Author Firmsconsulting

Objectives and Benefits of a Business Plan

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Business plan for a start up refers to the written plan of how the business will be established and developed. The biggest benefit of the business plan is that writing it forces an entrepreneur to consider all important areas of the business, which otherwise may be overlooked. Research regarding whether business plan contributes to success of the new venture shows mixed results. The key factor is not if businesses has a business plan but if such a plan was carefully prepared and if it is being implemented.

In certain circumstances it may not be needed to have a business plan. This can happen when it is vital to act immediately and there is just no time for planning or in situations when the business is very small and there are no plans for growth.

Objectives of a Business Plan

Most importantly, the goal of a business plan is to recognize and explain the new business opportunity.

Another objective is to present, in a written format, how an entrepreneur intends to take advantage of the business opportunity.

Business plans must provide descriptions of key success factors which will determine whether the business opportunity will be successful or not.

Therefore, part of the second objective of the business plan is to be a managerial tool to be used to ensure successful pursuit of the opportunity.

Yet another objective of a business plan is to allow entrepreneur to obtain funds necessary to establish a venture. Suppliers of funds usually include banks as well as potential investors.

Business plans shows to lenders of funds how well an entrepreneur thought about each aspect of the potential new business. Business plan also provides potential lenders with information that they require in making a decision about whether lending or investing funds into the venture is a suitable action.

Benefits of a Business Plan

Financing: Business plan helps entrepreneur to obtain financing for the new venture. Lenders and investors demand business plans from entrepreneurs before they would even consider lending or investing their money. In the past, business plans were mostly prepared by large businesses. In current times, business plans are prerequisites for entrepreneurs who seek funding from lenders and investors.

Indication of success: Business plan also provides an indication to the entrepreneur and other interested parties of whether a prospective new business will be a successful venture.

Writing a business plan allows entrepreneur to be certain that the prospective venture is really worth the entrepreneurs’ time and other resources. Writing a business plan also allows entrepreneurs to think through and decide on various key areas. A well written business plan is an indication that the entrepreneur researched the prospective venture well.

Identifies key success factors: Another benefit is the fact that it allows to identify key variables that will determine whether the business will succeed or not. This will ensure a more effective management of the business; as such variables can be closely monitored by interested parties.

Provides performance standards and milestones: It provides a roadmap that management can follow in implementing and establishing a new business. Business plans provide milestones and other performance standards against which actual performance can be measured.

Helps to build relationships: Well written business plan helps to build relationships with potential business partners, potential as well as current customers and suppliers. Many large companies will not even consider dealing with a small start up or small growing company unless a well written business plan is presented. Furthermore, the written plan can help small business to obtain trade credit from suppliers. Trade credit refers to suppliers providing product with agreement that payment will be made within certain period, usually 30 days or at the end of the month.

Helps to attract better employees: It allows potential employees to see that the company may have a chance to succeed and is a promising place to build a career.

Improves motivation of employees: Business plan helps to keep all employees informed and excited about where company is now, where it is going and how it is going to get there.

 

The Importance of Customer Relations Management

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Whereas in the past companies could afford to ignore consumers’ needs and preferences, this is no longer the case. With options available to consumers due to such factors as increased competition and drastic changes and improvements in technology, consumers become increasingly more educated and demanding.

For example, Portia have to work really hard to keep consumers of Pearlparadise.com satisfied and to build long lasting relationships with them. Otherwise they will move to a competitor.

Since Portia’s business is a small business, Portia has an advantage compared to large competitors. This advantage arises because Portia can address each customer personally and superior higher customer service which will lead to greater customer satisfaction and loyalty.

It is crucial for Pearlparadise.com to keep current customers satisfied since acquisition of new customers is very costly. It costs about five times more to acquire a new customer in comparison to keeping an existing one. Current customers also tend to buy more from the enterprise and may refer their family and friends.

On average, businesses keep between 70-90 percent of customers each year. However, if retention of customers could increase by 5-10 percent per year, than businesses could double their profitability.

This statistics highlights how incredibly important it is for Portia to keep current customers satisfied. So think about this for a minute. While Portia wants to spend money on advertising, that is really a small part of the battle. Once people see Portia’s advertising, she needs to convert them into paying customers. Once Portia converts them into paying customers she then needs to ensure they are repeat clients, otherwise she needs to spend even more on advertising. If she does a poor job serving existing customers, they may write poor review of her business which will lead to even less effect from her advertising.

Moreover, customers are often willing to pay a premium for excellent customer service. Therefore, Portia could even increase her profit margin by providing higher customer service than that of her competitors.

