Venture Capitalism and development of small businesses: guidelines for start-ups and SMEs
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Ram Dheeraj Srigiri
Table of Contents
Development of small businesses
In modern economies, start-ups have a key role as young innovative companies. Start-ups are new-born or young companies that can struggle to achieve their potential and growth. Today, one of the most challenging issues in corporate finance is to decide on firm valuation. It is even more difficult to evaluate companies that do not generate income. Hence, deciding the value of a Start-up is difficult as it considers a lot of other factors and requires knowledge of the Venture Capital world which we present as the first part of this paper. Another challenge related to start-ups and small businesses is the business planning and the planning of operations. Indeed for both, it is a question of survival as they both have to generate enough revenues. It is also a challenge for start-ups as it may lead to investors investing in the start-up. As a second part, we thus introduce different frameworks of business planning. 2020 business activities being impacted by the Covid-19 crisis, we applied a key framework to this crisis in order to provide assistance for business planning in 2020.
1. Venture capitalists
Venture Capitalism: It is a form of private equity financing by venture capital firms in start- ups or early stage emerging companies which show potential of a very high growth in exchange for equity stake. The start-ups benefit both financially and strategically. The start- ups tend to choose a venture capitalist who can be strategically aligned with their industry and goals to maximise the collaborative efficiency. Venture Capital is basically a limited partnership company with a committee to make investment decisions. The Venture Capital fund is pooled from multiple investors and used to fund emerging start-ups.
Start-ups usually have various funding stages as following :
Pre-Seed Capital : The Bootstrapping Stage
Seed Capital : The Product Development Stage
Series A funding : First Round of VC
Series B Funding : Second Round of VC
Series C Funding : Third Round of VC
Series D Funding : Special Round of Funding
IPO : Stock Market Launch
Factors VC’s consider when investing in a start-up: Start-ups do not have as much historical data as a well established company. The Investors take a huge risk investing in companies without their historical performance data. The Investors do consider a lot of other factors before investing in the company as follows:
Step 1: Require applicants to submit an expression of interest. This may include a business strategy, proposal, and a short video of their ideas. The venture capitalist will conduct an initial review of the proposal.
Is the market size and anticipated growth of the market large enough for this start-up; review of the start-ups fit in the industry to obtain information about competitors, entry barriers, the potential to exploit substantial niches, product life cycles, distribution channels.
Step 2: Start-ups that progress to the next stage will be invited to an interview. This gives the venture capitalist an opportunity to meet the entrepreneurs and their team. The venture capitalist will ask questions to each of the team members to ascertain who they are, and what they can bring to their team.
The team's ability to achieve business strategy/plan; the teams skills & backgrounds; ability to articulate and express their ideas; viability of the market to estimate the start-ups potential; the founding teams' composition and strengths; the company's competitive advantage.
Step 3: The VC will get together with their investment and co-founding team and review all teams that have passed the interview stage.
How well the startup fits with the firm's investment criteria
Step 4: Teams will be invited to pitch their ideas to the investment committee.
Product differentiation; process differentiation; price point differentiation; niche differentiation; how well does the start- up fit with the VC's underlying philosophy; has the start-up backed demonstrated progression with solid metrics and data;
Optional: Review of how the start-up intends to use the money.
Will you invest in advertising? Will you hire new talent, either a top-flight executive or new sales staff? Will you use the funds to acquire a small firm that provides something you need so you don’t have to develop it in-house?
The VC Method Valuation :
The usual methods of valuation does not apply to start-ups since they do not have financial statements or probable future cash flows. So, We approach the valuation of a start-up using the hugely used VC Method. In VC Method, we use net income to calculate terminal value of the company at the time of INvestor’s exit using P/E ratio and the IRR to calculate the current value of the company and further find out the ownership shares required to get the required return. For the VC to receive the required future value in the exit year out of the total terminal value, he will have to own a corresponding portion of the company’s stock. The required percent ownership at that time must be required future value/total terminal value.
