BA350

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Chapter Six
Small Business Entry:
Paths to Entrepreneurship
Copyright 2021 © McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.

2. © McGraw-Hill Education 2
Planning a Path into Business
Causal or predictive reasoning is a useful technique regardless of
whether you want a full-time or a part-time business.
An entrepreneur uses effectual reasoning when they imagine what can
be accomplished with the resources at hand.
• Affordable loss is the practice of bringing your product/service to
market with the minimum expenditure of capital, effort, and time.
• Strategic partnerships can be either formal or informal with others
who provide support to your efforts at starting your business.
• Leveraging contingencies is another way of saying “recognizing and
using opportunities.”

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Bootstrapping, Bricolage, and Lean Business Practices
These three ideas fit into both the causal and the effectual approaches.
• Bootstrapping is finding a low-cost, or no-cost way to do something.
• Bricolage is the practice of using whatever you have at hand.
• Lean business practices mean eliminating waste and producing a
minimum viable product.
Both lean operations
and bootstrapping
share three ideas:
• Waste not, want not.
• Create, standardize,
repeat.
• Keep in touch.
The key ideas of bootstrapping are simple:
• Do without as long as you can and cut all
expenses to the bone.
• Borrow, barter, rent or lease rather than buy
and consider offering equity if you must buy.
• Borrow money from yourself first.
• Minimize debt and limit credit card balances.
• Always keep track of your cash.

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The Five Paths to Business Ownership
The entrepreneur
can start a
completely new
business.
They can purchase
franchise rights to an
existing business.
They can purchase a
fully operating
business.
They can work in a
small business and
eventually gain
ownership.
They can inherit a
business from a
family member.

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Starting a New Business
The riskiest path,
but promises the
greatest rewards.
87% of start-ups
using an incubator
are still in operation
after 5 years.
Not all businesses
that close are a
failure.
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Advantages and Disadvantages of Start-Ups
• You can “do it your way.”
• You begin with a clean slate.
• You can use the most up-to-
date technologies.
• You can provide new, unique
products/services.
• You can keep the business
small to limit losses.
• You may take the time to
perfect your product/service
and processes.
• There will be no initial name
recognition.
• A start-up requires significant
time to get established.
• Difficult to finance with no
assets, sales, or cash flow.
• Cannot easily gain revolving
credit from suppliers or banks.
• A start-up may lack experienced
mangers and workers.
• You must train employees and
garner management support.

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Starting a New Business in an Existing Field
Most start-ups are “me-too” enterprises.
• Customers are familiar, offering some protection from failure.
• But it can be difficult to differentiate your business from others.
• Often the only competitive advantage is location.
• The concept leading to a start-up usually comes from the experience
of the person starting the business.
• The best predictors of success is the level of experience of the
founders.

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Increasing the Odds of Start-Up Success
1. Start the business in an
incubator or accelerator.
2. Take part in a mentoring
program.
3. Have a detailed start-up
budget.
4. Produce a product/service
with a proven demand.
5. Secure outside investment.
6. Start with more than one
founder for synergy.
7. Have experience managing
small firms.
8. Have industry experience.
9. Have previous experience in
creating a start-up business.
10. Choose a business that
produces high margins.
11. Start the business with
established customers – can
be a spin-off, competition, or
subcontracting.
12. Build trust in your “story.”

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Franchising a Business – What Is Franchising?
A franchise is an agreement between the franchisor who sets conditions
and grants permissions, and the franchisee, who pays a fee and agrees
to the conditions and standards.
Four elements of a franchise agreement.
• The franchisor grants the legal right to
sell the company’s products.
• The franchisor provides marketing.
• The franchisee can use the branding.
• The franchisee pays a fee for rights.
The agreement is valued by:
• The rights granted.
• Cash flow potential to the franchisee.
Four forms of franchising.
• Trade name franchising.
• Product distribution
franchising.
• Conversion franchising.
• Business format
franchising.
Some companies sell master
franchises which may sell
sub-franchises.