 

Introducing Business Plan

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There are three basic objectives of a business plan:

  • First, and most importantly, the goal of business plan is to recognize and explain the new business opportunity.  It forces you to crystallize your thinking before you share it with others.
  • Second, the objective is to present, in a written format, how an entrepreneur intends to take advantage of the business opportunity. Business plans need to describe which steps the entrepreneur intends to take to make his dream of a new business a reality. It should include various tools that the entrepreneur will be able to use in the management of the business opportunity, such as vision, mission, goals, budgets, financial forecasts and description of target markets. Business plans also must provide descriptions of key success factors where achievement of, or occurrence and non occurrence of, will determine whether the business opportunity will be successful or not. Therefore, part of the second objective of the business plan is to be a managerial tool to be used to ensure successful pursuit of the opportunity.
  • A third objective of business plan is to allow entrepreneurs to obtain funds necessary to establish a venture. Suppliers of funds usually include banks as well as potential investors. The business plan demonstrates to lenders of funds how well the entrepreneur thought about each aspect of the potential new business. Business plans also provide potential lenders with information they require in making a decision about lending or investing funds into the venture.

Another important main objective of the business plan is to identify factors that will determine if the business opportunity has good potential to be successful.

***

The business plan is a road map that allows entrepreneurs and other interested parties to see where prospective or current business is today, where it is going and how it is going to get there. In other words, it examines and identifies key areas that needed to be attended to as well as how it will be attended to and the performance standards which an entrepreneur expects to maintain, such as milestones.

If you work for a large corporate you can use business plan approach to get a buy in for a new project or to explain an existing initiative. You will be surprised at how useful it is to write a business plan. It is powerful because it forces you to think through all aspects of the project. Like a true entrepreneur, it makes you accountable for everything.

The content of the business plan should cover five key factors.

  • It should provide a big picture of the opportunity. This refers to the external factors or context of the opportunity such as regulatory environment, which is beyond the entrepreneur’s control
  • It should also address a management team with their qualifications and experiences
  • It should clearly describe the business opportunity
  • It should also present financial structure
  • It should indicate the resources needed for success of the venture

Structures of a business plan will differ from case to case. Generally, business plans can either be very brief, just covering main key areas and projections. Such plan is called dehydrated business plan and focuses on market issues such as pricing, distribution channels and competition. However, when people in business refer to the business plan, they are usually referring to in depth, all inclusive, business plan which are called comprehensive business plans.

Comprehensive business plan may include the sections discussed below.

It should start with the cover page, which should specify:

  • the name of the prospective venture and entrepreneur
  • the address
  • Contact details of the business venture and entrepreneur
  • It should also include the date when the business plan was completed and a disclaimer advising that information in the business plan is confidential and cannot be used without permission
  • Each copy should be numbered to keep track of the copies and for general transparency as it will indicate to investors, lenders and other parties how many copies were already handed out

Cover page is followed by the table of contents. This part of the business plan is created for convenience of the investors, lenders or any other parties that would be reading the business plan. Just as in any book, table of contents in the business plan sequentially lists each section and subsection and provides a page number where this section or subsection can be found. This allows anybody who is reading a business plan to find any section or subsection that they would like to examine in a fast and easy manner.

Executive summary should follow. This is generally the most important part of the business plan. This is because many people who will be reading this business plan will read executive summary first and will only read business plan in-depth if the executive summary generated enough excitement.

The executive summary brings together key points from each section of the business plan. It is an overview of the entire business plan and should be written last and be no longer than two or three pages. It should describe opportunity, explain the business concept, explain which market or markets will be targeted, provide an industry overview as well as the competitive advantage the new venture intends to deploy/create. Economics of the business opportunity should be provided and the management team should be briefly described. Lastly, if external funding from investors is required, main points from the offering section should be included regarding how much of external funding from investors is required as well as how this money will be allocated.

In writing the executive summary two strategies can be used, synopsis and narrative. Synopsis provides conclusion of each section of the business plan. It is very straightforward and dry. It is about getting right to the point regarding each section of the business plan. Synopsis is easier to prepare but it may not create enough excitement in the target audience to entice them to continue explore the business opportunity.

A narrative executive summary creates excitement, generates enthusiasm and sense of urgency. It tells a story about business opportunity and requires certain degree of writing talent. Narrative executive summaries are especially relevant if there is something really special about the new venture, such as if a new market or new innovative product is to be explored. An example can be if the business intends to become the first direct life insurance provider in Ukraine. Alternatively, a narrative is relevant if the business is to be led by a well respected entrepreneur or a businessman, which again makes the new venture more special than an ordinary start up.

An industry, target customer and competitor analysis can be presented next. The main purpose of these sections is to present business opportunity as well as to illustrate that there is a profitable and big enough market to be served.

