Lahore University of Management Sciences

Entrepreneurial Finance
Spring, 2007—2008

Instructor: Asad A. Alam

Office: 288
Office Hours: To be announced
Phone: 2288
E-mail address: aalam@lums.edu.pk

Required Text: There is no required text for the course. Course pack is available at the copy center

Course Objective:
Entrepreneurial Finance will focus on financial management within entrepreneurial firms. Most
of these will be young firms, although some are more established. The course will examine these
firms at all phases of their life cycle, from the initial idea generation to the ultimate harvesting of
the venture. The course will cover firms in a diverse set of industries including high technology,
low technology, and service. Financial management in entrepreneurial firms entails
understanding both sides of the balance sheet. Consequently, we will look at issues related to
both sides as well. The first section of the course will explore how to evaluate entrepreneurial
business opportunities. The skills necessary to make good investment decisions include
developing a framework of analysis for business opportunities. The process also entails
reinforcing and enhancing valuation skills. With these tools, you will be able to qualitatively and
quantitatively assess markets and opportunities.

The second section of the course examines how entrepreneurial investments are financed. An
emphasis will be placed on understanding financial institutions and deal terms. The course then
continues with an examination of harvesting. Unless an entrepreneur plans for the future
realization on investment, he or she could get left holding the bag with little value having been
created. We conclude the course by examining how entrepreneurial firms which have succeeded
need to continually reinvent and reinvigorate themselves in order to remain successful. This
transition to the second product or opportunity is often the most difficult time for the
entrepreneurial enterprise. Finally, we will make use of notes throughout the course. These notes
provide background information about industry facts and figures. They are meant to be
references that you can use often, both during the course and as you start your venture.

Module 1: Identification of Opportunity

The first module explores the structural model of entrepreneurship. We will use it as a
framework for evaluation. The behavioral model defines entrepreneurship as the pursuit of
opportunity without regard to resources currently controlled. The four stages of entrepreneurship
include: identifying opportunities; acquiring the financial, professional, and productive resources
to exploit the opportunity; implementing a plan of action; and harvesting the rewards.
Entrepreneurship should not, however, be seen as a linear process. True entrepreneurship
involves any or all the elements at any one particular time and should be viewed as a constantly
repeating cycle. A framework has been developed that identifies four critical success factors for
entrepreneurial ventures: people, opportunity, deal, and context. The cases in this course are
selected to highlight how these various factors influence success and failure for firms in various
industries. Each element is dynamic and can change over time, and the entrepreneur must
constantly reevaluate the four factors that are critical to entrepreneurial value creation. Three
questions can help center your analysis as you go forward:
What can go right?
What can go wrong?

What actions can be taken to increase the probability that things will go right or minimize the
chances that things will go wrong?

People
An important task in each case is to identify the key players. What is their experience? How does
this experience prepare or not prepare them for the opportunity that exists? What are the
strengths and weaknesses of the people involved on all sides of the transaction? Are there key
individuals that the company should add or replace?
Opportunity
The opportunity that arises may be a new product or service, a new method of delivery, or a new
production technique that provides a cost advantage. The entrepreneur must answer many
questions before he or she commits to the venture. What is the nature of the opportunity? Is there
a sustainable competitive advantage or is the idea easily replicated? Must the opportunity be
exploited immediately or is there the possibility of delaying investment until further information
is available? Are there intermediate milestones that can be used to assess the success of the
project?
Deal
Once the people and opportunity pass some litmus test, a proper deal must be structured.
Throwing money at good projects and good people will not guarantee success. Incentives and
contingencies are important considerations. The proper deal structure can minimize moral hazard
and adverse selection problems. From whom should the firm raise money: wealthy individuals
(angels), banks, venture capitalists? What is the proper financing instrument: debt, equity,
convertible securities, or a combination? Is a "no-compete" clause important? Can the deal create
stakeholders that increase the probability of success? Who bears the downside (upside) risk?
Context
Often the most difficult part of the analysis is identifying contextual issues that are relevant to
the success or failure of the project. Potential competitors may not be easily identified, but will
always be waiting to enter potentially profitable markets. The government is important because
regulations and restrictions can aid or harm the firm’s profitability. The entrepreneur must
attempt to forecast what policies the government might pursue in response to political pressure.
The opening of markets and the collapse of foreign regimes may be important in creating a
favorable environment for new ideas. Economic conditions and trends will also influence a
particular market and should be analyzed and understood.
The Concept of "FIT"
While most of the analysis may be divided into the four areas discussed above, it is important to
understand the big picture. In other words, how do the four elements relate to each other? Do the
people have the requisite skills and experience to exploit the opportunity? Does the deal provide
the proper incentive to all players given the necessity of their input and the level of their skills?
Will the context change the nature of the opportunity?

