Which information belongs-and which doesn't-may surprise you. How to Write a Great by William A.Sahlman Few areas of bus Nothing could be further from the truth.In my ups business plans rank no higher than 2 on a scale plan.Countless books and articles in the popular rit the top from I to 10-as a predictor of a new venture's suc elaborately lan contests are springing up across Both graduate and undergraduate schools devote What's wrong with most business plans!The an swer is relatively straightforward.Most waste too much ink on numb would-h ur andss sta glossy five-co charts bunde of meticulous cial projections for a new company-especially de. Ino ecade ofonchy tailed,month-by-month projections that stretch out for more than a year- -are an act o magination. knowns to predict revenues.let chool in Boston.Massach has been closely Moreover,few if any entrepreneurs correctly antici He teaches discount the figures in business plans.These ma. All rights reserve HARVARD BUSINESS REVTEW July-August 1997
Which information belongs–and which doesn’t–may surprise you. How to Write a Great by William A. Sahlman Few areas of business attract as much attention as new ventures, and few aspects of new-venture creation attract as much attention as the business plan. Countless books and articles in the popular press dissect the topic. A growing number of annual business-plan contests are springing up across the United States and, increasingly, in other countries. Both graduate and undergraduate schools devote entire courses to the subject. Indeed, judging by all the hoopla surrounding business plans, you would think that the only things standing between a would-be entrepreneur and spectacular success are glossy five-color charts, a bundle of meticulouslooking spreadsheets, and a decade of month-bymonth financial projections. William A. Sahlman is Dimitri V. d’Arbeloff Professor of Business Administration at the Harvard Business School in Boston, Massachusetts. He has been closely connected with more than 50 entrepreneurial ventures as an adviser, investor, or director. He teaches a secondyear course at the Harvard Business School called “Entrepreneurial Finance,” for which he has developed more than 100 cases and notes. Nothing could be further from the truth. In my experience with hundreds of entrepreneurial startups, business plans rank no higher than 2–on a scale from 1 to 10 – as a predictor of a new venture’s success. And sometimes, in fact, the more elaborately crafted the document, the more likely the venture is to, well, flop, for lack of a more euphemistic word. What’s wrong with most business plans? The answer is relatively straightforward. Most waste too much ink on numbers and devote too little to the information that really matters to intelligent investors. As every seasoned investor knows, financial projections for a new company – especially detailed, month-by-month projections that stretch out for more than a year–are an act of imagination. An entrepreneurial venture faces far too many unknowns to predict revenues, let alone profits. Moreover, few if any entrepreneurs correctly anticipate how much capital and time will be required to accomplish their objectives. Typically, they are wildly optimistic, padding their projections. Investors know about the padding effect and therefore discount the figures in business plans. These maCopyright © 1997 by the President and Fellows of Harvard College. All rights reserved. HARVARD BUSINESS REVIEW July-August 1997
Business Plan ers create a vicious circle of inaccuracy that siness plan on the fr Don't misunderstand me:business plans should 'winning"formula touted by some current how-to 四60 ther the Nor is it a guide o through the key drivers of the venture's success or dent factors critical to every new venture: failure.In manufacturing,such a driver might be The People.The men and women starting and lishincldon aproduction process;in maoware, the impa pate iers The model should also address the break-even The Opportunity.A profile of the business itself- issue:At what level of sales does the business begir what it will sell and to whom,whether the business can grow and fast,what its economics are,who The Context.The big picture-the regulatory plan.Near the back. environment,interest rates,demographic trends What goes at the front?What information does a g00 ange but cannot of ir and also make sure you have asked yourself the Risk and Reward.An assessment of everything HARVARD BUSINESS REVIEW July-August 1997 99
Business Plan neuvers create a vicious circle of inaccuracy that benefits no one. Don’t misunderstand me: business plans should include some numbers. But those numbers should appear mainly in the form of a business model that shows the entrepreneurial team has thought through the key drivers of the venture’s success or failure. In manufacturing, such a driver might be the yield on a production process; in magazine publishing, the anticipated renewal rate; or in software, the impact of using various distribution channels. The model should also address the break-even issue: At what level of sales does the business begin to make a profit? And even more important, When does cash flow turn positive? Without a doubt, these questions deserve a few pages in any business plan. Near the back. What goes at the front? What information does a good business plan contain? If you want to speak the language of investors – and also make sure you have asked yourself the right questions before setting out on the most daunting journey of a businessperson’s career–I recommend basing your business plan on the framework that follows. It does not provide the kind of “winning” formula touted by some current how-to books and software programs for entrepreneurs. Nor is it a guide to brain surgery. Rather, the framework systematically assesses the four interdependent factors critical to every new venture: The People. The men and women starting and running the venture, as well as the outside parties providing key services or important resources for it, such as its lawyers, accountants, and suppliers. The Opportunity. A profile of the business itself– what it will sell and to whom, whether the business can grow and how fast, what its economics are, who and what stand in the way of success. The Context. The big picture – the regulatory environment, interest rates, demographic trends, inflation, and the like – basically, factors that inevitably change but cannot be controlled by the entrepreneur. Risk and Reward. An assessment of everything that can go wrong and right, and a discussion of how the entrepreneurial team can respond. HARVARD BUSINESS REVIEW July-August 1997 99