Industry analyses should describe the industry within which the prospective business will be established. This should include industry size, growth, trends and main players. Then the industry should be broken down into main segments. Lastly you should describe the niche from which the entrepreneur would specifically like to focus on or start from.

Target customers should describe in detail the target customer market or markets. It should illustrate factors that confirm that this target market is being underserved.

It should include customer profiles. Customer profile usually includes demographic characteristics of customers, such as their age and gender. It can also include psychological, behavioural and sociological information. Customer profile also includes information regarding transactions history, responses to marketing stimuli and on contacts with customer.

Based on customer analysis, the competitor analysis should be presented which should include profiles of main competitors. Such profile should include SWOT analysis, which is an analysis of the strengths, weaknesses, opportunities and threats of the competitors. More detailed competitor analyses may also be presented.

Company description section may follow which focuses on the type of business, its objectives, where it will be located and which form of organization will be selected.

Vision and mission statements may follow. The vision statement is a statement of the dream of the organization. What the organization inspires to be and to accomplish. The mission statement describes how the organization plans to accomplish its mission. It is more detailed. The mission statement is written based on the vision statement.

A product or service plan may be presented next. This includes description of such areas as why the product or service which the company intends to provide will be better than that of competitors. If the product or service fills a particular gap in the market – it should be indicated as such. It also should be described if any secondary target markets are available. The prospective venture’s competitive advantage should be indicated as well as if this competitive advantage will be sustainable or is it very easy to copy.

Working model, photos of the product or product prototype as well as drawings may be included. Alternatively it can indicate where such information may be found in the appendices. Investors are interested in products that already were developed and shown in practice that they can work well and is useful and meet particular needs of the target market.

It should also be pointed out if company has any specific advantages, such as patent protection and innovative characteristics of the product or service. Product or service strategy for growth should also be included.

The Marketing plan can follow. This plan points out how the new business intends to promote its product or service. This refers to how customers will be persuaded and informed about the existence as well as benefits of the product or service.

The plan should include the pricing strategy and descriptions of which distribution channels will be used. It should be indicated what would be credit and pricing policies, which selling approach or approaches are intended. The plan must describe any types of sales promotions, advertising and how customers will be found and enticed to buy the product.

The marketing plan should include sales forecasts, which are developed based on other information provided in the marketing plan. The plan should describe if there are any warranties that will be provided. If business intends to have product updates than this also should be indicated.

The Operations and development plan can be presented next. This part of the business plan explains how the product will be manufactured or service provided. This section should indicate if the operations process will contribute to a competitive advantage. For example, this could be the case if the operation process is expected to be cheaper than that of competitors. The operations and development plan descries operational aspects of the business such as how much space the business will require, if the business will require a special location and which equipment is necessary for the operation of the business. The business plan should indicate what will be bought, built, owned and operated and/or outsourced and why. Lastly, it is important to point out how quality standards will be maintained, how and from whom raw materials are intended to be obtained, if business plasn to use subcontractors and which approach the new venture intends to use to control its inventory.

The management team section of the plan can follow. This is an important section because investors often look at the quality and calibre of the management team before they even look at what the new venture’s product of service will be.  Investors want to see a well balanced management team which consists of members with complementing skills. Investors want to see that all crucial skills and experience are present in the proposed management team. For example, investors and lenders may be looking to make sure that businesses have management with relevant skills, education and experience in areas such as finance, marketing, production and management.

Next, critical risks should be discussed. Investors, lenders and other interested parties understand that any business venture has critical risks. What they want to see is if the entrepreneur is aware of it and if entrepreneur has a plan how to manage, control or eliminate such risks. One example of critical risks includes lack of market acceptance which occurs when customers do not buy product or service as anticipated. Another example of critical risk is that competitors may respond by putting success of the new venture in jeopardy. For example, if the new venture is going to compete with a very large established company that produces the same kind of product, a large competitor may take action to ensure that the emerging new competitor is eliminated. For example, a very large company may temporarily lower its prices. The new venture will not be able to offer such low prices and may go out of business. Yet another example of critical risks can be unexpected government regulation which may have adverse effects on the new venture. New ventures generally have better protection from competitor response risk if they target a niche in which larger businesses are not so interested. Another way for the new venture to protect itself from competitor responses is to have a competitive advantage which is very difficult to imitate.

An offering section can follow. This section is relevant if the entrepreneur requires external financing from investors. This section describes how much money the venture will require from investors and at which times. It is advisable to present investors with sources and uses table which describes where money will come from, such as from equity or debt and for what purposes money will be used.

