CHAPTER 3

LEARNING OBJECTIVES
After studying this chapter,
you will be able to:

Differentiate between
lifestyle businesses and high-
growth ventures.

^ List four factors that have

contributed to the revival of the
small-business sector.

** List four important

functions of small business in

the economy.

^ Identify three ways of

getting into business for
yourself.

J Name five factors that are

critical for the success of a small
business.

w List four sources of

financing for lifestyle businesses.

* List six sources of equity

capital available to high-growth
ventures.

o
** List the pros and cons of
owning a franchise.
 Small Businesses,
New Ventures,
and Franchises

Turning Timber into Tender: Building a

Business from Chopsticks

Ian Ward, president of Lakewood Forest Products, Ltd. of Vancouver, British

Columbia, first got the idea for his business in 1983, when he was exporting
timber and fish from Canada to distant ports. One of his representatives
happened to be in South Korea when a Russian plane shot down a Korean
airliner, putting an abrupt end to the timber trade between Russia and
Korea. "Within days, we started getting requests from Koreans for aspen
logs," Ward recalls. When he asked what the wood was for, he was told
"Chopsticks for the Japanese market." After further questioning, Ward
learned that the Japanese use and throw away 130 million pairs of chopsticks
every day. What's more, demand is growing by 17 percent per year.
In the old days, all of the chopsticks were made in Japan in small, labor-
intensive factories. But as labor rates rose and the supply of high-quality
timber diminished, much of the production shifted to South Korea. Still, the
RIKINFCC flfKF IIP
Korean approach was not much of an improvement. All of the chopsticks
were still sorted by hand and inspected individually for defects, a time-
consuming process that drove up the cost of production.
When Ward received the rash of orders for aspen, he began to do some
serious thinking about the economics of chopstick production. He learned
that much of the wood is wasted, since the Japanese will not use chopsticks
with dark spots. For every 100 pounds of wood the Koreans imported, 60
pounds would be thrown away as waste — an expensive proposition, given
the high cost of shipping timber. "I said, there has to be a better way of doing
this," Ward recalls.
If he could make the chopsticks near the source of the timber, he could
save on shipping costs, since all that wasted wood would be left behind. And
if he could automate production and inspection, he could turn out chopsticks

more cheaply than the Asians, in spite of their lower wage rates. Ward
thought that maybe he could modify a Popsicle-stick machine so that it
would produce chopsticks instead. Sure enough, he was right. The idea for
automating the inspection process occurred to him when he was reading an
article on the use of vision technology in sorting Brazilian coffee beans. He

55
 56 Part One: Focus on Business Today

had a similar system designed that would inspect the color of the chopsticks
and reject those with dark spots.
But turning a good idea into reality costs money, and Ward needed
plenty of capital to build a factory capable of producing 6 million or 7 million
pairs of chopsticks a day. To get started, he decided to sell Industrial Devel-
opment Bonds. He also had a piece of good luck. The governor of Minnesota
heard of Ward's concept and offered him free land and a grant of $1.25 mil-
lion to locate the production plant in Hibbing, Minnesota, an economically
depressed area with plenty of high-grade aspens. Ward gladly agreed and
began construction on the plant, which will eventually employ 120 people.
Meanwhile, Ward got busy on the marketing end of the business. After a
little negotiating, he was able to line up a deal with a group of Japanese
importers, who guaranteed to buy all of the output of the plant for the next
five years.
But despite Ward's many successes, no start-up is without its problems.
There were a few glitches in the equipment that slowed up production, thus
Operating from a manufac- delaying the flow of revenues into the business. Ward needed more money to
turing plant in Hibbing,
correct the production bottleneck and cover expenses until sales reached the
Minnesota, entrepreneur
Ian Ward
plans to pick off break-even point. He took the company public, raising $206 million (Cana-
5 percent of the Japanese dian dollars) on the Vancouver stock exchange, and managed to raise another
market for disposable $3 million from outside financial institutions.
chopsticks.
Lakewood still faces many uncertainties. The production process is new
and experimental, and further problems could arise. Costs may be higher
than anticipated. Competitors could enter the business. But if all goes ac-
cording to plan, Lakewood Forest Products will soon have sales of close to
$20 million per year and an after-tax profit of $5 million. Ian Ward is opti-
mistic about the future. He is exploring markets for chopsticks in other parts
of Asia and in the United States as well. He's also considering additional
products using some of the scrap wood from the chopstick manufacturing
process. One possibility: wooden prayer boards that are displayed in Japa-
nese temples for a few days, then burned by the priests. Says Ward, "They use
them up even faster than chopsticks. ... I am totally enamored of disposable
1

products."

