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BU121 Study Guide - Final Guide: Leveraged Buyout, Operating Leverage, Cash Flow

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Roopa Reddy
Study Guide

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Seven Principles of Entrepreneurial Finance
1. Real, human, and financial capital must be ‘rented’ from owners.
2. Risk and expected reward go hand in hand.
3. While accounting is the language of business, cash is the currency.
4. New venture financing involves search, negotiation, and privacy.
5. A venture’s financial objective is to increase value.
6. It is dangerous to assume that people act against their own self-interests.
7. Venture character and reputation can be assets or liabilities.
Cash Vs Profit
Principle 3 of entrepreneurial finance: While accounting is the language of business, cash is the
Sales Revenue – Accounts Receivable
Expenses – Accounts Payable
Depreciation/Amortization – not cash
Owners’ Equity – cash to use for business
Need Cash in order to calculate profit. Credit in Accounts Receivable is not considered Cash, therefore it is not
tangible, and therefore it is not current profit.
Leverage: Often a company has to tradeoff accepting higher fixed costs to get lower VCRR. They must
increase operating leverage. For example, a firm could buy a new more highly automated piece of machinery
(higher fixed costs) to get lower labour and material costs per unit (lower variable costs)
Breakeven Driver: Most important influence/driver on a venture’s breakeven is its variable cost revenue ratio
Venture Financing
Through the Life Cycle
Development Stage – turning and idea to a business
Seed Financing – Entrepreneur’s assets and Love Money
Startup Stage – start of revenue generation
Startup Financing – Seed Financing Sources + Business Angles, Venture Capitalists
Survival Stage – revenue pays for some but not all expenses
First Round Financing – Business Operations, Venture Capitalists, Suppliers and Customers (Trade
Credit), Government Programs, Commercial Banks
Rapid Growth Stage – cash flow positive
Second Round Financing – same sources as first round
Mezzanine Financing – debt convertible to equity on default
Liquidity Stage Financing (IPO) – Investment Bankers
Early Maturity Stage

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Business Operations, Commercial Banks, Investment Banks
Venture Valuation Approaches
Income Approach – based on assumption that
Value = Present Value of Future Income + Potential Liquidity Event
The Discounted Cash Flow Method
1. Determine Free Cash Flows (Operating Cash Flow – CAPEX) + potential liquidity event
2. Discount for Risk (relatively high rate)
3. Valuation = Sum of the Present Values
Needs to know income stream, growth rate and discount rate which are subject to significant
uncertainty for new ventures
Risk of failure likely higher than discount rate (Venture Capitalists uses a portfolio of investments to
hedge risk)
If losses projected to occur at the first few years, it is likely to occur at a greater magnitude
Valuations also driven by subjective factors (i.e. the team, intellectual property, ect.)
Market Approach – determine value based on similar businesses with known values
Cost Approach – net cost of assets or original amount invested
Structure of Venture Financing
Most external capital raises through issuance of preferred stocks with provisions
Royalty arrangements also becoming more common
Growth Strategies – from low to high risk
Intensive Growth Strategies
Market Penetration – more quantity to current customers
Market Development – new geographic markets
Alternate Channels – different distribution channels
Product Development – new products to current and existing customers
Integrative Growth Strategies
Horizontal Integration – acquire / merge with competitor
Backwards Vertical Integration – acquire / merge / create supplier
Forwards Vertical Integration – acquire / merge / create distributor
Diversification – acquire / merge / create unrelated business
Key Consideration – Regardless of strategy, key transition from entrepreneur to manager occurs during rapid
growth stage*

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* Important to keep entrepreneurial characteristics to encourage innovation and creativity and transfer the spirit
to employees by Sharing Vision, Institutionalize Change as a Goal, Reward Innovation and Create and
Environment for Failure
Harvest and Exit
Entrepreneur – personal and financial
Investor – commitment to capital tied to harvest options
Sell the Company – Strategic Acquisition (e.g. result of a horizontal integration), Financial Acquisition (e.g.
leveraged buyout), or Employee Acquisition
Release Firm’s Free Cash Flows – stops reinvestment and starts harvesting; may harm venture
Take the Company Public (IPO)
Primarily to raise capital to finance growth; lends liquidity for harvest
Very Costly, Lock Up (founders can’t sell shares for a period), loss of secrecy and flexibility
Liquidate – may be the only option for some (e.g. Independent Lawyer)
Service vs. Manufacturing
Both transforms a raw material into a finished good
Services differs from manufacturing with
Both transform raw materials into finished goods but in a service:
Raw material is the person with a need or possession that requires care
Service performed, not produced.
Focus on the process as well as the outcome
Customer is part of the process
Impact on Capacity
-> Integrating of Marketing and Operations – the integration of marketing and operations due to the demand-
capacity tradeoff
-> Manufacturing – Sets capacity slightly ahead of demand: it is extremely difficult to add later than sit idle. In
short terms turn away customers or outsource at lower margins. Accounts for Seasonality – shift demand and
capacity requirements by pricing. You will need to handle some products different, as they will be mainly
purchased in different seasons. Ex. Gold clubs Ex. Ski shop in Toronto sells patio in summer, snowboard
-> Services - Extent of contact with customer.
High Contact – set capacity based on peak demand EX: restaurant lunch/supper time.
Low Contact – set capacity based on average demand. EX: an accounting firm in tax time.
May also effect scalability
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