The Financial plan can be presented next. This is a very important section. It provides financial forecasts of the new venture in the form of pro forma statements. It should include annual pro forma income statements, balance sheets and cash flow statements for a minimum of three and up to five years. This section should also include monthly cash budgets for the first year and quarterly cash budgets for the second and third years. Assumptions based on which the pro forma financial statements have been prepared as well as clarifications of how the pro forma statements were determined should be indicated.

Specific attention should be paid to statements of cash flows. Without cash inflows the business will not be able to survive even if it is profitable according to income statement. It indicates sources of cash and for which main investments, such as equipment or property, it will be used for.

Appendices should conclude business plan. This section contains supporting documents. It can contain details on information that is briefly discussed in the main body of the business plan. For example, in the case of the management team section, brief descriptions of the management team’s skills, education and experience should be supplemented with detailed resumes of each member of the management team which should be presented in the appendices. Appendices also may contain photographs of the product and facilities, copies of signed contracts with important customers and/or research documents, patent filings etc.

 

Customer Relationships

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Whereas in the past companies could afford to ignore consumers’ needs and preferences, this is no longer the case. With thousands of options available to consumers due to such factors as increased competition and drastic improvements in technology, consumers become increasingly more educated and demanding. Organizations have to work really hard to keep their consumers satisfied and to build long lasting relationship with them. Otherwise they will move to a competitor.

It is also crucial for businesses to keep current customers satisfied since acquisition of the customer is very costly. It costs about five times more to acquire a new customer in comparison to retaining existing customers. Current (older) customers also tend to buy more from the enterprise and may refer their family and friends.

On average, businesses keep between 70-90 percent of customers each year. However, if retention of customers could increase by 5-10 percent per year, than a business could potentially double its profitability. These statistics highlight how incredibly important it is to keep current customers satisfied.

Small businesses have an advantage compared to large business when it comes to customer satisfaction. This advantage arises because small businesses can address each customer personally and provide higher customer service which will lead to greater customer satisfaction and loyalty.

This is relevant especially when it comes to addressing customer complaints. Addressing customer complaints is important because it increases the chance for repeat purchases as well as increasing the chance that a complaining customer will recommend the company to the friends and family instead of complaining to them about the company.

Generally, in large businesses only individuals with certain title have authority to make a decision regarding customer complaints. This leads to inefficiency and often results in a situation where customers have to communicate with various employees before their complaint can be addressed. This often leaves customer dissatisfied.

In comparison small businesses are more flexible where each employee may be given power to assist customers and customer complaints could be potentially handled faster and to greater satisfaction of the customer.

Customers are often willing to pay a premium for excellent customer service. Therefore, if costs increase due to attempts to increase customer service than it most likely will be offset or more than offset by the higher premium that customers will be willing to pay for superior service. However, ensure you are tracking this.

To ensure higher customer satisfaction, an enterprise needs to address complaints in a timely manner, provide basic products according to a customer’s expectations, provide adequate customer support and try to customize products or services for the specific needs of the customer.

Businesses can monitor customer service levels by playing customers’ roles anonymously. That is sending in employees to anonymously pose as customers and record their experiences. It is helpful to observe how customers are treated by employees and how complaints are handled as well as directly asking customers about their experiences via such methods as surveys, comment cards or questionnaires.

Further ways to improve customer satisfaction and customer service include addressing customers by the name, respecting their time, contacting customers who no longer use the  products/services to find out the reason why they have discontinued dealing with the company and trying to win them back. It is also helpful to remember what customers preferences are, which is increasingly possible due to technology.

Technology may be used to build a positive relationship with customers. Relationship may be supported by connecting with customers via email, a website, phone calls, mail, videos, twitter, face book or other social networking sites. There is customer relationship marketing (CRM) software available for fostering this relationship.

Web based companies have specific software available to help them build relationships with customers and improve the company’s performance. An example of such software is Enterprise Miner. Furthermore, sometimes it may be cheaper for a small firm to outsource certain media tools for customer interactions such as call centers or live chat support.

An entrepreneur also needs to have a good understanding of the customer profile. Customer profiles usually include demographic characteristics of customers, such as their age and gender. It can also include psychological, behavioural and sociological information. A customer profile also includes information regarding transactions history, responses to marketing stimuli and historical contacts with the customer.

To understand customers, entrepreneurs need to know the stages of the consumer decision making process. They include:

  1. problem recognition
  2. search for information
  3. evaluation of alternatives
  4. purchase
  5. post-purchase evaluation

Businesses need to take these stages into account when approaching a customer. The stage of the consumer decision making should influence the way customer is approached.

To compare different alternatives (the third stage of the consumer decision making process), a consumer selects evaluation criteria which are the variables that the consumer uses to compare one brand against another.

An evaluative criterion is used by consumer to generate an evoked set. An evoked set refers to the set of brands that consumer is willing to consider to purchase from.