Condensed venture Capital Formulae:
required future value (investment) = (1 + IRR)years x (investment)
total terminal value = PER x terminal net income
final ownership required = required future value (investment) / total terminal value = (1 + IRR)years x investment PER x (terminal net income)
final ownership required = investment terminal value / (1 + IRR)years
When a venture capitalist invests in a company, additional shares are issued, diluting the ownership of the previous investors. Note that “percent ownership” refers to the portion of the total stock that is owned after the new shares are issued: % ownership acquired = new shares / old shares + new shares
The formula above may be solved to determine new shares, the number of shares to be issued:
new shares = % ownership x old shares 1 – (% ownership)
total shares = 1 / 1 – (% ownership ) x old shares
share price = investment / new shares
2. Development of small businesses
Small businesses can be defined as firms that are privately owned, in the form of sole proprietorship, partnership, or company. The most common measure to mark small businesses is the employee count, but also revenues, sales, assets etc. may be used. Depending on the country, the size in the definition varies from 15 people (in Australia) to 500 (according to the US Small Business administration). They are mostly present in the retail sector, as convenience and grocery stores, restaurants, small scale manufacturing, and Internet related services like graphic design. In the development of small businesses, the first year of the company's life is often considered as the important one since most of the enterprises are going out of the market within the first year of the operations. Although the development of the business is tough, the COVID-19 made it even worse, since many procedures and services are not working as rapidly as in normal times. Moreover, probably the most important, the demand for most of the products dropped down since many people are staying home due to the lockdown or based on their own decisions. And in many cases the government help in times of crisis is not sufficient to maintain the business, and business owners must invest their private money to not go bankrupt. Nevertheless, the market is still open for new products and innovations, which will make the company successful if there will be a demand for the company's product or services. What is very important is the fact that entrepreneurs, who want to open a new business, should take into consideration some advice, which is helpful in the normal (non-pandemic) times, but currently there are almost essential. First of all, the companies should prepare a well-developed business plan, which not only shows whether the business is feasible, but also will be an important document during the negotiations with financial institutions, governments intuitions, or the investors. Commonly, the business plan is needed to take the loan or the government’s grant. The second important aspect, which should be considered for the entrepreneurs is the fact how to minimize the COVID-19 influence on the company’s development.
2.1. Business plan As it was already mentioned, the business plan is not only useful but in many cases, it is necessary to set-up or develop the business. The topic of the business plan is very wide and therefore the business plan creation will not be presented in this paper in great detail since the
valuable guidelines for writing the business plan have more than 200 pages. In this article, there will be a presentation of the most important points, which should be considered by the entrepreneurs during the business plan creation. Business plan’s guidelines:
You should create a logical structure and be easy to understand that will help you to understand your idea better. Moreover, you should be realistic and do not imagine reality, just describe it.
You should use the sources that will increase your credibility.
Show your professionalism, 5 pages are not enough.
You should tailor the business plan to the specific needs. Banks focus on financials, governments on impact.
You should follow the instructions on how to write the business plan.
You should consult the plan with many people before starting. It is better to improve the potential mistakes and problems without spending a dollar on them.
There are just 6 points, which every entrepreneur should follow to increase their chances to be successful on the market. Unfortunately, many businesses' plans are not worth anything, since they are too general, too short, unprofessional, or not realistic. Nevertheless, the worst mistake done by the entrepreneurs is to not do a business plan at all, since it helps to understand the market, the necessary steps, or the actions, which needs to be performed.
In order to be sure that your business plan has all of the most important sections, please follow the 10 step process that it generally accepted to be efficient and effective.
Also in the business plan, it is very important to analyse the business via Business Model Canvas, which is a strategic management tool that helps to identify and define the business idea. Business model canvas include following points:
Key partners - analysing the key suppliers, from whom are we acquiring the key resources. Also it analyse the types of partnerships in the business; strategic alliances, joint ventures, cooperations, buyer- supplier relationships
Key activities - presents the key activities that are required by businesses value proposition. Also it discusses customer relationships, distribution channels, and revenue streams.
Key resources - analysing four types of resources and their impact on business. Types of resources: human, physical, financial, intellectual.
Value propositions - asking the most important question, which problem of a customer we are trying to solve. Also it is the point where we discuss the values delivered to the customers, which products and services we are offering, and which customer needs we are satisfying.
Customer relationships - discusses which types of relationships we should maintain with our customers, and how costly are they. The options to consider in this part are: dedicated personal assistance, automated services, self services, communities, etc.
Channels - discusses through which channels we will be reaching our customers, and which ones are the best and most efficient.
Customer segments - analyses the best customer groups (segments) to target and segmentation types.
Cost structure - presents the most important costs to the business model, shows the most expensive parts of business. Also it is the point to decide if the business is cost or value driven.
Revenue streams - methods of payment and sources of revenue in the business. The different revenue streams that may be considered are: asset sales, usage or subscription fee, lending, leasing, renting, licensing, brokerage fees, advertising. With both a business plan and business model canva, a small business has a clear potential vision for its business idea, and therefore higher chances to succeed. Also those tools force the business to understand its operations in a coherent and consistent way.
2.2. Business analysis In order to approach this crisis and ensure business continuity, three steps - known as ABC steps are essential to consider in everyday work of the business. Those three points are:
Assess - verifying established objectives and processes required to deliver the desired results. Analysing if they are working properly, where potential improvements can be made, and analysing potential new impacts from the environment.
Build - creating additional objectives, tools and changes to the business strategies to answer the need of necessary improvements and the risks coming from the competitive environment.
Communicate - communicating the task with the team and measuring them with established measurements.
And should be repeated after finishing the cycle, to provide continuous business supervision.