The Scope of Small Business

According to the Small Business Administration, over 98 percent of the na-
small businesses Compa- tion's companies are small businesses, independently owned and operated
nies that are independently firms that are not dominant in their field. 2 As a group, they account for
owned and operated, and nearly 40 percent of the gross national product and are a vital source of jobs,
are not dominant their
in
products, and services. 3 To be counted officially as "small," service busi-
field
nesses must have sales below $3.5 million, and goods-producing companies
must employ fewer than 500 to 1,000 people, depending on the industry. 4
Most small businesses fall at the low end of this size range. Four out of five of
them have fewer than 20 employees. 3
There are two distinctly different types of small businesses. Most —
lifestylebusinesses Small roughly 80 to 90 percent — are modest operations with little growth poten-
businesses intended to pro- tial. The corner florist and neighborhood pizza parlor fall into this category
6
vide the owner with a com- of lifestyle businesses (sometimes called "mom-and-pop operations").
fortable livelihood In contrast to lifestvle businesses, some small firms, like Lakewood For-
Chapter 3: Small Businesses, New Ventures, and Franchises 57

high-growth ventures est Products, arcsmall simply because they are new. These high-growth ven-
Small businesses intended tures aim
outgrowing their small-business status as quickly as possible.
at
to achieve rapid growth and Often run by a team rather than by one individual, they obtain a sizable
high profits on investment supply of investment capital and then attempt to introduce new products or
services to a large market.
The most rapidly growing of these ventures are listed by Inc. magazine
every year. On the average, their sales are increasing by 90 percent per year.
The Inc. list includes such firms as Orbital Sciences (manufacturers of NASA
space launch vehicles) and Enreco (provides environmental cleanup ser-
vices). In recent years, the list has been dominated by computer-related com-
panies and firms engaged in business services. 7

This checklist will help you 2. I'll work hard for a while. But when I've had

determineyourpotential for enough, that's it.

owning a small business.
3. can't see that hard work gets you anywhere.
I

G. Can you make decisions?

EJl. can make up my mind in a hurry if have to. It
I I

A. Are you a self-starter? usually turns out okay, too.

l. do things on my own.
I Nobody has to tell me to 2. can if have plenty of time. If have to make up
I I I

get going. my mind fast, later think that should have

I I

[J2. If someone gets me started. I keep going all right. decided the other way.
3. Easy does don't put myself out
it. I have until I to. [Zl3. don't like to be the one who has to decide
I

B. How do you about other people?

feel things.
l. Ipeople. can get along wkh just about
like I
H. Can people trust what you say?
anybody. Dl. You bet they can. I don't say things don't mean. I

LJ2. have plenty of friends. don't need anyone else.

I I
2. I try to be on the level most of the time, but
3. Most people irritate me. sometimes I just say what's easiest.
C. Can you lead others? d3. Why bother if the other person doesn't know the
Dl. can get most people to go along when start
I I
difference?
something. I. Can you stick with it?

\Z\2. can give the orders if someone tells me what we

I
Dl. If I make up my mind to do something, I don't let
should do. anything stop me.
3. let someone else get things moving. Then
I go I
CJ2. I usually finish what I start — if it goes well.
along if feel like it.
I
D3. If it doesn't go well right away, I quit. Why beat
D. Can you take responsibility? your brains out?
Dl. like to take charge of things and see them
I
J. How good is your health?
through. Dl. never run down!
I

LZl2. I'll take over if I have to. but I'd rather let 02. have energy for most
I things want to do. I

someone be responsible.
else 3. I run out of energy sooner than most of my
D3. There's always some eager person who wants to friends seem to.
look smart. I'm glad to let that person do the
work. Directions: If most of your checks were beside the
E. How good an organizer are you? firstanswer, you probably have what it takes to oper-
Dl. likeI to have a plan before I start. I'm usually the
ate a business successfully. If not, you are likely to
one to get things lined up when the group wants
to do something. have difficulty and should consider getting a partner
D2. Ido all right unless things get too confused. Then to compensate for your weaknesses. If most of your
I quit. checks were beside the third answer, not even a good
D3. When get all set. something comes along and
I
partner will enable you to overcome the deficiencies
presents too many problems. So just take things I

indicated.
as they come.
F. How good a worker are you?
l. Ican keep going as long as need to. don't I I