After a purchase is made and the customer has moved into the post-purchase stage of the consumer decision making process, the post-purchase dissonance can occur. It refers to manifestation of the cognitive dissonance. Post-purchase dissonance occurs when customers have doubts or second thoughts regarding whether or not the purchase was a good idea or whether a different product/service would have been a better fit.

If businesses would like to have repeat purchases from such costumer, it is helpful to attend to such problems by softening or removing post-purchase dissonance. An adequate return policy can be helpful to correct this problem. Another idea is to send an after-sales letter which will again highlight the main benefits that this particular product or service brings.

For example, if the customer purchased a white car, an after-sales letter can highlight the fact that based on some research white cars are the safest colour for a car. This benefit of buying a white car could be included along side with general benefits of buying this specific car. Such an after-sales letter could be very valuable if the customer had second thoughts about buying a white car or buying this specific car instead of another.

To improve product/service acceptance and performance in the market, an entrepreneur can benefit from knowledge of psychological factors that affect consumers. One such factor is perceptual categorization. This refers to perceiving dissimilar objects as members of the same category.

It can be used to the business advantage. For example, for a start up introducing their brand to the market it will be helpful to make a product look similar to the same product sold by successful brands. This way a consumer can easier perceive it as another alternative during the consumer decision making process. This obviously has some disadvantages so needs to be carefully considered. Other psychological factors to consider include consumer needs (physiological, social, psychological and spiritual) and motivations.

Certain sociological factors also affect customers’ choices and, consequently, the success of the enterprise. Such factors include culture and social class of customers. Culture is very influential on consumer decision making and is changing. It is important for an entrepreneur to undertake a culture analysis to ensure understanding of influences which culture brings to the business’s particular target markets.

Social class refers to the divisions of people into particular groups within society based on such variables as their income, education, social status and wealth.

 

 

Sources of financing

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When it comes to sources of financing, firms at any stage of the company’s life cycle have three options from which to choose:

  1. Internal financing – using retained profits.
  2. External financing – using funds invested by outside investors and lenders. Investors include the common stockholders, venture capitalists and entrepreneurs.
  3. Spontaneous financing – such as accounts payable, which increase automatically with increases in sales. Accounts payable, which is also called trade credit, are funds payable to suppliers.

Further, an entrepreneur needs to take into account certain variables when making a decision on optimal sources of financing. Particularly, entrepreneurs need to decide if they are willing to give up part of the voting control which will be inevitable if equity financing is chosen. Entrepreneurs also need to decide if they are willing to take on bigger financial risk which is inevitable when debt financing is selected.

Debt financing increases financial risk because debt must be repaid regardless of whether or not the firm makes a profit. If debt is not repaid according to an agreed upon schedule, creditors may even force the enterprise into bankruptcy. Alternatively, an equity investor is not entitled to more than what is earned by the enterprise.

Personal Sources of Financing

It is most likely that entrepreneurs will have to invest some of his or her “personal” money or money from “personal” sources to ensure that others will even consider investing in the enterprise. The “personal” sources of financing could be personal savings, credit cards, borrowing from friends and relatives or any other way of obtaining money such as selling an asset, such as a car or a summer house, to free up funds for investment in the enterprise.

Personal savings are usually the leading source of “personal” funds. Credit cards are often used but needed to be used with extreme caution as interest rates on outstanding amounts can be incredibly high.

Borrowing from friends and family is also very tricky and should be done with extreme care. If the business fails or does not perform as expected and money is not repaid when agreed than it can destroy or severely damage important relationships. When borrowing from friends and family, it is a good guideline to ensure that it is seen as an investment rather than a gift by the lending side of the transaction. Agreed upon deals should be put in writing since memories are not always reliable. Moreover, the amount borrowed should be repaid as soon as possible.

Bootstrapping

Bootstrapping is usually a strategy that entrepreneurs follow to survive at the beginning stages of business establishment and growth.A bootstrapping or bootstrap financing refers to a situation when entrepreneur uses his or her initiative to find capital or use capital more efficiently to survive.

It includes minimization of the company’s investments and refers to such situations as leasing instead of buying, adapting just-in-time inventory system, operating business from home, obtaining free publicity instead of paying for advertising and using other people’s resources as much as possible, while paying as little as possible.

Other examples of bootstrap financing include factoring and trade credit. Factoring refers to the situation when the business sells its accounts receivable to a financial institution at a discount rate. Factor refers to the financial institution which business is to purchase accounts receivable from other companies. Trade credit refers to situations when suppliers provide their products and services on credit. Suppliers usually extend interest free credit for 30 days or less commonly for 60 or 90 days interest free credit.

