted from the pro forma income statement withmodifications made to account for the expected timing of the changes in cash. If disbursements are greater thanreceipts in any time period, the entrepreneur must either borrow funds or have cash in a bank account to coverthe higher disbursements. Large positive cash flows in any time period may need to be invested in short-termsources or deposited in a bank to cover future time periods when disbursements are greater than receipts.Usually, the first few months of the start-up will require external cash (debt) to cover the cash outlays. As thebusiness succeeds and cash receipts accumulate, the entrepreneur can support negative cash periods. "