mind working hard for something want. I

58 Part One: Focus on Business Today

America's small-business roots run deep. The country was originally founded
The small-business by small-business people —
the family farmer, the shopkeeper, the crafts-
revival man. Successive waves of immigrants carried on the tradition, launching
restaurants and laundries, driving taxicabs, opening newsstands and baker-
ies and the like. These small businesses are the cornerstone of our economic
system.
Yet, despite our independent heritage, we have become a nation of em-
ployees. In 1800, 80 percent of Americans were self-employed; today, the
8
figure is 10 percent. The trend away from self-employment began after the
Civil War, when big business emerged as the primary economic force. Aided
by improvements in transportation and communication, large producers
economies of scale Sav- were able to achieve economies of scale, which are the savings resulting from
ings from manufacturing, manufacturing, marketing, or buying large quantities of an item. These large
marketing, or buying large producers could manufacture goods at lower costs than their smaller rivals
quantities and, hence, were able to charge lower prices. The small, independent busi-
nesses could not compete. As scores of them closed their doors, the dominant
firms became increasingly powerful, making it virtually impossible for new
9
rivals to enter many industries.
In the last 15 or 20 years, however, the trend toward bigness has slowed.
To some extent, this reflects the economy's shift toward services, where econ-
omies of scale are often elusive. But even in the manufacturing sector, small
firms have been able to hold their own against larger rivals. In many indus-
tries, the advent of computer-aided manufacturing equipment has enabled
small plants to operate just as efficiently as larger ones, eliminating the econ-
omies of scale that used to benefit the large-scale producer. Because of their
simpler organization and management structure, these small plants can
often provide customized service or deliver goods more quickly than their
larger rivals.
At the same time, a number more peo-
of other factors have encouraged
ple to leave the corporate world and form businesses of their own. Demo-
For many, the American graphic trends have had something to do with it. Baby boomers have reached
dream is still "to own their 30s and 40s, the prime age for starting businesses. Furthermore, many
my own business." Since of these people are frustrated by their career progress. With so many baby
1970, the number of self- boomers competing for the same positions in big companies, the odds of
employed people has in-
rising to the top are slim. Add the fact that many big companies have been
creased by 50 percent.
laying off middle managers, and you get a large pool of frustrated, experi-
enced people looking for a better option.
The movement of women into the work force has also been a factor. In-
deed, women are starting businesses at twice the rate of men. They currently
own about 25 percent of all small businesses, and by the year 2000 they are
10
likely to own as many businesses as men do. For many of these women,
self-employment provides an opportunity to combine a career with family
life. Many of their businesses are operated from the home; about half have
11
sales of less than $5,000 per year.
The upshot of all these forces has been a revival of the small business
sector. During the 1980s, three times as many new businesses have been
incorporated as was the case during the 1960s. 12 In 1988, Americans were
expected to form 700,000 new corporations, 500,000 sole proprietorships,
and 100,000 partnerships, bringing the total number of small businesses to
somewhere between 12 million and 17 million. 13 Exhibit 3.1 indicates which
kinds of businesses are started most often, which have the best chance of
surviving, and which are most likely to grow significantly.
Chapter 3: Small Businesses, New Ventures, and Franchises 59

EXHIBIT 3 1 Characteristics of New Businesses

MOST FREQUENTLY STARTED BUSINESSES MOST LIKELY TO BUSINESSES MOST LIKELY TO GROW
BUSINESSES SURVIVE SIGNIFICANTLY

RANK BUSINESS RANK BUSINESS RANK BUSINESS

1 Miscellaneous business 1 Veterinary services 1 Commercial savings banks
services

2 Eating and drinking places 2 Funeral services 2 Electronic-component

manufacturing

3 Miscellaneous shopping 3 Dentists' offices 3 Paperboard-container

goods manufacturing
4 Automotive repair shops 4 Commercial savings banks it Computer and office-
machine manufacturing
5 Residential construction 5 Hotels and motels 5 Miscellaneous paper-
product manufacturing
6 Machinery and equipment 6 Campgrounds and trailer 6 Miscellaneous plastic-
wholesalers parks product manufacturing

7 Real-estate operators 7 Physicians' offices 7 Basic steel manufacturing

8 Miscellaneous retail stores 8 Barbershops 8 Pharmaceutical

manufacturing

9 Furniture and furnishings 9 Bowling and billiards 9 Communication-equipment

retailers places manufacturing

10 Computer and data-process- 10 Cash grain crops 10 Partition and fixture

ing services manufacturing

not easy to run a small business. Those who succeed, whether they run a
It is
men and
The lifestylebusiness or a high-growth venture, have certain characteristics in
women who build common. They are generally well organized and responsible, able to commu-
businesses nicate well with customers and employees, willing to work hard, comfortable
with a degree of financial uncertainty, and passionately involved with their
work.
Small-business owners share another trait: resilience. They regard diffi-
culty as a challenge and learn from their mistakes. They stick to their princi-
ples and refuse to take no for an answer. When things go wrong, they bounce

Businesses owned by
women are the fastest-
growing segment of the
small business sector.
60 Part One: Focus on Business Today

EXHIBIT 3.2
What Makes
Entrepreneurs Different
The young and the restless
are most likely to be
entrepreneurs.

The data in the chart are based on a tele- executive officers and other senior executives
phone survey that the Gallup Organization did from Fortune magazine's list of the 500 larg-
for The Wall Street: Journal. Small business est American corporations. The respondents
executives own or manage a broad cross sec- were almost exclusively male. The entrepre-
tion of businesses with 20 or more employees neurs — 55 percent of whom are under the
but with sales of less than $50 million per age 45 — are a generation younger than the
year. Entrepreneurs are chief executives of corporate executives. Although most entrepre-
companies listed by Inc. magazine as among neurs run companies founded in the past de-
the 500 fastest-growing smaller companies in cade, the small business sample consists of
America. The Fortune 500 executives are chief more established companies.

back and try again. Even Henry Ford had two business failures before he
founded the Ford Motor Company.
Something more is required to run either a high-growth venture or a
start-up company New start-up company, in which all the necessary resources must be assembled
venture and organized from scratch. An entrepreneurial outlook helps the owner of
either type of business find creative solutions to challenges and cope with
substantial personal and financial risks. Among the most important compo-
nents of that outlook are vision and the persistence to make the vision a
reality. For example, when Ian Ward had problems with his production
equipment, he plunged ahead, raising more money to get the plant up to
speed, because he had faith in his idea.
Interestingly enough, entrepreneurs, small-business executives, and top
managers in Fortune 500 companies display some striking differences (see
Exhibit 3.2). As a group, entrepreneurs are younger and more likely to start
businesses while in school. They are not always academically inclined. Most
have held several different jobs, and manv have been fired or dismissed from
14
a job.