Module 2: Valuation
The second module of the course will address valuation techniques. Value is one of the
fundamental concepts of finance and should be familiar to you from your first year. To make
proper investment decisions, it is always necessary to undertake a valuation. Stating that the
uncertainty is too great to “value” a given project or company misses the point. Uncertainty
affects the distribution of possible values, not the ability to undertake a valuation. Valuation in
finance is a way to ask the right questions and understand what important assumptions determine
the ultimate value. In fact, if the range of potential outcomes is quite high, i.e., there is high
uncertainty, a thorough valuation can give information about when to invest, when to
discontinue a project, or when to investigate further. The sole purpose of valuation is not the
production of a single number. The first set of valuation problems are discounted cash flow
valuation models. While we discuss various discounted cash flow models, under the right
assumptions, they should all give similar answers. The most important lesson is to fully
understand the assumptions made in the process. We analyze discounted cash flow models in the
case of both mature leveraged buyout situations as well as young, startup ventures. The analysis
emphasizes both the strengths and weaknesses of such models. In fact, for many young firms,
simple discounted cash flow models can give misleading values.
The shortcomings of standard discounted cash flow models often stem the inability to account
real option value. Many projects have embedded optionality. A project that requires a small
investment today to allow for information gathering and a possible future investment is like a
financial option. The ability to delay investment until the acquisition of more information is a
real option. The ability to halt a project creates an option to abandon. The payoff curve is similar
to a call option where the only downside is the price of the option, but the upside is substantial.
If the entrepreneur does not understand the value of these options, he or she may make improper
investment decisions.

Module 3: Financing the Entrepreneurial Firm

Once the entrepreneur identifies an investment opportunity, a financing strategy needs to be
outlined. The opportunity may be a new firm, a new project, an expansion of a plant, or even the
hiring of new employees. Any of these types of investments present particular financing
problems. An entrepreneur who cannot raise the required resources will not succeed. A firm
needs cash to survive. Discussion will identify financial institutions and players that actively
provide resources to entrepreneurial firms. We will also examine the nature of contracting
between investors and entrepreneurial firms. Understanding the terms and conditions of
financing is important for all entrepreneurs to determine payoffs and incentives. Similarly, terms
and conditions determine who controls the firm under various circumstances. Control rights such
as board membership, information rights, covenants and restrictions are often employed in the
financing of entrepreneurial firms. Careful crafting of the financing document often increases
the likelihood of success. Various factors drive firms to seek capital from a multitude of capital
providers. Four primary factors that influence the source of funds can be identified.

Module 4: Harvesting the Entrepreneurial Venture

Every entrepreneur needs to consider harvesting at some point. Harvesting can take many forms.
Successfully planning for harvesting of the entrepreneurial venture is critical to maximizing the
value of your input. We will explore various modes of harvesting like initial public offerings
(IPOs) and acquisitions. The emphasis is on assessing whether the entrepreneurial firm is
“ready” for harvesting. In addition, we will emphasize the structural, legal, and dynamic issues
of various modes of harvest.
The public markets are a significant source of capital for emerging companies. For many firms,
accessing the public market is just the next phase of their dynamic capital process. For others, it
represents the beginning of the ability to receive the fruits of their labors. We explore the various
motivations for “going public” and the advantages and disadvantages of being a public company.
Structural and legal issues will be discussed. In addition, we explore the impact that the cyclical
nature of the initial public offering market has on firms access to capital. The role of various
intermediaries will be examined and the motivations of various parties discussed. The course
then covers acquisitions. Most firms will never be large enough for the public market and will
therefore need to find one specific buyer. The ability to find the best buyer and negotiate the best
deal terms of the deal for the entrepreneur is critical. We emphasize the role of bargaining and
auctions in the context of acquisitions. The motivations of buyers and sellers must be understood
to ensure the conclusion of a successful deal.

Conclusion
Entrepreneurial Finance is a course that examines the issues confronting entrepreneurial firms at
all stages of their existence. The course presents various frameworks and builds new skills
needed to identify important business ideas, raise and structure financing, and ultimately harvest
the project. The knowledge and skills learned are invaluable for all students, whether they find a
job in an entrepreneurial enterprise, work in a traditional firm, or start a company of their own.

Grading:

Grades will be based on the following point allocation:

Class Participation 20%

Assignments and Quizzes 10%
4 WAC 20%
Midterm exam 20%
New Venture Creation 30%
Total 100%

Class participation will be based on quality of input, not quantity of "air time". Quality class
participation includes both insightful comments and relevant, thoughtful questions. Regular
attendance and appropriate preparation are essential in scoring highly in class participation, and,
more importantly, in getting the most out of this class. If you miss more than 5 classes you will
automatically get an F grade in the course. I expect you to be punctual and be in your seat
before the class starts. Late walk-in will be counted as a nonattendance and will lower your
attendance grade. It is important to note that the course structure is integrated and one missed
class may result in relatively pervasive impact on understanding of concepts.