Borrowing from the Bank

When borrowing from the bank, an entrepreneur has a number of options. The following types of loans are generally available:

Lines of credit – this is when the bank agrees to make money available to the business. Agreement is made for up to a certain amount and is not guaranteed but only in place if the bank has sufficient funds available. Such agreement is generally made for a period of 1 year.

Revolving credit agreement – this is similar to the lines of credit but the amount is guaranteed by the bank. A commitment fee of less than 1% of the unused balance is generally charged. Therefore, such an arrangement is generally more expensive for the borrower.

Term loans – such loans are generally used for financing of equipment. The loan generally corresponds to the useful life of the equipment.

Mortgages – such loans are long-term loans and are available for purchase of the property which is used as collateral for the loan.

When banks consider loaning money, they generally will have to consider certain requirements before they will even consider loaning the funds. Such requirements include the request of a business plan to learn whether or not the entrepreneur have their “own skin in the game”.

Other considerations include the entrepreneur’s own net worth which refers to personal assets less personal liabilities. The projected annual income of the entrepreneur is also considered.

If the company is not a start up, the historical financial statements may be requested. Further, pro forma financial statements may be requested which include pro forma income statements, balance sheets and cash flow statements.

It is advisable for the entrepreneur to cultivate a good relationship with the banker since intuitive judgments also play a role when bankers decide whether or not they should lend money to the particular borrower. However, this is only valuable if all other considerations discussed above are attended to.

Banks use different methods to evaluate the appropriateness of the potential borrower. One of such methods, the five C’s method, is discussed below.

Five Cs of credit:

  1. Capital – businesses position with regards to debt versus equity
  2. Collateral – whether or not the entrepreneur has assets that can be sold to cover debt
  3. Character – borrower’s history of meeting obligations
  4. Capacity – ability to repay the loan. This is judged by such indicators as projected cash flows
  5. Conditions – conditions surrounding this particular lending opportunity such as market conditions and transaction conditions

Venture Capital

In exchange for investment, venture capitalists obtain partial ownership of the business. Convertible preferred stock or convertible debt is usually preferred. This is because venture capital firm would like to have the senior claim on assets in case of liquidation but still have an option to convert it to common stock if the business becomes successful.

Angel Investors

Angel Investors, which are also referred to as informal venture capital, are wealthy private individuals who invest in the firms in their individual capacity. Very small percentage of start ups manage to get such funding. Therefore, entrepreneur should have other options available as well.

Government Programs

There are also government supported financing options available which are specific to an entrepreneur’s location.

Other

Other less feasible options exist. One example is to obtain funding from large corporation which is willing to invest in the enterprise.

 

Preparing Pro Forma Statements using the Percentage-of-sales method

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This is a very simple method used to prepare pro forma income statements and balance sheets. Each entry in the income statement and balance sheet is expressed as a percentage of sales, usually based on the figures from the previous year.

For example, to find cost of goods as a percentage of sales based on the figures in the previous year, company needs to take cost of goods in the previous year (which can be found in the income statement) and divide it by sales (which also found in the income statement for the previous financial period). The same way an interest expense could be obtained, which is by dividing interest expense of the last financial period (found in the income statement) by sales.

Than a sales forecast is developed for the next financial period and used as a base for establishing values for pro forma income statement and balance sheet. All that is required is to take the projected sales and apply the percentages established in the previous step to estimate figures for pro forma statements.

The shortcoming of this technique is that it assumes that all costs are variable. However, some of the costs are fixed. Therefore, when sales are increasing profit will be understated, as the company does not take into account the benefit of fixed costs in case of increasing sales. However, if sale are decreasing, than the profit will be overstated.

However, this shortcoming can be avoided if costs are divided into fixed and variable when preparing pro forma statements. This gives a more realistic representation of expected profitability of the company over the coming financing period.

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Holding companies

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A holding company is a company that owns a big large percentage of common stock shares of a company or group of companies to exercise voting control over such business or businesses. Such voting control includes control over operations, management and boards of directors. Holding companies originated in 1889 in New Jersey, USA. New Jersey was the first state that made it legal to form a company with the single purpose of owning stocks in other companies.

The companies controlled by a holding company are called subsidiaries and holding company itself is called a parent company of such subsidiaries. If a holding company owns all the shares of the subsidiary than such subsidiary is called a wholly owned subsidiary.

The purpose of a holding company is usually only to own shares in other companies. However, if a holding company also runs the business operations then it is called a holding-operating company.

Liability of the holding company is limited to the value of the stock it has in particular companies. Acquiring control over the business via a holding company is much easier than to do so via leveraged buyouts or mergers.