Regardless of what makes them tick, the people who build businesses per-
The economic role form a valuable service for the rest of us. Small businesses play a number of
of small businesses important roles in our economy.

Providing jobs
Stop and think for a minute about the people you know who have jobs. Where
do they work? For big companies? For the government? Or for small busi-
nesses? If you're typical, at least half of your friends and relatives work for
small businesses. And the number who do so is likely to increase.
Chapter 3: Small Businesses, New Ventures, and Franchises 61

EXHIBIT 3.3
0-19
Sources of New Jobs
Companies with fewer than
Employees
20-99
L ~\ 35%
1
74%

Employees l
100 employees are respon-
100-499
sible for virtually all of the
Employees
I

1-11%
new jobs created in the past
|

few years. 500 +

Employees

As Exhibit 3.3 illustrates, virtually all of the new jobs created in the
United States in the past decade are in businesses with fewer than 100 em-
ployees. And most of that growth occurs in the new high-growth ventures like
Lakewood Forest Products or the firms on the Inc. 500 list. These rapid grow-
ers represent only 7 percent of all businesses in the country but create 67
15
percent of the new jobs.
The jobs created by small businesses differ from those created by big
companies in several key respects. For one thing, small businesses generally
pay less in terms of both cash compensation and employee benefits. A signifi-
cant share of these jobs —
roughly 25 percent —
are part-time. They tend to
be filled by employees who are either younger or older than the average
big-company employee. Many of these employees have never worked before;
many others have been out of work for a long time before finally finding a job
with a small company. On average, employees in small businesses have less
formal education than their counterparts in large companies. By hiring
workers who don't quite fit the corporate mold, small businesses serve as an
important safety net in our society. 16

Bringing out new products and services

Another important way small businesses contribute to economic growth is
by fostering innovation. A recent study of innovation in 121 industries found
that small firms or individual inventors produced 40 percent of the new
products, a remarkable percentage given the fact that small companies
17
spend less than 5 percent of the nation's research and development money.
Among the contributions that small businesses have made are the safety
razor, the self-winding wrist watch, the helicopter, stainless steel, and the
plain-paper copier.

Supplying the needs of large corporations

Besides providing new products and jobs, small businesses fill an important
role in the operation of large corporations, acting as distributors, servicing
agents, and suppliers.
In fact, some most successful companies in the country have based
of the
their business strategy on the use of small, outside suppliers. Consider Liz
Claiborne, one of the leading firms in the fashion industry, for example. The
company has no factories. All of its garments are made on contract by outside
suppliers. This gives Liz Claiborne the flexibility to change its designs
quickly —
an important competitive edge in the fickle world of fashion.
18

Providing specialized goods and services

Specialization is one way
Finally, many small businesses exist because they meet consumers' special
that a small business can
compete successfully needs. you want
If to rent a Santa Claus suit, buy an odd piece of sheet music,
against larger rivals. or get your watch fixed, you naturally turn to a small business for help. Big
62 Part One: Focus on Business Today

companies tend to shy away from businesses of this type because there isn't
enough demand to make mass production worthwhile.
Today, affluent consumers have "custom" tastes. They often seek out the
individualized or different item. Some small businesses have thus become
successful by meeting some of these far-fetched "needs." In New York City,
for example, you can buy a box of 12 small chocolate replicas of yourself for
19
$22.50. The market for chocolate people may be small, but businesses that
offer such unique products can often find a niche.

The Job of Building a Business

Suppose you have decided to join the ranks of business owners. What are
your chances of success? You may have heard some depressing statistics
about the number of new ventures that fail. Some reports say your chances of
success are only one in three; others claim that the odds are even worse —
that 85 percent of all new ventures fail within 10 years.
But according to David Birch, president of a research firm that analyzes
small businesses, these statistics are misleading:

Of course new businesses do fail. . . . But it's not anything like the lambs-to-
slaughter affair that the 85 percent figure suggests. They start out, these
new businesses, and within the first year 20 percent of them are gone, van-
ished. Then in the second year another 1 5 percent are gone, in the third year
another 10 percent and so on — the curve flattening out. In other words, the
chance of your failing in the first seven years in a new business in this
country is closer to 50 percent.

But, Birch goes on to say, some of those "failures" may really be success
stories. These businesses disappear for many reasons, only one of which is
failure. "In fact," he says, "we know that out of the 550,000 business closings
20
each year, only 15,000 or so are bankruptcies."

