Determining Pricing for Products or Services

When products or services are developed and ready to be provided to customers, an entrepreneur still needs to make a pricing decision. Entrepreneurs need to be careful to ensure that the appropriate price is determined since customers generally do not like increases in prices.

Price is one of the four Ps of the marketing mix, which are product, place (distribution), promotion and price. Price, further, is interrelated with other Ps of the marketing mix.

Price of the product or service directly affects the revenue of the business. It also indirectly affects demand for the product or service (level of sales). This refers to the fact that generally as price of the product or service decreases demand tend to increase and as price increases demand tend to decrease. Both of this influences of price needed to be taken into account when an entrepreneur decides on appropriate price for the product or service.

Sales revenue

Total sales revenue of the business depends on quantity sold and price. If we ignore the affect of changes in price on demand than we can assume that as price increases revenue will also increase and vice versa.

For example, if a small business owner increases its price from $6.5 to $7 and the demand stays the same at 150,000 units per year than the following changes in revenue will take place:

Sales revenue at $6.5 per unit: $6.5 * 150,000 = $975,000

Sales revenue at $7 per unit: $7 * 150,000 = $1,050,000

As we can see from the above, an entrepreneur can lose a $75,000 annually in sales revenue by charging just $0.5 less.

A price of the unit of product or service is the cost per unit sold plus profit per unit. To determine pricing, entrepreneurs firstly need to understand the total cost of providing product and service. This includes all costs involved in getting the product or service to customers and after sales service, and includes manufacturing, advertising, storage, delivery, taxes, salaries, et cetera. When considering costs, it is important to divide total costs into fixed costs and variable costs.

Fixed costs refer to costs which do not change as volume of sales changes. For example, assume that enterprise is renting a building. The rent paid is a fixed cost since it does not fluctuate with changes in sales volume. Even if company will not sell any products over a certain period, the rent must still be paid.

Variable costs, on the other hand, refer to costs which fluctuate with changes in sales volume. An example of variable cost is commission paid to sales personnel. For example, assume that the business sells product at $100 per unit and pays sales commission of $5 to its sales personnel. The sales commission is a variable cost since it will fluctuate with changes in sales volume.

Many entrepreneurs treat fixed and variable costs the same. An average pricing approach which is often used by entrepreneurs is a manifestation of this. To find average price, entrepreneurs take total cost from the last period and divide it by total number of units sold from the last period. This gives them an average cost per unit.

This approach is very risky. The problem with this approach is that it does not account for the difference in fixed and variable costs. For example, if sales of the business will be lower than last year than fixed cost will increase the average cost per unit. This can decrease or eliminate the profit margin of the business. What is even worse is that this can even lead to business making a loss.

For example, imagine that ABC Company in the last financial period had fixed costs of $750,000 and variable costs of $250,000. Over last period 150,000 units were sold. To determine the average cost per unit, ABC will divide $1,000,000 ($750,000 + $250,000) by 150,000 units. This results in average cost per unit of $6.7. Assume that on the basis of this ABC decided to charge $9 per unit.

However, the slowdown of the economy led to decrease in number of units that ABC could sell to 90,000 units. This decreased the variable cost to $150,000. However, the fixed cost of ABC was left unchanged at $750,000. The new average cost per unit of ABC is ($750,000+$150,000)/90,000=$10 per unit. Since company charges customers $9 per unit, which is less than its average cost per unit of $10, it is making a loss.

The above example illustrates very clearly how risky an average pricing is, especially for the small business.

Pricing changes and demand

When entrepreneurs determine pricing, it is important to consider how demand is affected by pricing. The response of demand to price changes depends on whether the goods or services is demand elastic or demand inelastic.

Elastic demand refers to demand for products and services when increase in price will result in decrease in quantity purchased and decrease in price will result in increase in quantity purchased. For example, a decrease in price of certain brand of chocolate may result in increase in quantity of this brand of chocolate that is purchased.

Inelastic demand refers to demand for products and services which do not respond much to changes in price. For example, if the price of sugar will increase, the quantity of sugar purchased will likely remain unchanged. This is because sugar is seen as necessity and the amount of sugar that is used is usually more or less fixed in quantity.

To determine whether demand is elastic or inelastic it is helpful to start from a desktop research. Desktop research refers to research that can be done at one’s desk, such as with the use of the internet. The product or service that the entrepreneur makes available is provided by other companies as well and information on their prices and volumes will be available. After some research you should be able to see if demand for the product or service that you want to provide is elastic or not.

The degree of elasticity will determine barriers that entrepreneur has to consider when increasing the price of the product or service. To decrease elasticity of demand for product or service, an entrepreneur can take steps towards making product or service more unique and more value adding compared to that offered by competitors. In other words, an entrepreneur needs to establish a sustainable competitive advantage.

 

Objectives and Benefits of a Business Plan

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

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

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.

