Archive for April, 2012
Entrepreneurs do not spend too much time planning, but often consider opportunities arising from uncertain conditions as they deal with original ideas. As new opportunities come into focus original ideas can garner new value not considered when the entrepreneur acted on an original opportunity.
Larger companies use net present value, internal rate of return, payback period, and many other sophisticated methods to evaluate cash streams from capital investments. Often these companies do not consider the “real options.” Capital budgeting involves understanding time value of money and probability analysis, which many entrepreneurs may not have learned about. The idea involves evaluating projects like a game of chance using the time value of money and probability analysis.
For example, the idea is similar to a card game in a casino and playing the odds. The player finding the project with the best odds usually wins. The concept of “real options” evaluates cash flow using net present value and the odds for each alternative to decide if the project has future value. If the expected value in a project turns negative the player can cut bait to minimize losses. On the other hand, continued investing may give the player an option to chase a project with a dubious future value.
Sometimes early losses can reverse and turn profitable. Without committing to an investment in a project, the entrepreneur may not see any prospect for net present value turning positive and not invest in the project. Thus the entrepreneur may find a project is worth investing in because the chances are good the net cash streams will turn positive sometime in the future.
“Real options” offer the entrepreneur a call option to help decide when to cut bait or to continue with a project. Without a sense of what lies ahead the entrepreneur may overlook good projects and exit too soon leaving the prize for someone else to discover.
What alternatives do you consider when deciding to invest in projects for your business?
The biggest problem I hear most entrepreneurs have in starting their business is how to raise the funds they need. The truth is 91% of entrepreneurs start their businesses by using debt, while only 7% use their own equity (Lam, 2010). This statistic is almost perfectly correlated with the failure rate. The high failure rate associated with the use of debt is no coincidence.
Many small business consultants offer services to develop a business plan to find financing. I suggest avoiding borrowing as much as you can. Bankers and other lenders are not your friend, but the enemy. Entrepreneurs pay dearly on borrowed money leading to high failure rates. How do you expect to earn a return high enough to cover the double-digit cost of capital when first starting out?
I find finances work better for a small business entrepreneur who can manage his or her own finances. An entrepreneur can control his or her own destiny by following this simple advice. Bootstrapping will set you free and make you independent of the loan sharks. What is bootstrapping? Quite simply, bootstrapping is “using other people’s money.” Moreover, bootstrapping is a continuing course of action, not a onetime affair. A savvy entrepreneur will learn how to use bootstrapping to lessen the need to borrow (Lam, 2010).
Some ways an entrepreneur can use bootstrapping include working out of your house, leasing rather than buying equipment, buying second-hand equipment, taking advantage of trade credit, hiring inexpensive labor, and employing family members in the business. An entrepreneur can also develop a savings club to raise capital for start-up (Lam, 2010). Using these techniques avoids the need for external financing and reduces the financing gap. A good entrepreneur balances the cost of funding with the returns the business can earn. A good entrepreneur manages the gap between immediate demand and the firm’s funding needs.
By using bootstrapping the small business entrepreneur shows the ability to manage capital in an efficient way. The small business entrepreneur does not need to give up control to find external financing and can highlight his or her management ability. Bootstrapping shows the small business entrepreneur has the ability to manage relations with others including family, customers, supply-chain partners, banks, and suppliers.
The small business entrepreneur who employs this strategy shows financiers the ability to manage capital so these financiers are more likely to want to offer external financing. The best time to find financing is when the business least needs it. Showing this ability allows the small business entrepreneur to find external financing at more desirable rates without sacrificing ownership and control.
Please let me know why you need financing to start your business by leaving a comment. Do you want to learn more about how to attract financing to your business using this proven forumula?
Lam, W. (2010). Funding gap, what funding gap? Financial bootstrapping: Supply, demand and creation of entrepreneurial finance. International Journal of Entrepreneurial Behaviour & Research, 16(4), 268-295. doi: 10.1108/13552551011054480
I have read many divergent ideas about starting a business and how to succeed. One recurring theme I hear is to understand how to manage risk and avoid failure. I emphatically reject this idea for several reasons. First, small business entrepreneurs can mitigate risk through insurance and what the entrepreneur deals with is not risk, but uncertainty. Uncertain conditions are not manageable. How can you manage something you do not know about yet?
Second, instead of demonizing failure I believe an entrepreneur should embrace it because I do not know a single entrepreneur that hasn’t failed before succeeding. Failure is part of the program, like it or not! A seasoned entrepreneur knows how to fail and does not quit. Failure paralyzes the inexperienced entrepreneur who moves no further forward. Steve Jobs recognized the need to move on and jump to the next innovation. Jobs believed intelligent people change their minds. A seasoned entrepreneur learns something from each failure and gains valuable experience. An inexperienced entrepreneur is likely to walk away and find a reason on which to blame failure.
I just read in another blog this morning about how Richard Branson’s mother taught him to not look back on failure, but to focus on continuing to move forward. What excellent advice! Setbacks do not bother Branson as he simply goes on to another idea. I wish my mother would have drilled that into me. Richard Branson is the founder of the Virgin Group in case you do not recognize the name.
In my view, successful entrepreneurs have to build a thick skin and rapidly put failure behind them. Successful entrepreneurs learn what they can do differently next time and develop a “gut” to react to uncertain conditions and limit their losses by knowing when to move on and try a different approach.
Small business entrepreneurs still need hard skills to run their business, but they can gain these along the way by finding the right people and learning from them. The successful entrepreneur realizes success is a learning curve and learning comes from trying new approaches and associating with the right people.
What do you think? Does successful entrepreneurship come from managing risks or learning from failure? I would love to hear your thoughts. Please leave a comment with your thoughts or click here to learn more.