If you decide to take the risk, there are three ways to get into business for
Finding an
yourself: Startfrom scratch, buy an existing operation, or obtain a franchise.
opportunity Starting from scratch is the riskiest and most difficult option, but it gives you
the most scope for creating something.
You can reduce the risks somewhat by giving careful thought to your new
business concept. Try to choose a field in which you have an advantage based
on experience, knowledge, interests, or contacts. If your own experience fails
to yield good concepts, you might try reading business publications to get
ideas for companies that are likely to succeed. If possible, work for a while in
a business similar to the one you hope to start. And do plenty of research to
test your idea. Talk to potential customers, suppliers, and competitors. At-
tend seminars and trade shows. Discuss your plan with a lawyer, an account-
ant, a banker. Exhibit 3.4 suggests some avenues for developing entrepre-
neurial ideas.
Buying an existing business reduces the risks considerably. When you
buy a business, you instantly acquire a known product or service and a sys-
tem for producing it. You don't have to go through the painful period of
building a reputation, establishing a clientele, and hiring and training em-
ployees.And financing the venture is generally much easier; lenders are reas-
sured by the history and assets of the going concern. With these major details
already settled, you can concentrate on making improvements.
Chapter 3: Small Businesses, New Ventures, and Franchises 63

EXHIBIT 3.4
How to Get Good Ideas Upgrade Take a basic product, and Designer blue jeans, gour-
for New Businesses enhance it. met cookies
In looking for ideas for new Downgrade Take a quality product, and No-frills motels, budget
companies, think in terms of reduce its cost and price. rental cars

what people want but can't Bundle Combine products to pro- Laundromats that serve
vide double benefits. food or beverages
get. According to the ex-
perts. "Inventing a fancy Unbundle Take a product that has Term life insurance that
multiple features, and offer has no savings value
gizmo and then finding
first
only one of those features
out later that no one wants independently.
it is a waste of time."
Transport Move a product that sells "Ethnic" restaurants
well in one area to another
area.
Mass-market Take a product that has Industrial cleaners repack-
been used for a specific aged for consumer markets
purpose and find a larger
audience for it.
Narrowcast Aim for a narrow portion Cable TV service for rural
of a large market. markets
Think big Offer the broadest possi- Electronics
ble selection of a general "supermarkets"
category of goods.
Think small Offer a complete selection Bookstore that sells only
of a specific type of mystery novels
product.
Compete on price Offer more value for the "Warehouse" stores
same price, the same value
for a lower price, or lower
quality at a far lower price.

Obtaining a franchise is another alternative. The franchiser's name,

proauct, and system are already established, and you can build on that base.
Although good franchises are generally expensive, your chances of success
are excellent: The failure rate for franchises is estimated at only 4 percent for
21
the first year of operation.

Once you have identified a promising opportunity, you need to decide on the
Deciding on a form of business you will use. You can choose a sole proprietorship, a part-
form of ownership nership, or a corporation, depending on your needs and the advantages and
disadvantages of each, spelled out in Chapter 2. For each type of organiza-
tion, certain legal formalities must be met.
The sole proprietorship can be started by opening a checking account for
the business, obtaining invoices and other forms, and accumulating the cash
to pay a month's rent. But you may also have to obtain a business license and
take care of other legal details, depending on the type of business.
To start a partnership, you need two additional things: a partnership
agreement, which spells out the basic outlines of your arrangement with
your partner or partners, and a buy/sell agreement, which defines what will
happen if one of the partners dies.
For a corporation, you must choose the state in which you want to incor-
porate, file incorporation papers, form a board of directors, name officers,
and also set up a stock redemption plan, which serves the same functions as
the buy/sell agreement in a partnership.
64 Part One: Focus on Business Today

The "best" form of business depends on your circumstances: your finan-

cial situation, thetype of business you're starting, the number of employees,
the risks involved, and your tax position. It is generally worthwhile to con-
sult a lawyer, an accountant, or both for advice on this issue.
Regardless of whether you form a sole proprietorship, a partnership, or a
corporation, you need to obtain various licenses and permits. The require-
ments differ from state to state and from business to business. For informa-
tion, contact the Internal Revenue Service or the chamber of commerce in
your area.

. Perhaps the most important step in launching your own business is planning.
Developing a y u need to develop a written statement that explains what you are going to
DUSineSS plan do. Your plan should describe the basic idea for your business and set forth
specific goals and objectives. This plan not only guides your efforts but also
helps convince lenders and investors to finance your business.

Experts maintain that the A summary of your financial projections and expected return

business plan (also re- on investment

ferred to as a "business The amount of money you now seek, in what form, and for

proposal") one of the most critical tools of any en-

is what purpose
terprise, whether the company is in its infancy or ex- 2. Company and industry. Give full background information.
panding. For the entrepreneur or manager, the busi- (Investors are attracted to growth industries.)
ness plan establishes strategies and goals. For 3. Products. Give a complete but concise description, focus-
potential lenders, it provides information about a ing on the unique attributes of your products. (Many inves-
company, including its track record and future plans. tors are more interested if you have a product line and not
Business plans are used not only by independent just a single product.)

entrepreneurs seeking financing but also by executives k. Market. Provide data that will persuade the investor that

seeking funding for an independent project or a new you understand your market and can achieve your sales
product line within the company they work for. The open-ended markets to be more
goals. (Investors find
desirable.)
principle behind the plan is to persuade someone else
that a promising project should be financed. In short, 5. Marketing strategy. Provide projections of sales and mar-
ket share,and outline strategy for identifying and contacting
a business plan is the ticket of admission to the in-
customers, setting prices, servicing customers, advertising,
vestment process.
and so forth.