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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

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

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

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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Financial Position Statement Format (Balance Sheet)

As we mentioned earlier, a balance sheet (financial position statement) is one of the most important financial statements. Other important financial statements include the income statement, cash flow statement and statement of changes in equity. A balance sheet (financial position statement) outlines the financial position of the company at a given point in time. It is often called a “snapshot” of the company’s financial position.

Below we present the general format of the balance sheet (financial position statement). We also explain the items in the balance sheet.

General balance sheet format


(1) ASSETS

(1.1) Current assets comprise:

Cash

+

Marketable securities

+

Accounts receivable

+

Inventories

=

Total current assets

(1.2) Non-current assets (fixed assets) comprise

Land and buildings

+

Machinery and equipment

+

Vehicles

+

Fixtures and Furniture

+

Other (for example financial leases)

=

Total gross fixed assets

Less: Accumulated depreciation

=

Net fixed assets

+

Other assets (investments, goodwill, copyrights and patents)

=

TOTAL ASSETS

(2) LIABILITIES AND (3) EQUITY

Liabilities comprise current and non-current liabilities:

(2.1) Current liabilities:

Accrued expenses

+

Accounts payable

+

Short-term notes (notes payable)

=

Total current liabilities

(2.2) Non-current liabilities

Mortgage

+

Other long-term debt

=

Total Non-current liabilities

(3) Equity comprises:

Common stock

+

Paid-in capital in excess of par on common stock

+

Preferred stock

+

Retained earnings

=

TOTAL EQUITY

=

TOTAL LIABILITIES AND EQUITY

Assets


CURRENT ASSETS

Current assets are listed first in the balance sheet (financial position statement). Current assets are those that can be converted into cash within 12 months. The main reason why small businesses often experience financial trouble is inefficient management of current assets. That is, they run out of cash. This can happen for such reasons as having insufficient cash on hand or underestimating the amount of time it takes to liquidate assets to create cash.

Marketable securities, also often called “near cash”, are liquid securities such as US Treasury bills.

Accounts payable refer to money that has not yet been received from the firm’s debtors. Debtors are the firm’s customers who bought from the firm on credit and still need to pay for a product or service provided.

Inventories refer to the raw materials, products in the process of production and completed products ready for sale. Basically, inventory is the physical products the business intends to sell.

In the balance sheet (financial position statement), the most liquid assets are usually listed before less liquid assets. That is why we also listed current assets in terms of decreasing liquidity: cash, marketable securities, accounts receivable and inventories.

NON-CURRENT ASSETS OR FIXED ASSETS

After current assets are listed, we can list non-current assets in the balance sheet. Non-current assets or fixed assets refer to assets that cannot be converted into cash within a 12 months period. The majority of fixed assets are depreciable. It means that the cost of the asset is allocated over its useful life and deducted as expenses on the income statement. This decreases the amount of tax the firm has to pay.

On the balance sheet we need to show the net fixed assets, which refer to the gross fixed assets (assets before depreciation is taken into account) less accumulated depreciation (depreciation deducted over the useful life of the asset, up to this point). The net fixed assets of the firm is also referred to as the book value.

OTHER ASSETS

Other assets show assets on the balance sheet that do not fit under the first two categories and include such assets as goodwill, copyrights and patents. For some companies this can contribute a sizable portion, if not the majority, of their value.

Liabilities and equity


The second part of the balance sheet presents how the business was financed. It basically shows from which sources assets were financed. The two main sources of financing are debt and equity.

CURRENT LIABILITIES

We start the second part of the balance sheet with current liabilities. Current liabilities include accrued expenses, accounts payable and short-term notes.

Accrued expenses are expenses which the company is obligated to pay within 12 months and includes such items as salaries and wages.

Accounts payable refer to payments that company is still obligated to make within 12 months to the creditors which supplied their product on credit to the company.

Short-term notes refer to the money that must be repaid to the lenders within 12 months.

LONG-TERM LIABILITIES

The next step in compiling the balance sheet requires us to list long-term liabilities. Long-term liabilities refer to debt payment which is due in a period longer than 12 months.

EQUITY

The last step in compiling the balance sheet requires us to illustrate the equity position of the firm. Equity indicates the claims of firm’s owners on the firm.

Items “common stock” and “paid-in capital in excess of par on common stock” indicate the amount paid by common stock shareholders for their shares of common stock.

Preferred stock shows the amount of money received from issuing preferred stock.

Retained earning show the earnings of the firm which were not distributed in the form of dividends to the shareholders.

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Overview of the Balance Sheet (Financial Position Statement)

A balance sheet – financial position statement is one of the most important financial statements. Other important financial statements include the income statement, cash flow statement and statement of changes in equity.

A balance sheet is the financial position of the company at a given point in time. It is often called a “snapshot” of the company’s financial position.