2.2.1. “Assess” step To assess business performance it is important to have a clear vision and understanding of the strategy, that is defined in the business plan and business model canvas. Also, each department should be analysed separately with the most important KPIs as:
Finance - earnings before interest and taxes, economic value added, liquidity ratio, contribution margin, net cash flow,
Human Resources - employee satisfaction levels, average recruitment time, workplace accidents, absenteeism, retention rates, revenue per employee, turnover rate.
Sales and Marketing - sales revenue, cost per lead, marketing qualified leads, customer retention, cost per customer acquisition, marketing return on investment, sales qualified leads, opportunity to win ratio.
Research Development - capital invested in R&D, cost savings due to R&D, number of innovations introduced because of R&D, quantity of new patents.
Customer Service - customer satisfaction score, net promoter score, first response time, customer retention rate, employee engagement.
Production - number of obsoletes, quantity of products produced, number of default products. Also it is very important to know one’s internal and external impacts, by analysing the environment and its business. This can be done by conducting:
• PESTLE analysis - analysing political, economic, social, environmental, technological, legal, and environmental impacts on the business.
• SWOT analysis - analysing external threats and opportunities of the business, as well as internal strengths and weaknesses. Besides, in the case of small businesses it is very important to conduct a competitor analysis with the Porter’s five forces analysis, and position themselves well among them to survive.
2.2.2. “Build” step The main objective of this step is to reflect on the strategy and the potential improvement points that were discovered in the previous step. The first thing is to focus on the necessary response strategy that should be implemented. There are the 4 levels of strategy at different business levels:
Corporate level - corporate strategy - the company overall direction, created and controlled by top tier management. It is the set of strategic alternatives from which an organization chooses as it manages its operations simultaneously across several industries and several markets.
Business level - business strategy - basis on which the company is competing within the industry, it is defined by senior managers, and presents competitive advantages.
Functional level - functional strategy - it is the departmental/division strategy designed for each organizational function. Each business unit created their own objectives that follow the general business strategy.
Operational level - operational strategy - it is formulated at the smallest operating units of an organization, factories, local divisions etc. Local/field-level managers develop an operating strategy to achieve immediate objectives, and focus more on short term goals.
Where implementing the changes, when the bigger decisions need to be made, the more levels it should include. This means, if there is just a simple task to be done, the operational level (the lowest one) should be involved, but if there is a need in a global business strategy, all of them should be reinvented.
Second part of building a business is creation and maintenance of strong leadership and relationships. This means maintaining the highest level of satisfaction among the employees. If during the first step of analysis we will find out that the employees are not satisfied with their current workplace, there are two things that should be revised. First one is Maslow’s hierarchy of needs, that states there are five levels of needs that humans can fulfill. When the lower level is fulfilled and satisfied then the individual can go up on the hierarchy. These are the levels:
Self actualization - achieving one’s full potential, including creative activities
Esteem needs - prestige and feeling of accomplishment
Belongingness and love needs - having intimate relationships and friends
Safety needs - security and safety
Physical needs - food, water, financial needs
When one of the levels is not satisfied, the higher levels may not be achieved, that is why managers must take into consideration if their employees are fulfilling all of the needs at work. Also, it is important to revise Pink’s framework to make sure the employees are self motivated, and eager to develop. The framework states 3 important factors that must be created or encouraged by the managers to have great leadership and employees:
Autonomy - be able to control what one's doing, and directing it.
Mastery - having the willingness and desire to develop and improve at one’s position.
Purpose - obtaining the real reason why the work one is doing is important.
As these points are satisfied, the next step is to match key roles and responsibilities, which means adjusting the roles to the right teams and people. In this part the company’s financial results are entering the talk. They are telling us with the performance indicators, which responsibilities and things must be done first. If the business is still not over the break even point, or it is entering the crisis time it is crucial to start putting all of the resources into the task of maintaining the business most crucial objectives. As the roles are assigned, then the top management should check technology and labor. With the external analysis conducted, they should be able to compare what competitors are offering, what are their sizes and production lines, as well as what is right now as a trend on the market in terms of innovation and customer demand. Because of that the necessary innovations, purchases of new equipment, employment of new designers etc should be done, to maintain businesses innovativeness. Last but not least, in the modern world it is very important to think about corporate responsibility, even in the case of small businesses. All of the actions to reduce the environmental impact and improve the lives of the societies impacted by the business should be considered, as it may be one of the crucial things of business performance in the future. Customers are getting more and more aware about the negative business impacts, and they become more picky about the products they choose. In the end, the company should create a timeline, to implement in life all of the decisions and changes that should be made within the business. With the specific time limits it will be easier to track and see the progress.
2.2.3 “Communicate” step As the business is assessed with specific measures, and the strategies to tackle the necessary points are built, it is a must to communicate the changes to all of the people affected by the company. The stakeholder groups that we should consider are:
Employees, managers and business owners
Suppliers, distributors and other business partners
The local community
National Government and regulatory authorities