Advantages of holding companies

One of the advantages of holding company includes isolation of risks.This occurs because each organization the holding company controls operates independently. If one of the organizations fails or becomes involved in a lawsuit then other organizations are not affected. This also allows the holding company to take on bigger risks at individual subsidiaries.

There are some exceptions to this. In certain circumstances the parent company may feel responsible for rectifying the problems in particular subsidiaries to maintain its reputation. Lenders may also require guarantee from the holding company when lending to subsidiaries. Therefore, this advantage is not always relevant for holding companies.

Holding companies are also able to control many assets with fractional ownership. Holding companies control a large amount of assets with a relatively small percentage of ownership and therefore relatively small investment. The percentage of shares required to obtain voting control differs from situation to situation. In smaller organizations it may be around 30%. However, if the holding company wants to obtain the voting control of a large company with widely distributed shares, than even 10-20% of the outstanding stock may be enough to have such control.

Disadvantages of holding companies

One of the disadvantages of holding company is double taxation. In the United States, if the holding company wants to obtains tax consolidation benefits such as tax free dividends than it needs to own at least 80% of the subsidiaries to do so. If it owns from 20% to 80% than it needs to pay taxes on 20% of the dividends received from the subsidiaries. If it owns below 20% than it needs to pay taxes on 30% of dividends received from subsidiaries. Such disadvantage is not relevant to mergers as no double taxation occurs in mergers.

Another disadvantage of holding companies is costly administration. This occurs because each subsidiary is maintained as a separate entity and therefore no economies of scale are possible as in the case of a merger.

A further disadvantage of holding companies is increased risk. If a holding company finances investments through debt than it needs to service the debt. If one or more of subsidiaries are not able to distribute dividends due to economic downturn or any other reasons then the holding company may not be in a position to be able to service debt and may be forced into bankruptcy.

It is also easier to request dissolution of the holding company if it is found guilty in breaking antitrust laws.

Another disadvantage is that due to the availability of voting control, the holding company may ignore interests of the minority shareholders.

 

Hostile Takeover (Hostile Merger) Defence Strategies

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A target company has various options on how to fight a hostile takeover, which is also called a hostile merger. The target company generally obtains assistance of an investment banker and lawyer to ensure that fighting the hostile takeover will be successful. Below are the nine common hostile takeover defence strategies used by target companies.

Target companies may inform shareholders why the merger will be disadvantageous for the company.

Repurchase of stock is sometimes undertaken by companies to decrease the attractiveness of the target company for hostile takeover. Mergers can be attractive due to a company’s liquidity position. If the company has a lot of cash, it can be used to cover all or part of the debt undertaken to finance the acquisition. By using available cash to repurchase stock, the firm decreases its attractiveness as a takeover target. Moreover, repurchase of shares increases the price per share which makes hostile takeover more expensive.

Greenmail is another defensive strategy against hostile takeover. It leads to the target company buying a large bulk of shares from one or more shareholders which attempted a hostile takeover.

Another strategy to protect itself against hostile takeover is defensive acquisition. The purpose of such action is for the target company to make itself less attractive to the acquiring company. In such situations, the target company will acquire another company as a defensive acquisition and finance such acquisition with debt. Due to increased debt of the target company, the acquiring company, which previously planned hostile takeover, will likely lose interest in acquiring now highly leveraged target company. Before a defensive acquisition is undertaken, it is important to make sure that such action is better for shareholders’ wealth than the merger with the acquiring company which pursues a hostile takeover.

Finding a white knight is another hostile takeover defence strategy. It involves finding a more appropriate acquiring company that will take over the target company on more favourable terms and at a better price than the original bidder. White knights are seen as a protector of the target company against the black knight which is the acquiring company which attempted a hostile takeover.

Golden parachutes is another way to discourage hostile takeover. This strategy means including provisions in the employment contracts of top executives which will require a large payments to key executives if the organization is taken over. Nevertheless, the amounts to be paid are small relative to the size of the transaction. Therefore, this strategy may not be sufficiently effective on its own but will make the acquisition target less attractive.

Leveraged recapitalization is yet another way to deter hostile takeover. It refers to the distribution of a sizable dividend financed by debt. This increases the financial leverage of the target company and decreases its attractiveness.

The term poison pill was created by mergers and acquisitions lawyer Martin Lipton in the 1980’s and refers to a further hostile takeover defence strategy. It involves an arrangement that will make the target company’s stock unattractive for the acquiring company.

The poison pill strategy includes two main variations. Such variations are flip-in and flip-over. Flip-in tactic occurs when management offers to buy shares at a discount to all investors except for the acquiring company. Such an option is exercised when the acquiring company purchases a certain amount of the shares of the target company. Flip-over occurs where the Target Company will be able to purchase shares of the acquiring company at a discount after the merger is completed. This will decrease the value of the acquiring company’s shares and dilute the company’s control.