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Franchising a Business:
Advantages, Opportunities, and Legal Considerations
Perhaps the single greatest advantage is that it comes as a complete
business system – some are actually “turnkey.”
Finding a franchise is easy.
• Entrepreneur magazine lists the top
500 franchises.
• Government resources include the FTC
and the SBA.
• There are franchising associations.
Once you have the franchise, perform due
diligence, same as for any other business.
• Consider interviewing current
franchisees.
Before you sign, study:
• The franchise agreement.
• The uniform franchise
offering circular (UFOC).
You want to know:
• If/how you can transfer
the license to another.
• How you (or franchisor)
can end the contract.
• What disclosures you are
required to make.

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Buying an Existing Business
Advantages include: established customers and immediate cash inflows;
having business processes in place; and lower cash outlay required.
Disadvantages include:
• Finding a successful firm for sale.
• Determining a firm’s worth.
• Existing staff may resist change.
• The firm may have a bad reputation.
• The firm may be in decline due to
changes in technology.
• Facilities or equipment may be
obsolete or in need of major repair.
Use multiple sources to find
the right business to purchase.
• Make some calls.
• Consider a broker.
• Networking.
• Trade journals.
• The internet.
• Local businesspeople and
associations.
• Your employer.

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Buying an Existing Business: Performing Due Diligence
Due diligence is the process of investigating to determine the full and
complete implications of buying a business - nothing is taken for granted.
• Conduct extensive interviews with the sellers of the business.
• Study the financial reports and other records of the business.
• Make a personal examination of the site (or sites) of the business.
• Interview the business’ customers and suppliers.
• Develop a detailed business plan for the acquisition.
The first five steps make up the process of due diligence, after which:
• Negotiate an appropriate price, based on business plan projections.
• Obtain sufficient capital to purchase and operate the business.

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Due Diligence
A basic tenet of business law is caveat emptor, or “let the buyer beware.”
Due diligence has two primary goals.
• First, look for any wrongdoing – fraud,
misrepresentations, or missing information.
• Second, look for inefficiencies, waste,
opportunities, or mismanagement.
The first goal affects the value of the business
and the second shows potential ways to
increase the firm’s value.
• This gives you a negotiating advantage.
Financial statements
should include:
• A balance sheet.
• An income statement.
• A statement of cash
flows.
• Intangibles are likely
to be misstated.

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Determining the Value of the Business
The most rigorous method uses discounted cash flows.
• Based on estimates of future cash outflows and inflows, given the
change in leadership – also highly problematic.
• Due to these difficulties, it is common to use less rigorous methods.
• Asset valuation.
• Comparable sales.
• Financial ratios.
• Industry heuristics.

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Determining the Value of the Business
Asset Valuation Methodology
Asset valuation assumes the firm’s value is assets minus liabilities, but
there are two major problems with this methodology.
• Such estimates do not consider the value of an ongoing firm over the
value of its identifiable assets.
• It is very difficult to separately identify and value all the assets.
Three methods used to estimate value of a firm’s assets.
• Book value is acquisition cost minus depreciation – unreliable as
depreciation is arbitrary and some assets have no book value.
• Net realizable value is the amount an asset would sell for, less the
cost of selling it.
• Replacement value estimates what an identical asset would cost to
acquire and prepare for service.

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Determining the Value of the Business:
Comparable Sales and Financial Ratios
There are two major problems with the comparable sales approach.
• First, no two firms are exactly alike, and second, there are often no
recent sales to use for comparison.
Some of the commonly used ratios are:
• The earnings multiple ratio is firm’s value divided by actual/expected
annual earnings.
• Pretax return on assets (ROA) divides earnings before tax by asset
value.
• Net income to equity is determined by dividing income by owner equity.
• Net income to (equity + debt) is an extension of net income to equity
that explicitly includes the value of borrowed capital.
• Income capitalization divides projected net income less depreciation,
interest, and owner draws, by the return you could expect elsewhere.