6. Design and development plans. If your product requires

BUSINESS-PLAN BASICS design or development, describe the nature and extent of
what needs to be done, including costs and possible
A business plan should highlight the following infor- problems.
mation for investors:
7. Operations plan. Provide information on the facilities,
Summary. A crisp overview will help investors decide
1. equipment, and labor needed, including background on prin-
whether reading the whole plan is worthwhile. Potential in- cipals, directors, and key management personnel.
vestors spend an average of five minutes screening a plan. If 8. Overall schedule. Show development of the company in
you don't grab their interest at the beginning, your plan will terms of completion dates for major aspects of the business
probably disappear into the wastebasket. It should include: plan.
A brief description of your product and market 9. Critical risks and problems. Identify all negative factors,
A brief description of your company and its principles and discuss them forthrightly.
Chapter 3: Small Businesses, New Ventures, and Franchises 65

Although the business plan has a simple, straightforward purpose, it re-

quires a great deal oi thought. Before you even open your doors, you have to
make important deeisions about personnel, marketing, facilities, suppliers,
and distribution. For best results, the financial portion of the plan should
include a detailed budget of start-up and operating costs, as well as projec-
tions for income, expenses, and cash flow for the first two years of business.

With your business plan in hand, you can begin the search for financing. The
Obtaining most common sources of funds for new businesses fall into two basic catego-
financing ries: debt and equity. Debt must be repaid with interest out of earnings;
debt Funds obtained by equity does not have to be repaid, but it entitles the investor to a piece of your
borrowing company and a share of future profits. Most businesses are financed with a
equity Funds obtained by. mix of debt and equity.
selling shares of ownership Once the business is launched, it will have a continuing need for money,
in the company as Ian Ward discovered when he ran into production problems and had to

10. Financial information. The amount you provide will de- WHAT TURNS INVESTORS OFF
pend on the stage Aim for completeness,
of your financing.
with three-year projections for profit and loss and for cash Four danger signs stand out most to financiers:
flow.
1. A product orientation. If there's a single cause of exces-
The plan should be written with the particular sive entrepreneurial optimism, it's infatuation with the com-
audience in mind. A plan designed to raise financing pany's product rather than with the market for it. Business
from venture capitalists will need a different approach plans that devote more space to describing the product than
than one designed to obtain financing from a bank. to detailing who will buy it and how it will be sold make

Venture capitalists want to see a strong return on investors suspect that the company is really just a playpen in

their investment; bankers are more concerned with which the founders can fiddle with their latest toys.

the survival of the business so that it can repay its 2. Projections that deviate excessivelyfrom industry norms.
loans. Each industry has a range of accepted financial results. If a
fledgling company's business plan makes projections that
differ sharply from acceptable ranges in an industry, inves-

WHAT TURNS INVESTORS ON tors will worry that the entrepreneur hasn't done his or her
homework or is being unduly optimistic.
As investors skim through the hundreds of business 3. Unrealistic growth projections. Entrepreneurs tend to have

plans that land on their desks, they are looking for exaggerated expectations of long-term growth. Investors
four ideal characteristics: know that and expect it. But when the projections begin los-
ing touch with reality, all kinds of alarms go off in investors'
1. Evidence of customer acceptance. Investors like to know minds. Unless the spectacular projections are explained and
that a company's new product is already being used, even if
argued convincingly in the business plan, investors are likely
only on a trial or demonstration basis.
to be skeptical. Only slightly less bothersome to investors
2. Appreciation of investor needs. Investors usually want to are entrepreneurs who are excessively cautious in their
recoup their investment within three to seven years, so they growth projections.
want to see some evidence that entrepreneurs have thought 4. Reliance on custom or applications work. When a com-
about how to make this possible.
pany's basic product needs to be altered or specially de-
3. Evidence of focus. Investors want to feel that a com- signed for each customer, potential investors see high costs
pany's founders know which one or two things the firm does and low profits. Specially designed goods or services may be
best and will concentrate their efforts on them. Investors successful, but entrepreneurs forming companies of this type
know that companies trying to do too many things won't do should expect resistance when they try to raise investor
any single thing well enough to allow for fast-track growth. funds.
t*. A proprietary position. Exclusive rights to a product or
process usuallycome in the form of patents; they alsc may The challenge for entrepreneurs as they put to-
be obtained by copyright or trademark protection. A com- gether their business plans, then, is to convince inves-
pany with such protection has an advantage over its tors that the new venture will exploit high-growth
competitors. opportunities while minimizing possible risks.
66 Part One: Focus on Business Today

raise money buy new equipment. You can't expect to obtain all the financ-
to
ing you need in one fell swoop. Although a few businesses do grow entirely

through internally generated funds, most need repeated transfusions from

outside lenders or investors. Ian Ward used both equity financing (sale of
bonds and stock) and bank loans to keep his company going.
But let's say that you're just starting out. Where should you turn first for
capital? The answer depends on the size and type of business you want to
launch. Lifestyle businesses require much less cash than more ambitious
high-growth ventures and are funded by different sources.

