part 7 PowerPoint Presentation by Charlie Cook Copyright © 2003 South-Western College Publishing. All rights reserved. All rights reserved. Risk and Insurance Financial Management in the Entrepreneurial Firm 12e

Copyright © by South-Western College Publishing. All rights reserved. 24–2 Looking Ahead After studying this chapter, you should be able to: 1. Define risk and explain the nature of risk. 2. Explain how risk management can be used in coping with business risks. 3. Describe the risks associated with different types of assets, both physical and human. 4. Explain the basic principles used in evaluating an insurance program and the fundamental requirements for obtaining insurance. 5. Identify the different types of insurance coverage.

Copyright © by South-Western College Publishing. All rights reserved. 24–3 What is Risk? Risk –The chance that a situation may end in loss or misfortune. Market Risk –The uncertainty of a gain or a loss associated with an investment decision. Pure Risk –The uncertainty associated with a situation where only loss or no loss can occur—there is no potential for gain (only downside).

Copyright © by South-Western College Publishing. All rights reserved. 24–4 Risk Management –Ways of coping with risk that are designed to preserve assets and the earning power of a firm. The Process of Risk Management Step1:Identify risks. Step 2:Evaluate risks. Step 3:Select methods to manage risk. Step 4:Implement the decision. Step 5:Evaluate and review.

Copyright © by South-Western College Publishing. All rights reserved. 24–5 Methods to Manage Risks Risk Control –Minimizing potential losses by avoiding or reducing risk. Risk Avoidance –Preventing risk by choosing not to engage in hazardous activities. Risk Financing –Making funds available to cover losses that cannot be managed by risk control.

Copyright © by South-Western College Publishing. All rights reserved. 24–6 Methods to Manage Risks (cont’d) Risk Transfer –Buying insurance or making contractual agreements with others to transfer risk. Risk Retention –Choosing—whether consciously or unconsciously, voluntarily or involuntarily—to manage risk internally. Self-Insurance –Designating part of a firm’s earnings as a cushion against possible future losses.

Copyright © by South-Western College Publishing. All rights reserved. 24–7 Tools For Managing Risk TABLE 24-1

Copyright © by South-Western College Publishing. All rights reserved. 24–8 Fig 24-1 The Wheel of Misfortune

Copyright © by South-Western College Publishing. All rights reserved. 24–9 Risk Management and the Small Firm Risk management differences from large firms: –It is more difficult for small firms to get insurance coverage. –Large firms can assign responsibilities for risk management to a specialized staff manager. –Risk management is not something that requires immediate attention.

Copyright © by South-Western College Publishing. All rights reserved. 24–10 Classifying Risk by Type of Asset Property Risks FireFire Natural Disasters “Acts of God” Customer Risks Employee Dishonesty Competition from Former Employees Personnel Risks On-Premises Injury Product Liability Burglary and Business Swindles Loss of Key Executives Bad Debts ShopliftingShopliftingBankruptcyBankruptcy

Copyright © by South-Western College Publishing. All rights reserved. 24–11 Insurance for Small Business Basic Principles of a Sound Insurance Program –Identify insurable business risks  Workers’ compensation and automobile liability insurance are required by law. –Limit coverage to major potential losses  Avoid overspending insurance resources. –Relate premiums to probability of loss  Insure most improbable but critical losses first.

Copyright © by South-Western College Publishing. All rights reserved. 24–12 Requirements for Obtaining Insurance The risk must be calculable so that premiums can be calculated. The risk must exist in large enough numbers to allow the law of averages to work. The insured property must have commercial value. The policyholder must have an insurable interest in the property or person insured.

Copyright © by South-Western College Publishing. All rights reserved. 24–13 Types of Insurance Commercial Property Insurance –Coverage that protects against losses associated with damage to or loss of property.  Coinsurance clause Business Interruption Insurance –Coverage of lost income and certain other expenses while the business is being rebuilt. Dishonesty Insurance –Coverage that protects the firm against employees’ crimes.

Copyright © by South-Western College Publishing. All rights reserved. 24–14 Types of Insurance (cont’d) Surety Bonds –Coverage that protects against another’s failure to fulfill a contractual obligation. Credit Insurance –Coverage that protects against abnormal bad-debt losses.

Copyright © by South-Western College Publishing. All rights reserved. 24–15 Commercial Liability Insurance

part 4 PowerPoint Presentation by Charlie Cook Copyright © 2003 South-Western College Publishing. All rights reserved. All rights reserved. Exit Strategies 14 The New Venture Business Plan 12e

Copyright © by South-Western College Publishing. All rights reserved. 14–17 Looking Ahead After studying this chapter, you should be able to: 1. Explain the importance of having an exit strategy. 2. Describe the options available for exiting 3. Explain how to value a firm being sold and how to decide on the method of payment. 4. Provide advice on developing an effective exit strategy.