e accompanying article talks mainly about entrepreneurs.But quite often,start-ups are resumes of all the people involved.What has the launched within established companics Do thos er to the first question is an ewvenreoorsviceh ha the answer to th ues after the intraprencurial ventre lifts off.Wher etween products or ser BUSINESS panies,they track per ing money into them be e scene PLANS: That shouldn't or needn' FOR ENTREPRENEURS to projections?What deci he form of capital-budget. ONLY? tion:Have changes in th ext made add ona f such proposals,a plan never has been submitted un the help ofventuretisMany of thed arge com ntraprencurial ventures tures,one lesson being:Write a great business plar The assumption behind the framework is that enced,energetic managerial team from the top economic environments.Risk is understood,and the bottom.The team's members have skills and the team has considered ways to mitigate the im- experiences directly relevant to the oppor ifficult even the f futogether in the past.The op ofthework completely has an attractive,sustainable business model;it is The People e a bus to the nterprisedtteam.Value can be eue When I recei ss plan,I always read th resume section first.Not because the pec ople part of ed from the business in a number of ways either the new venture is the most important.but because HARVARD BUSINESS REVIEW July-August 1997
The assumption behind the framework is that has an attractive, sustainable business model; it is Many options exist for expanding the scale and – – ing down or liquidating. The context is favorable The People Tbusiness plans in a familiar context, as a tool for launched within established companies. Do those put together? The answer to the first question is an emphatic yes; the answer to the second, an equally emphatic no. All – – need to pass the same acid hind the scenes. inside big companies, new and a consensus-building résumés of all the people involved. What has the team done in the past that would suggest it would be panies, they track perbe the case. A business plan helps managers ask such questions as: How is the sions has the team made in tion? Have changes in the context made additional mistakes and triumphs. Many successful companies have been built with BUSINESS PLANS: FOR ENTREPRENEURS ? great businesses have attributes that are easy to identify but hard to assemble. They have an experienced, energetic managerial team from the top to the bottom. The team’s members have skills and experiences directly relevant to the opportunity they are pursuing. Ideally, they will have worked successfully together in the past. The opportunity possible to create a competitive edge and defend it. scope of the business, and these options are unique to the enterprise and its team. Value can be extracted from the business in a number of ways either through a positive harvest event a sale or by scalwith respect to both the regulatory and the macroeconomic environments. Risk is understood, and the team has considered ways to mitigate the impact of difficult events. In short, great businesses have the four parts of the framework completely covered. If only reality were so neat. When I receive a business plan, I always read the résumé section first. Not because the people part of the new venture is the most important, but because he accompanying article talks mainly about entrepreneurs. But quite often, start-ups are new ventures require business plans? And if they do, should they be different from the plans entrepreneurs new ventures whether they are funded by venture capitalists or, as is the case with intrapreneurial businesses, by shareholders tests. After all, the marketplace does not differentiate between products or services based on who is pouring money into them beThe fact is, intrapreneurial ventures need every bit as much analysis as entrepreneurial ones do, yet they rarely receive it. Instead, businesses get proposed in the form of capital-budgeting requests. These faceless documents are subject to detailed financial scrutiny process, as the project wends its way through the chain of command, what I call the “neutron bomb” model of project governance. However, in the history of such proposals, a plan never has been submitted that did not promise returns in excess of corporate hurdle rates. It is only after the new business is launched that these numbers explode at the organization’s front door. That problem could be avoided in large part if intrapreneurial ventures followed the guidelines set out in the accompanying article. For instance, business plans for such a venture should begin with the successful in the future, and so on? In addition, the new venture’s product or service should be fully analyzed in terms of its opportunity and context. Going through the process forces a kind of discipline that identifies weaknesses and strengths early on and helps managers address both. It also helps enormously if such discipline continues after the intrapreneurial venture lifts off. When professional venture capitalists invest in new comformance as a matter of course. But in large companies, scrutiny of a new venture is often inconsistent. That shouldn’t or needn’t new venture doing relative to projections? What deciresponse to new informafunding necessary? How could the team have predicted those changes? Such questions not only keep a new venture running smoothly but also help an organization learn from its the help of venture capitalists. Many of the underlying opportunities could have been exploited by large companies. Why weren’t they? Perhaps useful lessons can be learned by studying the world of independent ventures, one lesson being: Write a great business plan. ONLY 100 HARVARD BUSINESS REVIEW July-August 1997
BUSINESS PLAN tely 2 000 business plan read the resumes of tions in min he inser ")All th so they say.Bu members:What do they know?Whom do they count.As Arthur Rock,a venture capital legend as. sociate 1 stat. invest inpe tors,not surprisingly,value managers who have times A business pla team me oduct that they're talking plan writers should keen thi service:its production processesand the markett they craft theirpro osal.Talk about cre is noth rs have wo the the uld think college-but worked. lanching the venture agair Investors also look favorably on a team that is The Opportunity When it co rtunity itself a good run by people well known to supplicrs custom ing on two questions and employees.Their enterprise may be brand new, out they aren't Is thetotal arket for the The surprise el ment of working vice large,rapidly growing,or bo s the ind orate ?E0 :nlan should receive special care because,simply stated,that's growing markets mainly because it is often easier to obtain a share rket than to fight with entrer a matur Who Are These People,Anyway? ly in their evolution:that's where the big payoffs are.And,indeed 550 cvee Where have they worked-and for whom? looking for markets that actually allow businesse to mak -brainer within the busi to thst agpertunity they are pursuing?evonr was new and exciting.Dozens of companies jumpe into the fray,aided by an army of professiona investors Twenty years however,the th must des sign t roducts to meet the per ality people? OFM)selins Produet t oment manufactur. OEMs is compof the What are their motivations ings.Moreover,product life cycl HARVARD BUSINESS REVIEW July-August 1997 10