How to think about a balance sheet (financial position statement)


A good way to compare the balance sheet statement, income statement and cash-flow statement is to think of a river leading to a dam. The income statement and a cash-flow statement record the movement of money over a specific period of time. It is similar to recording the volume flowing down a river over a specific period. The balance sheet – financial position statement is the dam. Everything collects there.

Therefore, by looking at the balance sheet we can see how everything comes together at a given point in time. If the company is reporting strong cash-flow in the statement of cash-flows, then that cash must be collecting somewhere, in the balance sheet. Provided a balance sheet is constructed honestly and correctly, it is a wonderful source of information about the company. Like a dam, any poisonous material or waste, gets washed down into the balance sheet. Therefore, paying careful attention to the balance sheet (financial position statement) allows to evaluate important information about the company.

Understanding the balance sheet (financial position statement)


To understand the balance sheet (financial position statement), one first needs to understand the difference between assets and liabilities. A simple explanation is as follows: if you take an unpaid vacation or are between jobs for a while, assets will or will have the potential of adding money to your bank account every month. Liabilities, however, will deduct money from your bank.

For example, if you own a fully paid-off house, which is currently empty, this is an asset. You may choose to earn money from this asset by renting it out. Therefore, even if you are not working, you will have rental income generated from your asset. However, if you leased an expensive car and lost your job, the bank will still deduct money from your bank account every month. Therefore, this is a liability. Alternatively, if the car is fully paid-off, it is an asset and you could generate income from it.

We also can define assets and liabilities more formally.

ASSETS

Assets are any tangible or intangible economic resources that a company or individual possesses and which can be used to cover the individual’s or company’s debt. For example, in the case of an individual, retirement savings and stocks are examples of assets. In the case of a company, fully owned equipment and buildings are examples of assets.

As represented on the balance sheet, current assets are assets which are excepted to be converted into cash within 12 months and non-current assets are assets which are expected to be converted into cash at some point in the future which is longer than 12 months.

LIABILITIES

Liability is a legal obligation to settle debt which arises as a result of a past transaction or event. A liability should, by law, be settled at a specified future period or over a specified period and, possibly, at specified intervals.

As represented on the balance sheet, current liabilities are debts which must be settled within 12 months and non-current liabilities are debts which must be settled at some point in the future which is longer than 12 months.

An example of personal liability can be a personal loan that must be repaid to the bank. Company liability examples include accrued expenses such as wages as well as long-term loans.

 

Innovation and Small Business

Why do innovation and small business go together? Consider this: small businesses account for 95% of all radical innovations and for half of all innovations. Inventions such as the personal computer originated from a small business. Therefore, innovation and small business are often very much aligned and this trend is expected to continue into the future.

After all, innovation and small business have to be associated because, in many cases, one can only break into established markets and compete with the recognized giants by introducing innovative solutions to customers’ needs.

Interestingly, large organizations usually focus on improving existing solutions rather than on inventing new solutions. As Scott Anthony, co-author of the book “Seeing What’s Next: Using Theories of Innovation to Predict Industry Change”, and partner at Innosight, a Watertown (Massachusetts) Innovation consulting firm, mentioned, “The thing that’s so tricky is that everything an established company is trained to do – watch your markets carefully, listen to your best customers, innovate to meet their needs – oftentimes causes them to miss some of these disruptive transformation trends”. Moreover, large organizations are often very bureaucratic, which slows down or even kills innovation efforts of employees.

The factors above further contribute to the competitive power of innovation in small business. Small business should embrace its less bureaucratic environments and enhance its innovation efforts. However, innovation efforts of small business have to be designed carefully. The following factors should be considered within the context of innovation and small business:

Six factors to consider


1 – Entrepreneurs need to ensure that adequate financing is available or is accessible for the entire duration of the innovation effort.

2 – A new and innovative product or service must add real value to customer. Innovation can only be a successful effort if there is a demand for the new solution.

3 – It is best to choose an area in which an entrepreneur has personal experience.

4 – It is best to concentrate on products and services which are currently not available or underserved. This will allow entrepreneurs to achieve more rapid growth as well as to have less competition, at least initially.

5 – If innovative products and services is the focus of the business, than continuous innovation should be given a priority.

6 – It is advisable for innovation to be of a type that allows for further products and services to be developed based on the initial innovation.

Innovation and small business success


Due to widespread globalization and advancement in technologies, innovation is accessible to small businesses in a way that was never possible before. Innovation and small business should go together, it is the only way to establish a strong foothold in the market while competing with recognized giants.

There has never been a better time for small businesses to grow and prosper. Think about the opportunities that technology and globalization offers to small business. For example, the internet has made it possible to access markets anywhere in the world, at a very low cost. The only thing that small businesses need is a solution to customers’ needs that is new and in demand. Small business needs innovation. Therefore, innovation and small business success are also very much aligned.

The following article may be of interest to you if you would like to understand this better: “All Shook Up – You can’t control disruptive innovations, but you can learn to predict them–and to react to them in a positive way.”