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Economics

Profits After Tax. High and durable growth margins usually trans­late into strong and durable after-tax profits. Opportunities that have potential for durable profits of at least 10-15 percent, and often 20 per­cent or more, will lure growth capital. Companies generating after-tax profits of less than 5 percent are quite fragile.

Breakeven and Positive Cash Flow. Consistent positive cash flow for a three- to five-year period indicates the economics of the company are exciting. Fluctuating between breakeven and positive cash flow, even if the degree of positive cash is significant, is a red flag.

ROI Potential. An important corollary to forgiving economics is reward. Truly high-potential opportunities have the power to yield a return on investment of 2 5 percent or more per year. After all, during the 1980s, many venture capital funds achieved only single-digit returns on investment, and since 2000 many of those same firms are in nega­tive territory. High and durable gross margins and high and durable after-tax profits usually yield high earnings per share and high return on stockholders' equity, thus generating a satisfactory "harvest" price for a company. This is most likely true whether the company is sold through an initial public offering or is acquired. Given the risk typi­cally involved, a return on investment potential of less than 15-20 per­cent per year is simply not exciting.

Capital Requirements. Capital for growth is much more accessible than capital for a new venture. The reality is that resource providers are risk averse. New ventures are speculating about markets. Small busi­nesses with a track record have a much clearer path to success and there­fore greater access to capital. Deciding who is the right capital provider for your business's growth and how to properly communicate with those providers is a subject we will tackle in depth later in the book.

Internal Rate of Return Potential. Is the risk-reward relationship attractive enough? The response to this question can be intensely per­sonal because every individual has a different perspective on risk and return and a different personal utility curve, but the most appealing opportunities often have the promise of - and deliver on - a very sub­stantial upside of five to ten times the original investment in five to ten years. Of course, the extraordinary successes can yield fifty to one hun­dred times or more, but these truly are exceptions. A 25 percent or more annual compound rate of return is considered very healthy. In 2003, those investments considered basically risk free had yields of 3-8 percent.

Free Cash Flow Characteristics/ Free cash flow is a way of under­standing a number of crucial financial dimensions of any business: the robustness of its economics; its capital requirements, both working and fixed assets; its capacity to service external debt and equity claims; and its capacity to sustain growth. We define unleveraged free cash flow (FCF) as

Earnings before interest but after taxes (EBIAT)

Plus Amortization (A) and depreciation (D)

Less Spontaneous working capital requirements (WC)

Less Capital expenditures (CAPex),

or

FCF = EBIAT + [A+D] - [+ or -WC] - CAPex.

EBIAT is driven by sales, profitability, and asset intensity Low-asset-intensive, high-margin businesses generate the highest profits and sus­tainable growth.7

Gross Margins. High and durable gross margins (i.e., the unit sell­ing price less all direct and variable costs), or at least the potential to achieve them with growth, is important. Gross margins exceeding 40-50 percent provide a tremendous built-in cushion that allows for more error and more flexibility to learn from mistakes than do gross margins of 20 percent or less. High and durable gross margins, in turn, mean that a venture can reach breakeven earlier, an event that prefer­ably occurs within the first two years. Thus, for example, if gross mar­gins are just 20 percent, for every $1 increase in fixed costs (e.g., insurance, salaries, rent, and utilities), sales need to increase $5 just to stay even. If gross margins are 75 percent, however, a $1 increase in fixed costs requires a sales increase of just $1.33. R. Douglas Kahn, an entrepreneur who built the international division of an emerging soft­ware company to $ 17 million in highly profitable sales in just five years (when he was twenty-five years of age), offers an example of the cush­ion provided by high and durable gross margins. He stresses there is simply no substitute for outrageous gross margins: "It allows you to make all kinds of mistakes that would kill a normal company. And we made them all. But our high gross margins covered all the learning tuition and still left a good profit."8 Gross margins of less than 20 per­cent, particularly when they are fragile, are a red flag.

Harvest Issues

Value-Added Potential. Companies that have strategic value in an industry, such as important technology, are intrinsically more valuable than those with low or no strategic value. Opportunities with extremely large capital commitments, whose value on exit can be severely eroded by unanticipated circumstances, are less interesting to the capital mar­kets. Nuclear power is a good example. Niche dot-coms proved to be another.

Thus, one characteristic of businesses that command a premium price is that they have high value-added strategic importance to their acquirer: distribution, customer base, geographic coverage, proprietary technology, contractual rights, and the like. Such companies might be valued at four, five, or even six times (or more) last year's sales, whereas perhaps 60-80 percent of companies might be purchased at .75 to .04 times sales.