Funding the lifestyle business

Most people who start small businesses do so, at least in part, with their own
savings or with loans from relatives and friends. Often $20,000 is enough to
get a small service business off the ground.
The second most common source of funds is bank loans, although banks
are often reluctant to back new ventures. Many banks limit start-up loans to
50 percent of the amount needed and demand both collateral and personal
22
guarantees to back the loan. In addition, banks typically charge small busi-
nesses relatively high interest —
two or three points above the prime rate
available to large corporate clients. In periods when interest rates in general
are high, this practice may impose a severe burden on small companies. It
pays to shop around for the most attractive rate. Different banks have differ-
ent loan criteria and business objectives. Some cultivate small businesses
and offer attractive interest rates or special services. It doesn't hurt to apply
at two banks simultaneously.
Loans of up to $150,000 have been available from the Small Business
Administration. The SBA, established by Congress in 1953, has also helped
firms obtain bank loans of up to $500,000 by guaranteeing repayment if the
business should fail. But it is not easy to get SBA assistance: In 1985, the SBA
made only 1,989 direct loans totaling $127.2 million to small businesses and
guaranteed an additional 17,290 loans valued at $2.66 billion. 23
One of the best and most overlooked sources of financing for small busi-
nesses is credit from suppliers. Let's say that you want to open a store. You
might be able to convince a potential supplier to provide your initial inven-
tory on credit. The supplier's risk minimal
in a deal like this; if you don't
is

sell back. You might also be able to make

the product, the supplier can take it

some special arrangements with customers. Perhaps you can take a deposit
for merchandise or arrange to be paid when the product is delivered.
Later, you can ease your financial situation by negotiating liberal pay-
ment terms with your vendors or by using the money that others owe you to
secure a loan.

Funding the high-growth venture

Ifyour ambition is to launch a high-growth venture, you will probably need
$50,000 or more in capital to begin operations. Most conventional lenders
shy away from this type of start-up, which typically doesn't produce a profit
for a while and has few assets to use as security for the loan. Thus, you may
have to sell equity in your company. Exhibit 3.5 lists the options for raising
equity capital.

private investors As the figure indicates, wealthy individuals are one of the
most promising sources of equity financing. However, finding a so-called
Chapter 3: Small Businesses, New Ventures, and Franchises 67

EXHIBIT 3.5 Sources of Equity Funding for New Businesses

Private investors. Wealthy individuals interested in an ownership posi- Personal savings and commercial loans are the
tion in promising new ventures. In exchange for their investment, they typi- main funding sources for new businesses,
cally expect a seat on the board of directors and some degree of involve- regardless of whether they are started from
ment in the company's affairs. Most are looking for potential returns of 3 to scratch or purchased from previous owners.
5 times their initial investment within a period of about five years.
To start business To purchase existing
Venture capitalists. Firms that operate investment pools for funding
new businesses. Most have formal criteria for evaluating a business, special-
from scratch business
A%
3_%._
ize in certain types of business, and expect an ownership position. They pre-
4% 7%
fer companies with the potential for going public and hope to earn 40 to 60
4%
percent on their investment each year, over five to seven years. The typical
venture capital firm plays an active role in managing the affairs of the fledg- 11%
ling company.
Corporate sources. Venture capital pools funded by large corporations
that take minority positions in fledgling ventures with the objective of obtain-
ing new technology. Often, the corporation provides various types of busi-
ness assistance as well as financing.
SBICs and MESBICs. Federally licensed, privately owned investment
pools that operate much like corporate venture capital pools. They provide
both startup and continuing financingin exchange for ownership in the

company.
State and local programs. Venture capital pools in approximately
twenty states. These programs usually fund companies with good job-crea-
tion potential.
Public stock offerings. Raising capital by selling shares in a company.
This expensiveand involved process is only appropriate for ventures that
have reached a significant sales level.

Friends or relatives | Lending institutions |

Personal resources

angel may be difficult. Bankers, accountants, brokers, financial planners,

and other entrepreneurs are often able to provide leads. One organized list-
ing of private investors is the Venture Capital Network, a nonprofit corpora-
tion based in New Hampshire, which uses a computer to match investors and
entrepreneurs.

venture capitalists In addition to looking for private investors, many high-

venture capitalists Invest- growth ventures attempt to attract the interest of venture capitalists, invest-
ment specialists who pro- ment specialists who raise pools of capital to fund new ventures that are
vide money to finance new likely to become public corporations. The investment funds available to ven-
businesses exchange for a
in
ture-capital firms come from corporations, wealthy individuals, pension
portion of the ownership.
funds, and other pools of capital, such as university endowments.
with the objective of making
Venture capitalists do not simply lend money to a small business as a
a considerable profit on the
bank would. Instead, they provide capital in return for an ownership interest,
investment
which may amount to half of the stock or more. Often they become involved
in helping to run the business. In a typical scenario, the venture-capital firm
buys part of the stock in the company at a low price —
say, 50 cents a share;
then, when the company goes public, the venture capitalist sells at a much
higher price.
Because the goal of venture capitalists is to make a considerable profit,
these firms look specifically for businesses with the potential for rapid
growth. In recent years, high-technology firms have been particularly popu-
lar. Now, however, many venture capitalists are looking at lower-technology
alternatives like health care and retailing as a way of diversifying their risks.
68 Part One: Focus on Business Today

Regardless of the business you're in, however, you may have trouble find-
ing venture capital. There are only about 300 private venture-capital firms in
24
the country, and each of them funds only 10 or 15 new companies per year.

corporate sources Yet another source of equity capital is "big" business.