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Determining the Value of the Business:
Industry Heuristics
Industry heuristics are rules of thumb used to estimate firm value in
relation to some easily observable characteristics of the business.
• For example, two heuristics in the small inn industry are that an inn
should sell for approximately $100,000 per rental room.
• The second is that an inn should sell for approximately four times its
annual gross revenue.
Industry heuristics can be amazingly accurate.
• Industry heuristics exist for all industries and are usually available from
the group’s trade association.

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Buying an Existing Business: Structuring the Deal
A buyer and seller get together to negotiate the final price.
• The buyer should have performed due diligence and arrived at the
highest price they would pay, the point of indifference.
• You will open negotiations with a price below that point as you want
keep the price low and the seller knows the first offer is low.
• In addition to price, you also negotiate the terms of sale.
• You may buy out the seller’s interest in the business.
• You buy in by acquiring some, not all, of the ownership.
• You may buy only the key assets and not the business itself.
• You may take over a public business by controlling stock interest.

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Structuring the Deal:
Buyouts and Buy-Ins
LLCs, corporations, and some
partnerships are subject to
buyouts.
• Accomplished through
purchasing ownership interest.
• The subsequent business is
considered a new entity.
• Primary advantage is simplicity.
• A buyout can take place all at
once, in a single point of time.
• An employee buyout occurs
through an employee stock
ownership plan (ESOP).
A buy-in occurs when someone
acquires part ownership.
• One advantage is it allows the
purchaser to leverage inside
knowledge.
• Another is it aids in keeping
key employees.
• On the other hand, key
employees such as the owner
or managers may be a
disadvantage when they stay.

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Structuring the Deal:
Key Resource Acquisitions and Take Overs
Key resource acquisitions, or bulk
asset purchases, are the only way
a sole proprietorship is purchased.
• The seller keeps cash and
receivables and retains short-
term liabilities.
• The most difficult aspect is
valuing intangible assets.
• One important advantage is the
buyer is not responsible for any
of the acts of a prior owner.
Takeovers are possible only in
firms with transferable stock.
• The buyer purchases enough
stock to gain control.
• The raider gets control without
permission of all owners.
• Takeovers are hostile events.
• The raider may liquidate all or
parts of the business.
• Only a few businesses are
vulnerable – corporations and
certain partnerships.
• Rare in small businesses.

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Inheriting a Business
Whether inheriting or bequeathing, the problems are the same.
• A successful transition needs specific actions to organize the business.
• Develop a comprehensive business plan with goals and objectives.
• The founder must pass knowledge to successor, who must learn.
The founder must be proactive in
bringing family member in.
• There is no force used.
• Offer experience/training.
• Let them use their strengths.
• Leadership does not have to be
a family member.
Write out your specific decisions
and desires.
As successor, you must gain
loyalty and walk a fine line.
The essential skills you need:
• Technical knowledge.
• Financial knowledge.
• People skills.
• Leadership skills.
• Knowledge of your limitations.

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Inheriting a Business: Ownership Transfer
Do not wait until the founder’s death to transfer ownership.
• If you are the founder, your desires become irrelevant.
• If you are the successor, there is now no authority figure to help with
issues of control and strategy.
In most cases, a gradual transfer is preferable to a single inheritance.
• May not work with multiple heirs.
• Of greatest importance is who gets voting stock.
The transfer of ownership is complex and unique to each family business.
• For larger, successful firms, consider using experts and specialists.

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Professional Management of Small Business
If a business grows large enough, it becomes too much for one person
and one of two things happens:
• The business starts to decline.
• Or, professional managers are hired to share the management load.
Professional managers are not easy to find.
• Ideally it would be a current employee.
• If you have the skills and experience of a professional manager, taking
a position provides a unique perspective on the business.
• If you like the business, you may move to acquire it in the future.
• Employee managers of small firms are often would-be entrepreneurs.

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Getting Out of Your Business
Succession transfers
or terminates a firm.
A token purchase price
is a sell off, and no
payment is a pass off.
Closing with no debts
is a walkaway.
In a workout, the
owner pays off debt by
working another job.
The worst case is
bankruptcy.
An entrepreneur may
close one firm to start
another – a serial
entrepreneur.
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