Valuation Multiples and Comparables. Consistent with the previ­ous point, there is a large spread in the value the capital markets place on private and public companies. Part of your analysis is to identify some of the historical boundaries for valuations placed on companies in the market/industry/technology area in which you compete. The rules of thumb outlined in Exhibit 2.1 are variable and should be thought of as a boundary and a point of departure.

Exit Mechanism and Strategy. Businesses that are eventually sold - privately or to the public - usually are started and grown with a harvest objective in mind. Planning is critical because, as is often said, it is much harder to get out of a business than to get into it. Giving some serious thought to the options and likelihood that the company can eventually be harvested is an important initial and ongoing aspect of the entre­preneurial process.

Capital Market Context. The context in which the sale or acquisi­tion of the company takes place is largely driven by the capital market context at that particular point in time. Timing can be a critical com­ponent of the exit mechanism because, as one study indicated, since World War II the average bull market on Wall Street has lasted just six months. For a keener appreciation of the critical difference the capital markets can make, recall the stock market crash of October 19, 1987, the prolonged bear market of 2000-2003, or the bank credit crunch of 1990-1992. Initial public offerings are especially vulnerable to the fluc­tuations of the capital markets; here the timing is vital. Some of the most successful companies grow when debt and equity capital were most available and relatively cheap.

Competitive Advantages Issues

Variable and Fixed Costs. An attractive opportunity has the poten­tial for being the lowest-cost producer and for having the lowest costs of marketing and distribution. For example, Bowmar was unable to remain competitive in the market for electronic calculators after the producers of large-scale integrated circuits, such as Hewlett-Packard, entered the business. Being unable to achieve and sustain a position as a low-cost producer shortens the life expectancy of a new venture.

Degree of Control. Desirable opportunities have potential for moderate-to-strong degree of control over prices, costs, and channels of distribution. Fragmented markets where there is no dominant com­petitor - no Microsoft operating system - have this potential. These markets usually have a market leader with a 20 percent market share or less. For example, sole control of the source of supply of a critical component for a product or of channels of distribution can give a new venture market dominance even if other areas are weak. Lack of con­trol over such factors as product development and component prices constrain an opportunity. A market where a major competitor has a market share of 40 percent, 50 percent, or especially 60 percent usu- ally implies one in which power and influence over suppliers, custom­ers, and pricing create a serious barrier and risk for a new firm. Such a firm will have few degrees of freedom. However, if a dominant com­petitor is at full capacity, is slow to innovate or to add capacity in a large and growing market, or routinely ignores or abuses the customer (remember "Ma Bell"), there may be an entry opportunity. However, entrepreneurs usually do not find such sleepy competition in dynamic, emerging industries dense with opportunity.

Entry Barriers. Having a favorable window of opportunity is impor­tant. Having or being able to gain proprietary protection, regulatory advantage, or other legal or contractual advantage, such as exclusive rights to a market or with a distributor, is important to a durable oppor­tunity. Having or being able to gain an advantage in response/lead times is important, since these can create barriers to entry or expansion by oth­ers. For example, advantages in response/lead times in technology, prod­uct innovation, market innovation, people, location, resources, or capacity enhance the potential of an opportunity. Possession of well-developed, high-quality, accessible contacts that are the product of years of building a top-notch reputation and that cannot be acquired quickly is also advantageous. In fact, there are times when this competitive advantage may be so strong as to provide dominance in the marketplace, even though many of the other factors are weak or average. An example of how quickly the joys of entrepreneur ship may fade if others cannot be kept out is the experience of firms in the hard-disk industry that were unable to erect entry barriers in the United States in the early to mid-1980s. By the end of 1983, some ninety hard-drive companies were launched, and severe price competition led to a major industry shakeout. Take a look at the cell-phone business. During the 2 003 Christmas hol­idays there were seventeen different cell-phone retailers on Oxford Street in London in a linear mile! If a firm cannot keep others out or if it faces already existing entry barriers, it can get lost in a fragmented market. An easily overlooked issue is a firm's capacity to gain distribution of its prod­uct. As simple as it may sound, even venture-capital-backed companies fall victim to this market issue. Air Florida apparently assembled all the right ingredients, including substantial financing, yet was unable to secure sufficient gate space for its airplanes. Even though it sold passen­ger seats, it had no place to pick the passengers up or drop them off.

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