BUSINESS PLAN without the right team, none of the other parts really matters. I read the résumés of the venture’s team with a list of questions in mind. (See the insert “Who Are These People, Anyway?”) All these questions get at the same three issues about the venture’s team members: What do they know? Whom do they know? and How well are they known? What and whom they know are matters of insight and experience. How familiar are the team members with industry players and dynamics? Investors, not surprisingly, value managers who have been around the block a few times. A business plan should candidly describe each team member’s knowledge of the new venture’s type of product or service; its production processes; and the market itself, from competitors to customers. It also helps to indicate whether the team members have worked together before. Not played – as in roomed together in college–but worked. Investors also look favorably on a team that is known because the real world often prefers not to deal with start-ups. They’re too unpredictable. That changes, however, when the new company is run by people well known to suppliers, customers, and employees. Their enterprise may be brand new, but they aren’t. The surprise element of working with a start-up is somewhat ameliorated. Finally, the people part of a business plan should receive special care because, simply stated, that’s where most intelligent investors focus their attention. A typical professional venture-capital firm rePlan Should Answer � ? � ? � – and for whom? � – – in the past? � ? � ? � What skills, abilities, and knowledge do they have? � success and the tribulations it will face? � Who else needs to be on the team? � ? � ? � choices that have to be made? � ? � ? Who Are These People, Anyway? Fourteen “Personal” Questions Every Business Where are the founders from Where have they been educated Where have they worked What have they accomplished professionally and personally What is their reputation within the business community What experience do they have that is directly relevant to the opportunity they are pursuing How realistic are they about the venture’s chances for Are they prepared to recruit high-quality people How will they respond to adversity Do they have the mettle to make the inevitable hard How committed are they to this venture What are their motivations ceives approximately 2,000 business plans per year. These plans are filled with tantalizing ideas for new products and services that will change the world and reap billions in the process – or so they say. But the fact is, most venture capitalists believe that ideas are a dime a dozen: only execution skills count. As Arthur Rock, a venture capital legend associated with the formation of such companies as Apple, Intel, and Teledyne, states, “I invest in people, not ideas.” Rock also has said, “If you can find good people, if they’re wrong about the product, they’ll make a switch, so what good is it to understand the product that they’re talking about in the first place?” Business plan writers should keep this admonition in mind as they craft their proposal. Talk about the people – exhaustively. And if there is nothing solid about their experience and abilities to herald, then the entrepreneurial team should think again about launching the venture. The Opportunity When it comes to the opportunity itself, a good business plan begins by focusing on two questions: Is the total market for the venture’s product or service large, rapidly growing, or both? Is the industry now, or can it become, structurally attractive? Entrepreneurs and investors look for large or rapidly growing markets mainly because it is often easier to obtain a share of a growing market than to fight with entrenched competitors for a share of a mature or stagnant market. Smart investors, in fact, try hard to identify high-growth-potential markets early in their evolution: that’s where the big payoffs are. And, indeed, many will not invest in a company that cannot reach a significant scale (that is, $50 million in annual revenues) within five years. As for attractiveness, investors are obviously looking for markets that actually allow businesses to make some money. But that’s not the no-brainer it seems. In the late 1970s, the computer disk-drive business looked very attractive. The technology was new and exciting. Dozens of companies jumped into the fray, aided by an army of professional investors. Twenty years later, however, the thrill is gone for managers and investors alike. Disk drive companies must design products to meet the perceived needs of original equipment manufacturers (OEMs) and end users. Selling a product to OEMs is complicated. The customers are large relative to most of their suppliers. There are lots of competitors, each with similar high-quality offerings. Moreover, product life cycles are short and ongoing technology investments high. The industry is HARVARD BUSINESS REVIEW July-August 1997 101
The Opportunity of a Lifetime- or Is lt? and or growing,and one that's structurally attrac. Nine Questions About the Business Every Business tive.The second step is to make sure their business Plan Should Answer ho is th。ne enough of a profit that investors (or potential em ployees or suppliers,for that matter)will want to participate. nture's indust pany will build and launch its product or service arketplace.Again,a seri cussion. ieofauretipm How or8anioatesohcoequestioaseeale How easy is it to retain a customer tatal flaw in the businessvese that with a grea are sellist subject to major shifts in technology and customer viable access to customers is the key to business Drean approa t,an sible in the real world The information services industry,by contrast,is It is not always easy to answer questions about the likely co nsum new products or data to the fin ancial t tuall prov competitive advantage on their side.First,they car om deodorizers would sell?One entrepreneur ass conten know proposed to introduce an electronic news to thousa clipping servi He made 1 is pitch to a prospectiv the world.And although it is often exp sive to de. ng"ust don't think the doe s will eat the do velop the service and to acquire initial custor food."Later,when the entrepreneur's company once up and running,these companies can deliver went public,he sent the venture capitalist an anony mous dog The market is as fickle as it is prospectus.If it were easy to predict unpredictable.Who would have what people will buy,there wouldn't guessed that plug-in room much t h to but a business plan must address deodorizers would sell? that topic.Sometimes,the dogs wil cat the log food,bu y at a prce content to customers very cheaply.Also,customer portunities for value pricir pay in advance of receiving the service,which makes cash flow very handsome,indeed.In short but consumers will still pay a lot for it.No one i the structu formation services in ing to i vesta company when margins are in of loomberg nd all put the diskrive sive products and services-even in commodities.A business to shame. business plan must demonstrate that careful con. 102 HARVARD BUSINESS REVIEW July-August 1997