Copyright © by South-Western College Publishing. All rights reserved. 14–18 The Importance of the Exit Exiting (or harvesting) –The process used by entrepreneurs and investors to reap the value of a business when they get out of it. –The process involves:  Capturing value (cash value)  Reducing risk  Creating future options

Copyright © by South-Western College Publishing. All rights reserved. 14–19 Fig Methods for Exiting a Business

Copyright © by South-Western College Publishing. All rights reserved. 14–20 Exiting: Selling the Firm Buyers’ reasons for purchasing a firm: –Strategic acquisition  Synergies to be gained in combination with other assets –Financial acquisition  Profitability of the firm as a stand-alone business –Employee acquisition  Preservation of employment for current employees

Copyright © by South-Western College Publishing. All rights reserved. 14–21 Exiting: Selling the Firm Strategic Acquisition –A purchase in which the value of the business is based on both the firm’s stand-alone characteristics and synergies that the buyer thinks can be created by the strategic fit of the firm and a potential buyer. + = $$$$ $$$$ $$$$ +

Copyright © by South-Western College Publishing. All rights reserved. 14–22 Exiting: Selling the Firm Financial Acquisition –A purchase in which the value of the business is based on the stand-alone cash generating potential of the firm being acquired. Leveraged Buyout (LBO) –A purchase heavily financed with debt, when the potential cash flow of the target company is expected to be sufficient to meet debt repayments.  Bust-up LBO—purchasing with the intention of selling off assets  Build-up LBO—purchasing similar firms to make one larger company

Copyright © by South-Western College Publishing. All rights reserved. 14–23 Exiting: Selling the Firm Employee Stock Ownership Plan (ESOP) –A method by which a firm is sold either in part or in total to its employees. –Employees retirement contributions are used to purchase shares in the firm. –Frequently is the exit method of last resort. –Motivates the employee- owners to perform.

Copyright © by South-Western College Publishing. All rights reserved. 14–24 Leveraged ESOP Buyout EmployerFirm SellingOwner ESOPTrust Lender 1. Employer firm guarantees payment of loan. 2. ESOP trust borrows money from lender. 6. ESOP trust makes payment on loan. 4. Stock is sent to ESOP trust for benefit of employees. 3. Cash from loan is used to buy owner’s stock. 5. Employer firm makes annual contribution for employee stock purchases.

Copyright © by South-Western College Publishing. All rights reserved. 14–25 Exiting: Releasing the Firm’s Cash Flows Exiting by Withdrawing Firm’s Cash –Advantages:  Retain control of firm while harvesting investment.  No need to seek a buyer or incur expenses associated with sale of business –Disadvantages  Loss of development potential and opportunities  Tax disadvantages of cash withdrawal  Requires patience to siphon off cash slowly

Copyright © by South-Western College Publishing. All rights reserved. 14–26 Exiting: Going Public Initial Public Offering (IPO) –The first sale of shares of a company’s stock to the public in order to:  raise capital to repay outstanding debt  strengthen the balance sheet to support growth  create a source of capital that can be selectively accessed to fund continuing growth  create a liquid currency to fund future acquisitions  create a liquid market for the company’s stock  broaden the shareholder base  create ongoing interest in the company and its continued development Source: Lisa D. Stein, vice-president, Salomon Smith Barney.

Copyright © by South-Western College Publishing. All rights reserved. 14–27 Exiting: Going Public—The IPO Process 1.The firm’s owners decide to go public. 2.If not already completed, an audit of the last three years financial statements is conducted. 3.An S-1 registration is drafted. 4.Management responds to suggested comments by the SEC, and issues a Red Herring/Prospectus. 5.Firm goes “on the road” explaining its attributes to investors. 6.On the day before the public offering, an offering price is decided upon. 7.Offering the stock to the public and seeing how it is received.

Copyright © by South-Western College Publishing. All rights reserved. 14–28 Exiting: Going Public—Using Private Equity Private Equity (Capital) –Money provided by venture capitalists or private investors. Factors in the Transfer of Family-Owned Firms –Liquidity for exiting family members –Continued financing for company growth –Maintenance of family control of the firm

Copyright © by South-Western College Publishing. All rights reserved. 14–29 Firm Valuation and the Exit The Actual Value –Opportunity cost of funds  The rate of return that could be earned on another investment of similar risk Harvest Value/Market Comparable Valuation –Establishing the value of a privately held company based on the value of a similar or comparable publicly traded company.

Copyright © by South-Western College Publishing. All rights reserved. 14–30 Firm Valuation and the Exit (cont’d) Earnings Before Interest, Taxes, Depreciation, and Amortization –A company’s earnings before subtraction of interest expense, taxes, and noncash expenses, such as depreciation and amortization. Valuation Multiple –A multiple of a firm’s earnings based on risk and expected earnings, used to value the company –Based on the experience and judgment of the buyer/person; influenced by strength of the desire to purchase the firm.

Copyright © by South-Western College Publishing. All rights reserved. 14–31 EBITDA Example Net income$ 4,675,000 Income taxes3,175,000 Interest expense115,000 Depreciation and amortization 1,175,000 Earnings before interest, taxes,$ 9,140,000 depreciation, and amortization (EBITDA) Multiple of EBITDA x 5 Firm Value$45,700,000 Long-term debt 1,350,000 Equity value$44,350,000

Copyright © by South-Western College Publishing. All rights reserved. 14–32 Exiting: The Method of Payment Payment Alternatives –Cash  Immediate and stable in value  Tax liability consequences –Stock  Immediate but uncontrollable in value  Potential problems with disposal of stock

Copyright © by South-Western College Publishing. All rights reserved. 14–33 Developing an Effective Exit Strategy Manage for the Exit –Manage for the long-term. –Avoid playing the harvest game. Expect Conflict—Emotional and Cultural –Strains of selling own business –Personal ties to the business after sale Get Good Advice –Advisors with harvest transaction experience –Other entrepreneurs who have sold their firms

Copyright © by South-Western College Publishing. All rights reserved. 14–34 Developing an Effective Exit Strategy Understand What You Want –Motives for exiting  Money  Independence  Health of the company  Your management team  An heir apparent taking over –Personal identity and the business itself –Avoid “seller’s remorse”

Copyright © by South-Western College Publishing. All rights reserved. 14–35 What’s Next Whatever you decide to do, do it with passion and let your life bless others in the process.