The poison pill can be effective in discouraging a hostile takeover and allows the target company more time to find a white knight. Yahoo is a famous example of a company that uses poison pill as a defence strategy. It will be exercised if any company or investor buys more than 15% of its shares without the approval of the board of directors.

The target company may also use the crown jewel defence strategy. Crown jewels refer to the most valuable assets and parts of the company. According to this strategy, the target company has the right to sell its best and most profitable assets and valuable parts of the business to another party if a hostile takeover occurs. This discourages hostile takeover as it makes the target company less attractive.

Pac-Man defence is a hostile defence strategy named after the popular arcade video game of the 1980’s. According to this strategy, the target company “turns the tables” and attempts to acquire an acquiring company which attempted a hostile takeover.

Although these hostile takeover defence strategies may be successful, there are costs such as transaction costs which are involved in undertaking them. Transaction costs may include hiring of investment bankers and lawyers. In making decisions whether or not to undertake any defence actions against hostile takeover, management needs to continue to act in the best interests of shareholders by keeping the maximization of the shareholders’ wealth as the main objective.

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Merger Negotiations

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Merger negotiations and mergers, similar to marriages, often fail. Therefore, it is very important to plan and execute merger negotiations properly to improve a merger’s chances for success.

Acquiring firms need to understand the deal very well before approaching the target company. Space for bargaining should be considered. For example, acquiring firm could initially offer somewhere between 75-90% of what it believes the target company is worth. However, it is also important to be reasonable when the initial offer is made. If the price will be too low then the relationship between parties may be severely damaged.

Good atmosphere and a respectful and positive tone of negotiations should be created. A Win-win mindset in negotiation should be maintained, not a win-lose mindset.

It is also important for the acquiring firm not to show its eagerness as this will decrease its bargaining power. Another essential point is the vital importance of being completely ethical and honest in conducting negotiations. Conflicts of interest also should be carefully avoided.

Negotiations should also be seen as an extension of the due diligence. It should be used to find explanations to unclear issues. It is important to remain sceptical and to check the information provided by the other party.

It is also recommended to engage competent advisors to attend to various important areas associated with merger negotiations. Such areas include, but are not limited to, due-diligence, tax, legal, regulatory matters and the valuation of the company.

Investment bankers are often hired to manage merger negotiations. Investment bankers may be hired by the acquiring company and/or target company and assists either party from the very beginning of the process by finding a target or a buyer all the way throughout assisting in merger negotiations, use of tender offers and in the execution of hostile merger defence strategies. The compensation of investment bankers may be commission-based, fixed fee or a combination of both.

In terms of personnel issues, it is imperative to be aware of the sensitivity with which employees of the target company are likely to approach possible relocation, changes in management, changes in the way operations are conducted and titles.

A good way for the target company to secure a good price is to follow a closed auction strategy. According to a closed auction strategy, the target company invites all interested parties to submit their sealed bids before the deadline. This is in comparison to open auction where all parties are aware of the previous bids submitted by other interested parties.

Prior to the submission of bids, all interested parties should receive a memorandum and an ability to undertake a limited due diligence. A closed auction strategy usually involves few rounds and concurrent negotiations with various interested parties.

The target company may even follow this strategy if there is only one company interested in the acquisition. This is possible because interested parties have no access to information regarding how many organizations are involved in a closed auction.

If a friendly takeover is not welcomed by the target company, the acquiring company may undertake a hostile takeover (hostile merger). The acquiring company will do so by using a tender offer. Tender offers refer to a formal offer made to the shareholders in the market place to obtain certain amount of shares at a given price which is above the current market price.

 

Finding the Market Price Ratio of Exchange

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When the acquiring company knows the ratio of exchange, it can be used to find the market price ratio of exchange. The market price rate of exchange is found as follows:

(MP of acquiring company * ratio of exchange)/ MP of the target company

Where: MP refers to the market price per share.

The market price ratio of exchange indicates how much of market price per share of the acquiring firm is exchanged for every $1.00 of the market price per share of the target company.

It is normal for the market price ratio of exchange to be above 1. This is an indication that the acquiring company pays a premium above the market price to acquire a target company.

Test yourself:

ABC (acquiring company) is acquiring BCD (target company) with the use of a stock swap transaction. ABC’s market price is $60 and BCD’s market price is $55. However, during merger negotiations, ABC agreed to a 1.5 ratio of exchange where it valued BCD’s shares at $90.

Find the market price per share in the ABC/BCD merger.

Solution:

(60*1.5)/55=1.6

This means that ABC gives $1.6 of its market price in exchange for every dollar of the BCD’s market price.

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