Thus, the first step for entrepreneurs is to make sure they are entering an industry that is large and/or growing, and one that’s structurally attractive. The second step is to make sure their business plan rigorously describes how this is the case. And if it isn’t the case, their business plan needs to specify how the venture will still manage to make enough of a profit that investors (or potential employees or suppliers, for that matter) will want to participate. Once it examines the new venture’s industry, a business plan must describe in detail how the company will build and launch its product or service into the marketplace. Again, a series of questions should guide the discussion. (See the insert “The Opportunity of a Lifetime–or Is It?”) Often the answers to these questions reveal a fatal flaw in the business. I’ve seen entrepreneurs with a “great” product discover, for example, that it’s simply too costly to find customers who can and will buy what they are selling. Economically viable access to customers is the key to business, yet many entrepreneurs take the Field of Dreams approach to this notion: build it, and they will come. That strategy works in the movies but is not very sensible in the real world. It is not always easy to answer questions about the likely consumer response to new products or services. The market is as fickle as it is unpredictable. (Who would have guessed that plug-in room deodorizers would sell?) One entrepreneur I know proposed to introduce an electronic newsclipping service. He made his pitch to a prospective venture-capital investor who rejected the plan, stating, “I just don’t think the dogs will eat the dog food.” Later, when the entrepreneur’s company went public, he sent the venture capitalist an anonysubject to major shifts in technology and customer competitive advantage on their side. First, they can content business to shame. or Is It? Plan Should Answer � ? � How does the customer make decisions about buying ? � ? � ? � segments? � ? � ? � ? � ? The market is as fickle as it is deodorizers would sell? needs. Intense rivalry leads to lower prices and, hence, lower margins. In short, the disk drive industry is simply not set up to make people a lot of money; it’s a structural disaster area. The information services industry, by contrast, is paradise. Companies such as Bloomberg Financial Markets and First Call Corporation, which provide data to the financial world, have virtually every assemble or create proprietary content – that, by the way, is like life’s blood to thousands of money managers and stock analysts around the world. And although it is often expensive to develop the service and to acquire initial customers, once up and running, these companies can deliver content to customers very cheaply. Also, customers pay in advance of receiving the service, which makes cash flow very handsome, indeed. In short, the structure of the information services industry is beyond attractive: it’s gorgeous. The profit margins of Bloomberg and First Call put the disk drive The Opportunity of a Lifetime – Nine Questions About the Business Every Business Who is the new venture’s customer this product or service To what degree is the product or service a compelling purchase for the customer How will the product or service be priced How will the venture reach all the identified customer How much does it cost (in time and resources) to acquire a customer How much does it cost to produce and deliver the product or service How much does it cost to support a customer How easy is it to retain a customer unpredictable. Who would have guessed that plug-in room mous package containing an empty can of dog food and a copy of his prospectus. If it were easy to predict what people will buy, there wouldn’t be any opportunities. Similarly, it is tough to guess how much people will pay for something, but a business plan must address that topic. Sometimes, the dogs will eat the dog food, but only at a price less than cost. Investors always look for opportunities for value pricing–that is, markets in which the costs to produce the product are low, but consumers will still pay a lot for it. No one is dying to invest in a company when margins are skinny. Still, there is money to be made in inexpensive products and services–even in commodities. A business plan must demonstrate that careful con- 102 HARVARD BUSINESS REVIEW July-August 1997
BUSINESS PLAN sideration has been given to the new venture's pric of individuals who have devised a be ing scheme. ousetrap-newfangled creations from inflatablo ThelitotqcioshbotteReweaCetnrS portunity on es and ng syst ems rew these driven compal ts of and the also involves ass ssing the business model from a money required by or share the rewards sufficiently ospective that takes into account thehqu with the b sinesssideotthccmaMit9出g 1。 dressed so that investors can understand the cash resobetter-mousetrap businesses have an un flow implications of pursuing an opportunity: canny way of malfunctioning. When does the business gencalhneeatopayatgmi How long does it take to acquire a customer? trage ventures are created to take advantage of ired to sur asoa Whatever the reason,better- nvestors,of lookng mousetrap businesses have an uncanny way of malfunctioning. eeds to spell out how close to that ideal the new venture is expected to come.Even if some pricing disparity in the marketplace.MCI -and it usually is-at least Communications Corporation,for instance,was ofa busine also bring a few other issues to the surface.First,it tions going on today reflect a different kind of arbi can grow base.or geographi Pscope Often companies are able to create virtual pipelines that support the eco- Taking advantage of arbitrage opportunities is he final analysis Similarly,building on the success of its persona is to use the arbitrage profits to build a more endur ar program tuit now sells and business plans must ex- an well a As for printing supplies and on-line information services- ing that all business pans should carefully and to name just a few of its highly profitable ancillary horoughly cover this territory,yet some don't spin-ofts lots of business plans run That is a glam ing omission.For rs every bu wing question subject of the new venture's t the co netition Who are the new venture's current competitors? I into some What resources s do they control?What are their ore structurally unattractive.But there are other weaknesse the new venture's deci on to enter the business? How can the new venture respond to its competi tors response HARVARD BUSINESS REVIEW July-August 199 103