Examinations are administered during class. You are required to sit for an examination on the
day it is scheduled. In general, there are no make-up examination—if you are unable to resolve
conflicts with scheduled examinations with me, you should withdraw from the course.
Examinations are demanding of both your efficiency and effectiveness in addressing accounting
measurement, reporting, and analysis issues. There are two examinations during the term.
Examinations are normally comprised of problems, essay questions, and various analyses and
interpretation components.

Method of Instruction:
Class sessions entail a mixture of lecture, breakout sessions, problem analysis, and class
discussion. The content of each class presumes and expects you have carefully studied the
assigned reading and completed all assignments. Lectures emphasize major topics and readings,
yet you are responsible for all assigned materials. You are encouraged to ask questions and to
stimulate discussion on topics that you have difficulty understanding. Since I believe it is
important that you be able to articulate effectively your thoughts and analyses of financial
reporting, I often will call on you.

Assigned materials must be completed before class. Failing to complete assignments when they
are due is a recipe for failure. You are expected to come prepared to discuss issues relevant to all
assignments. While we cannot cover all assigned materials in class, remember that they are an
integral and important part of this course. I believe that working together in teams of two or
three can help in your understanding of these materials.

Class participation will be based on quality of input, not quantity of "air time". Quality class
participation includes both insightful comments and relevant, thoughtful questions. Regular
attendance and appropriate preparation are essential in scoring highly in class participation, and,
more importantly, in getting the most out of this class.
 Assignments: An important part of the grading of assignments is evidence of a serious attempt
at all parts of the assignment—accordingly, show all work. Assignments are typically collected
at the start of class, and late assignments are not accepted.

Quizzes Intermittent quizzes are possible—they are unannounced and are in-class. To
emphasize their importance, quizzes are graded and there are no make-up quizzes.

Academic Honesty Dishonesty is unacceptable. Anyone behaving in a dishonest manner (such

as cheating) will be prosecuted pursuant with policies of The Lahore School of Management
Sciences.

Course Outline
Session 1 Introduction
Tuesday Note: Do you have the right stuff to start a business
Session 2 Note: Finding and evaluating the opportunity: Is it real and large enough
Thursday Note: New Venture Financing
Case: Sound Strategy
Session 3 Guest Speaker: Bushra Azhar
Tuesday Topic: Company Registration Process
Session 4 Guest Speaker: Sohaib Umar
Thursday Topic: Valuation
Session 5 Presentation of your business Idea and team. Also file your company’s registration
Tuesday with Farhan.
Session 6 Guest Speaker: Monis Rehman
Thursday Topic: Deal Structure and Negotiating with a VC
Session 7 Note: How venture capitalist evaluate potential venture opportunities
Tuesday Case: GolfLogix: Measuring the Game of Golf
Session 8 Note: Angels and Venture Capitalists: For serious outside equity
Thursday Case: Ilinc: Case Study of a Start-up
Session 9 Note: Bootstrap Finance: The Art of Start-ups
Thursday Financing the Business: Where’s the Money?
Case: ProfitLogic
Session 10 Note: Valuation Concepts: Evaluating Opportunity
Tuesday Note: Valuing Companies: An overview of analytical approaches
Case: TCS: An Entrepreneurial Air-Express Company in Pakistan
Session 11 Note: Valuation issues in Start-Ups & Early-Stage companies: The Venture Capital
Thursday Method
Note: Valuation, Financing and Capitalization Tables
Case: XMS
Session 12 Note: Valuing Privately-Owned Companies: Valuation Techniques
Tuesday Note: A note on valuation of venture capital deals
Note: The Basic Venture Capital Formula
Case: Apex Investment Partners
Session 13 Mid Term
Thursday
Session 14 Note: A Note on Pre-Money and Post-Money Valuation
Tuesday Case: TBA
Session 15 Note: Deal Structure and Deal Terms
Thursday Case: Term Sheet Negotiations for Trendsetter, Inc.
Session 16 Note: Angels and Venture Capitalists: For serious outside equity
Tuesday Case: Walnut Venture Associates: A, B, & C
Session 17 Note: Deal Structure and Deal Terms
Thursday Case: Walnut Venture Associates_D
Session 18 Note: Harvest Time: Reaping What You’ve Sown
Tuesday Case: DayOne
Session 19 Note: Harvest Time: Reaping What You’ve Sown
Thursday Case: Spyder Active Sports
Session 20 Presentations
Tuesday