BUSINESS PLAN sideration has been given to the new venture’s pricing scheme. The list of questions about the new venture’s opportunity focuses on the direct revenues and the costs of producing and marketing a product. That’s fine, as far as it goes. A sensible proposal, however, also involves assessing the business model from a perspective that takes into account the investment required–that is, the balance sheet side of the equation. The following questions should also be addressed so that investors can understand the cash flow implications of pursuing an opportunity: � When does the business have to buy resources, such as supplies, raw materials, and people? � When does the business have to pay for them? � How long does it take to acquire a customer? � How long before the customer sends the business a check? � How much capital equipment is required to support a dollar of sales? Investors, of course, are looking for businesses in which management can buy low, sell high, collect early, and pay late. The business plan needs to spell out how close to that ideal the new venture is expected to come. Even if the answer is “not very” – and it usually is – at least the truth is out there to discuss. The opportunity section of a business plan must also bring a few other issues to the surface. First, it must demonstrate and analyze how an opportunity can grow–in other words, how the new venture can expand its range of products or services, customer base, or geographic scope. Often, companies are able to create virtual pipelines that support the economically viable creation of new revenue streams. In the publishing business, for example, Inc. magazine has expanded its product line to include seminars, books, and videos about entrepreneurship. Similarly, building on the success of its personalfinance software program Quicken, Intuit now sells software for electronic banking, small-business accounting, and tax preparation, as well as personalprinting supplies and on-line information services– to name just a few of its highly profitable ancillary spin-offs. Now, lots of business plans runneth over on the subject of the new venture’s potential for growth and expansion. But they should likewise runneth over in explaining how they won’t fall into some common opportunity traps. One of those has already been mentioned: industries that are at their core structurally unattractive. But there are others. The world of invention, for example, is fraught with danger. Over the past 15 years, I have seen ing systems. Few of these idea-driven companies canny way of malfunctioning. – need to pay attention some pricing disparity in the marketplace. MCI Communications Corporation, for instance, was ness plan should answer the following questions about the competition: � � � sion to enter the business? � mousetrap businesses have an uncanny way of malfunctioning. scores of individuals who have devised a better mousetrap – newfangled creations from inflatable pillows for use on airplanes to automated car-parkhave really taken off, however. I’m not entirely sure why. Sometimes, the inventor refuses to spend the money required by or share the rewards sufficiently with the business side of the company. Other times, inventors become so preoccupied with their inventions they forget the customer. Whatever the reason, better-mousetrap businesses have an unAnother opportunity trap that business plans – and entrepreneurs in general to is the tricky business of arbitrage. Basically, arbitrage ventures are created to take advantage of formed to offer long-distance service at a lower price than AT&T. Some of the industry consolidations going on today reflect a different kind of arbitrage – the ability to buy small businesses at a wholesale price, roll them up together into a larger package, and take them public at a retail price, all without necessarily adding value in the process. Taking advantage of arbitrage opportunities is a viable and potentially profitable way to enter a business. In the final analysis, however, all arbitrage opportunities evaporate. It is not a question of whether, only when. The trick in these businesses is to use the arbitrage profits to build a more enduring business model, and business plans must explain how and when that will occur. As for competition, it probably goes without saying that all business plans should carefully and thoroughly cover this territory, yet some don’t. That is a glaring omission. For starters, every busiWho are the new venture’s current competitors? What resources do they control? What are their strengths and weaknesses? How will they respond to the new venture’s deciHow can the new venture respond to its competitors’ response? Whatever the reason, betterHARVARD BUSINESS REVIEW July-August 1997 103
Visualizing Risk and Reward When it comes to the matter of risk and reward in venture,a business plan be fits enorm stors that th two graph naps graphs ir money that illustrate the most likely relationship between nd it High aip ce ther the middle of thes ures say more The first pic e depicts the amount of mone need there is a smal ve cash ihspawn a 200% rate invest i Microsoft when it was a private company. money rale of relurn per year termin hat cla w venture drill ing for No orth sea carly and often.But most d hy the picrure ve hen the cash ouow is high and of a Thi ogical gamble and proba ably less Of course inc the world of new ventures is popu- tion.It's then up to the investors to decide how much d by wi you might expect the they want tol With ag st what kind of ard slope than it should.It usaly s.But to be that apicture ngs in the b a signinicant return is d the nright hug the new venture's is con mpletely out of touch e picture's beauty.Whatit The sccond picture complements the first.It shows investors the range of possible returns and the like caveat emptor. Who else might be able to observe and exploit the plan doesn't whitewash the latter.rather it p me opportunity? Are there ways to co-opt potential or actual com bad.and the ugly that the venture faces ahead. petitors by The Context plan that describes an insuperable lead or a propri Opportunities exist in a context.At one level is inition written by naive at goe le macroeconomicctivitoncluding the ther exc cussion of the opportunity.All opp rtunities have wide ra nge of government rules and regulations promise:all have vulnerabilities.A good business that affect the opportunity and how resources are 104 HARVARD BUSINESS REVIEW July-August 1997
graphs is the This image helps the investor understand the depth – lated by wild-eyed optimists, you might expect the lihood of achieving them. The following example – risk they want to live with against what kind of odds. Again, the people who write business plans might and the possibility of loss is negligible. And, again, I money potential reward time depth time to positive cash flow of hole probability 15% 15% -100% (total loss) 45% 200% (big hit) flat section Visualizing Risk and Reward When it comes to the matter of risk and reward in a new venture, a business plan benefits enormously from the inclusion of two graphs. Perhaps wrong word; these are really just schematic pictures that illustrate the most likely relationship between risk and reward, that is, the relationship between the opportunity and its economics. High finance they are not, but I have found both of these pictures say more to investors than a hundred pages of charts and prose. The first picture depicts the amount of money needed to launch the new venture, time to positive cash flow, and the expected magnitude of the payoff. and duration of negative cash flow, as well as the relationship between the investment and the possible return. The ideal, needless to say, is to have cash flow early and often. But most investors are intrigued by the picture even when the cash outflow is high and long as long as the cash inflow is more so. Of course, since the world of new ventures is popupicture to display a shallower hole and a steeper reward slope than it should. It usually does. But to be honest, even that kind of picture belongs in the business plan because it is a fair warning to investors that the new venture’s team is completely out of touch with reality and should be avoided at all costs. The second picture complements the first. It shows investors the range of possible returns and the likeshows investors that there is a 15% chance they would have been better off using their money as wallpaper. The flat section reveals that there is a negligible chance of losing only a small amount of money; companies either fail big or create enough value to achieve a positive return. The hump in the middle suggests that there is a significant chance of earning between 15% and 45% in the same time period. And finally, there is a small chance that the initial outlay of cash will spawn a 200% internal rate of return, which might have occurred if you had happened to invest in Microsoft when it was a private company. Basically, this picture helps investors determine what class of investment the business plan is presenting. Is the new venture drilling for North Sea oil highly risky with potentially big payoffs – or is it digging development wells in Texas, which happens to be less of a geological gamble and probably less lucrative, too? This image answers that kind of question. It’s then up to the investors to decide how much be inclined to skew the picture to make it look as if the probability of a significant return is downright huge would say therein lies the picture’s beauty. What it claims, checked against the investor’s sense of reality and experience, should serve as a simple pictorial caveat emptor. rate of return per year � Who else might be able to observe and exploit the same opportunity? � Are there ways to co-opt potential or actual competitors by forming alliances? Business is like chess: to be successful, you must anticipate several moves in advance. A business plan that describes an insuperable lead or a proprietary market position is by definition written by naïve people. That goes not just for the competition section of the business plan but for the entire discussion of the opportunity. All opportunities have promise; all have vulnerabilities. A good business plan doesn’t whitewash the latter. Rather, it proves that the entrepreneurial team knows the good, the bad, and the ugly that the venture faces ahead. The Context Opportunities exist in a context. At one level is the macroeconomic environment, including the level of economic activity, inflation, exchange rates, and interest rates. At another level are the wide range of government rules and regulations that affect the opportunity and how resources are 104 HARVARD BUSINESS REVIEW July-August 1997
BUSINESS PLAN tec Risk and Reward anges n some conte reate opportu when the airline industry was deregulated in the late 1970s.The context for financing was also fa- think of a good business plan as a snapshot of an Th are times when the con makes it narl 1990s combined withadiffi fi ity,and the context from multip a difficult Ther a pl story of ital dishur vac the Good business plans in other words disouse people,opportunity,and context as a moving tar cally,those relatively tight con litions,which made factors (and the relationship among ints to get going, ge as a n to company 1990s,as capital markets heated up.) fore any husines s plan worth the time it takes to Sometimes,a shift in context turns an unattrac write or read needs to focus attention on the dy s into an attractive one,and vice vers naicaspectsoftheentreprenearnalpirCcesilit ago that se a pa g to pre le tial in about to be Put on the block.Then came the of the One of the greatest myths about tamper-proof seals,and in a matter entrepreneurs is that they are I performance risk seekers.All sane people in 1986 created havoc for companies want to avoid risk. in the real estate business,elin ing almost every positive incentive with a new ncil and tw put in place. and Reward."But even with these drawings,risk Every business plan should contain certain table pieces of evi shence elateo context.First,the er of outcomes.It is ulti the new yenture's contert and how it helns or hin enc ders their specific proposal.Second,and more im- success,and to decrease the likelihood and implica 1 tions of problems. they opr专 entrep ha the great myths abou Further.the businesplan should spell ou what All sa management can(and will)do in the event the con- (and venture capitalist)Howard Stevenson says, text grows unfavorable.Finally,the business plan true entrepreneurs want to capture all the reward HARVARD BUSINESS REVIEW July-August 199 105
BUSINESS PLAN marshaled to exploit it. Examples extend from tax policy to the rules about raising capital for a private or public company. And at yet another level are factors like technology that define the limits of what a business or its competitors can accomplish. Context often has a tremendous impact on every aspect of the entrepreneurial process, from identification of opportunity to harvest. In some cases, changes in some contextual factor create opportunity. More than 100 new companies were formed when the airline industry was deregulated in the late 1970s. The context for financing was also favorable, enabling new entrants like People Express to go to the public market for capital even before starting operations. Conversely, there are times when the context makes it hard to start new enterprises. The recession of the early 1990s combined with a difficult financing environment for new companies: venture capital disbursements were low, as was the amount of capital raised in the public markets. (Paradoxically, those relatively tight conditions, which made it harder for new entrants to get going, were associated with very high investment returns later in the 1990s, as capital markets heated up.) Sometimes, a shift in context turns an unattractive business into an attractive one, and vice versa. Consider the case of a packaging company some years ago that was performing so poorly it was about to be put on the block. Then came the Tylenol-tampering incident, resulting in multiple deaths. The packaging company happened to have an efficient mechanism for installing tamper-proof seals, and in a matter of weeks its financial performance could have been called spectacular. Conversely, U.S. tax reforms enacted in 1986 created havoc for companies in the real estate business, eliminating almost every positive incentive to invest. Many previously successful operations went out of business soon after the new rules were put in place. Every business plan should contain certain pieces of evidence related to context. First, the entrepreneurs should show a heightened awareness of the new venture’s context and how it helps or hinders their specific proposal. Second, and more important, they should demonstrate that they know the venture’s context will inevitably change and describe how those changes might affect the business. Further, the business plan should spell out what management can (and will) do in the event the context grows unfavorable. Finally, the business plan sion of risk and how to manage it. I’ve come to think of a good business plan as a snapshot of an – possible to give potential investors a sense of the risk seekers. All sane people want to avoid risk. should explain the ways (if any) in which management can affect context in a positive way. For example, management might be able to have an impact on regulations or on industry standards through lobbying efforts. Risk and Reward The concept that context is fluid leads directly to the fourth leg of the framework I propose: a discusevent in the future. That’s quite a feat to begin with taking a picture of the unknown. But the best business plans go beyond that; they are like movies of the future. They show the people, the opportunity, and the context from multiple angles. They offer a plausible, coherent story of what lies ahead. They unfold possibilities of action and reaction. Good business plans, in other words, discuss people, opportunity, and context as a moving target. All three factors (and the relationship among them) are likely to change over time as a company evolves from start-up to ongoing enterprise. Therefore, any business plan worth the time it takes to write or read needs to focus attention on the dynamic aspects of the entrepreneurial process. Of course, the future is hard to predict. Still, it is kind and class of risk and reward they are assuming with a new venture. All it takes is a pencil and two simple drawings. (See the insert “Visualizing Risk and Reward.”) But even with these drawings, risk is, well, risky. In reality, there are no immutable distributions of outcomes. It is ultimately the responsibility of management to change the distribution, to increase the likelihood and consequences of success, and to decrease the likelihood and implications of problems. One of the great myths about entrepreneurs is that they are risk seekers. All sane people want to avoid risk. As Harvard Business School professor (and venture capitalist) Howard Stevenson says, true entrepreneurs want to capture all the reward One of the greatest myths about entrepreneurs is that they are HARVARD BUSINESS REVIEW July-August 1997 105
A Glossary of Business Plan Terms What They Say... and What They Really Mean We conservatively project. We read a book that said we had to be a $50 million We took our best guess and divided by 2 We accidentally divided by 0.5. We project a 10%margin. The project is9%complete. Our business model is proven. We have a six-month lead We only needa 10%market share Sodo the other 50 entrants getting funded. Customers are clamoring for our product. We are the low-cost producer We have no competition OnllBMMcroot,Ne nno Dur management team has a great deal of experience. consuming the product or service A select group of investors is considering the plan. copeplnr We seek a valueadded investo Weare ooking for a passive,dumb-asrocks investor. aanwmooma6oseggeowhda四 nd give all the risk to others.The best business is reneur to a post office box to which people send cashier's ecks Yet risk is unavoidable.So what does that de l awaits those who do pose them and then pro- an for a business plan? ght be high A new t unflinchingly con venture for example front the risks aheadin terms of people, tive to inter st rates.Its busin ss plan would bene nity,and context.What happens if one of the new fit enormously by stating that management intends to hedge its exp ure through the fi arket by pur ch ng a the source of a key raw materiall What will man offering nce lIt also makes sense agement actually do? for the business itself.] 106 HARVARD BUSINESS REVIEW July-August 1997
and give all the risk to others. The best business is mean for a business plan? agement actually do? pose, especially when seeking capital. But a better for the business itself.) What They Say… and What They Really Mean the numbers. our 50 locations and extrapolate it for all the others. six-month lead. So do the other 50 entrants getting funded. confident that we will be able to. announced plans to enter the business. right, you might get your money back. a post office box to which people send cashier’s checks. Yet risk is unavoidable. So what does that It means that the plan must unflinchingly confront the risks ahead – in terms of people, opportunity, and context. What happens if one of the new venture’s leaders leaves? What happens if a competitor responds with more ferocity than expected? What happens if there is a revolution in Namibia, the source of a key raw material? What will manThose are hard questions for an entrepreneur to deal awaits those who do pose them and then provide solid answers. A new venture, for example, might be highly leveraged and therefore very sensitive to interest rates. Its business plan would benefit enormously by stating that management intends to hedge its exposure through the financial-futures market by purchasing a contract that does well when interest rates go up. That is the equivalent of offering investors insurance. (It also makes sense A Glossary of Business Plan Terms We conservatively project… We took our best guess and divided by 2. We project a 10% margin. The project is 98% complete. Our business model is proven… We have a six-month lead. We only need a 10% market share. Customers are clamoring for our product. We are the low-cost producer. We have no competition. Our management team has a great deal of experience… A select group of investors is considering the plan. We seek a value-added investor. If you invest on our terms, you will earn a 68% internal rate of return. We read a book that said we had to be a $50 million company in five years, and we reverse-engineered We accidentally divided by 0.5. We did not modify any of the assumptions in the business plan template that we downloaded from the Internet. To complete the remaining 2% will take as long as it took to create the initial 98% but will cost twice as much. if you take the evidence from the past week for the best of We tried not to find out how many other people have a We have not yet asked them to pay for it. Also, all of our current customers are relatives. We have not produced anything yet, but we are Only IBM, Microsoft, Netscape, and Sun have consuming the product or service. We mailed a copy of the plan to everyone in Pratt’s Guide. We are looking for a passive, dumb-as-rocks investor. If everything that could ever conceivably go right does go 106 HARVARD BUSINESS REVIEW July-August 1997
BUSINESS PLAN ortant area in the realm of risk/ capital is often m able," risky,as I've noted;what can go wrong will.When they mear he company be taken pub hat appens,unsophistica investors panic,get angry so would reveal information that might harm its roll up their sleeves and help the company solve its problem theyvehad experience sav ae.They umderst ta companies,but rather they are not sustainable as indepen- The best business is a post of the process.How will the investor office box to which people eventually get money out of the send cashier's checks. busine only marg articularly like ss strategy and a strong tactical plan.they knov atwiefxitionThe howtcmotivatteam members.They are also familiar with the Byzan those opt ine ins an corporations that could someday actually buy know-how is worth the money needed to buy it. them.Investors feel a lot better about risk if the There is an old expression directly relevant to is discussed up front.There is an neurial finance: Too clever by half."Often off and get very cre trepreneurial strategies kno n craft just the opposite is true: My experience has prov en again and again that sen you had better know where you might end up and le deals have the following six characteristics: ere.A business plan hey are simple every traveler knows,a journey is a lot less risky Thev emphasize trust rather than legal ties when you have directions. They do not blow apart if actual differs slightly The Deal and Beyond e pervers s tha They are written on a pile of papers no greater That is a topic for another than one-quarter inch thick article in its utI will add a wwords here. rules miss an impor to finance an sition the valuation and terms of the deal they will re of a lump sum.Instead,it is incumbent upon entre ceive. Their explicit goal seems to be to minimize ding,to phatuiovthe l suffer in raising capital.Im about capita cquisition as a dynami main as passive as a tree while the ed and when they will need it. n money building their business.On the food chain of in How is that accomplished?The trick is for the vestors,it seems,doctors and dentists are best and h arge share of the returns. group to test the product,build a protot and hat notion-like the idea that excruciatingly de atch it perfo ed financial projections are useft HARVARD BUSINESS REVIEW July-August 199 107
BUSINESS PLAN Finally, one important area in the realm of risk/ reward management relates to harvesting. Venture capitalists often ask if a company is “IPOable,” by which they mean, Can the company be taken public at some point in the future? Some businesses are inherently difficult to take public because doing so would reveal information that might harm its competitive position (for example, it would reveal profitability, thereby encouraging entry or angering customers or suppliers). Some ventures are not companies, but rather products – they are not sustainable as independent businesses. Therefore, the business plan should talk candidly about the end of the process. How will the investor eventually get money out of the business, assuming it is successful, even if only marginally so? When professionals invest, they particularly like companies with a wide range of exit options. They like companies that work hard to preserve and enhance those options along the way, companies that don’t, for example, unthinkingly form alliances with big corporations that could someday actually buy them. Investors feel a lot better about risk if the venture’s endgame is discussed up front. There is an old saying, “If you don’t know where you are going, any road will get you there.” In crafting sensible entrepreneurial strategies, just the opposite is true: you had better know where you might end up and have a map for getting there. A business plan should be the place where that map is drawn, for, as every traveler knows, a journey is a lot less risky when you have directions. The Deal and Beyond Once a business plan is written, of course, the goal is to land a deal. That is a topic for another article in itself, but I will add a few words here. When I talk to young (and old) entrepreneurs looking to finance their ventures, they obsess about the valuation and terms of the deal they will receive. Their explicit goal seems to be to minimize the dilution they will suffer in raising capital. Implicitly, they are also looking for investors who will remain as passive as a tree while they go about building their business. On the food chain of investors, it seems, doctors and dentists are best and venture capitalists are worst because of the degree to which the latter group demands control and a large share of the returns. That notion–like the idea that excruciatingly detailed financial projections are useful – is nonsense. that happens, unsophisticated investors panic, get – sible deals have the following six characteristics: � � � � � � tant point. A deal should not be a static thing, a one-shot document that negotiates the disposition think about capital acquisition as a dynamic need and when they will need it. How is that accomplished? The trick is for the The best business is a post From whom you raise capital is often more important than the terms. New ventures are inherently risky, as I’ve noted; what can go wrong will. When angry, and often refuse to advance the company more money. Sophisticated investors, by contrast, roll up their sleeves and help the company solve its problems. Often, they’ve had lots of experience saving sinking ships. They are typically process literate. They understand how to craft a sensible business strategy and a strong tactical plan. They know how to recruit, compensate, and motivate team members. They are also familiar with the Byzantine ins and outs of going public an event most entrepreneurs face but once in a lifetime. This kind of know-how is worth the money needed to buy it. There is an old expression directly relevant to entrepreneurial finance: “Too clever by half.” Often, deal makers get very creative, crafting all sorts of payoff and option schemes. That usually backfires. My experience has proven again and again that senThey are simple. They are fair. They emphasize trust rather than legal ties. They do not blow apart if actual differs slightly from plan. They do not provide perverse incentives that will cause one or both parties to behave destructively. They are written on a pile of papers no greater than one-quarter inch thick. But even these six simple rules miss an imporof a lump sum. Instead, it is incumbent upon entrepreneurs, before they go searching for funding, to process – to figure out how much money they will entrepreneurial team to treat the new venture as a series of experiments. Before launching the whole show, launch a little piece of it. Convene a focus group to test the product, build a prototype and watch it perform, conduct a regional or local rollout of a service. Such an exercise reveals the true ecooffice box to which people send cashier’s checks. HARVARD BUSINESS REVIEW July-August 1997 107