Roughly 65 corporations have formal programs that make direct venture
25
investments, more than double the number five years ago. In addition,
many other large companies provide equity funding through investment
pools run by venture capitalists.
In general, the large corporation's interests differ from the venture capi-
talist's. Apart from hoping for a profitable investment, most large companies
want to gain access to promising technology, with the possible goal of ac-
quiring the operation. Corporate investors often provide more than money.
They sometimes share marketing expertise or provide distribution capabili-
ties the new venture lacks.

may also come from Small Business Invest-

sbics and mesbics Equity capital
ment Companies (SBICs) and Minority Enterprise Small Business Invest-
ment Companies (MESBICs), which are federally licensed, shareholder-
owned investment companies. Through the SBA, these companies have
borrowed money at lower rates to put into new ventures. SBICs and
MESBICs are similar in operation to venture-capital firms, although they
tend to make smaller investments and are willing to consider less glamor-
ous businesses. There are about 500 investment companies like these in
operation.

state and local programs In the past five years, a new source of equity fund-
ing has opened up. Today, about 20 states have created their own venture-
capital companies, and similar programs are pending elsewhere. Unlike
other sources of equity funding, state and local programs tend to fund busi-
nesses that have the potential to boost employment in the state or locality.
Lakewood Forest Products benefited from such a program run by the State of
Minnesota.
In a related development, many state and local economic development
offices and universities are forming "incubator" facilities to nurture fledg-
ling businesses. In a typical incubator, new companies can lease space at
bargain rates and share secretaries, receptionists, telephone equipment, fi-
nancial and accounting advice, marketing support, and credit-checking ser-
vices. Some incubators are open to businesses of all types, but many special-
ize. For example, the Spokane Business Incubation Center operates the
Kitchen Center, where small food-processing companies can share a com-
mercial kitchen. 26 There are 209 incubators now in operation in 39 states, a
fivefold increase in the past two years. These facilities can make a big differ-
ence to the success of a start-up business. According to the National Business
Incubation Association, 8 out of 10 of the businesses nurtured in incubators
27
succeed.

public stock offerings After a high-growth venture has been operating for a
going public Act of raising few years, has the option of raising capital by going public, or selling stock
it

capital by selling shares in a in the company onthe open market. Going public achieves two purposes:
company to the public for (1) It raises moneyfor the company, and (2) it enables the founder and
the first time other early equity investors to make money by selling at a profit the
stock they obtained at low prices.
 tapter 3: Small Businesses, New Ventures, and Franchises 69

FACTORS THAT BREED SUCCESS FACTORS THAT LEAD TO FAILURE

Finding a solid business opportunity,
based on a product that meets a clear
need
Building effective management skills
Having adequate capital and credit to
finance the business
Employing modern business methods for
planning and controlling operations
Borrowing money without planning just how and when to pay it back
Attempting to do too much business with too little capital
Not allowing for setbacks and unexpected expenses
Buying too much on credit
Extending credit too freely
Expanding credit too rapidly
Failing to keep complete, accurate records
Carrying habits of personal extravagance into the business
Mistaking the freedom of being independent for liberty to work or
not, according to whim

EXHIBIT 3.6
Why New Ventures
Succeed or Fail
The case of Paul Brainerd is an interesting example. In 1984, Brainerd
All new companies have
problems. The companies
founded Aldus Corporation, which makes a popular software program for the
that succeed do so because desktop publishing industry. In June 1987, when he took the company public,
2
Brainerd could theoretically have made $80 million by selling his holdings.
*'

the founder has anticipated

trouble and is ready to han- Although the potential rewards for going public are enormous, problems
dle it. exist as well. Success depends on the public demand for stock in new compa-
nies, which varies considerably from year to year. Another problem with
going public is the expense. In a typical initial public offering, a company
might raise $2 million but spend $0.5 million of that on various fees and
printing costs. Most companies don't consider going public until they have
29
annual sales of $15 million to $20 million and profits of $1 million or more.

Assuming that you obtain adequate financing to start or buy your own busi-
Managing the ness, your next job is to run it. You may find yourself working 12-hour days
business week in, week out —
with no boss to blame for your miseries! It is common
for small-business owners not only to put out the product —
be it chopsticks,
According to Paul Hawken, video tapes, homemade bread, or legal advice —
but also to function as sec-
a successful entrepreneur
retary, personnel manager, financial planner, public-relations expert, and
and author, "Good man-
agement is the art of mak- janitor all rolled into one.
ing problems so interesting The manager of a big business doesn't have this problem. In other re-
. that everyone wants to
. . spects, however, managerial tasks are the same in big businesses and small
get to work and deal with ones. Just as a manager in a large, established company must make business
them. Bad manage-
plans, organize resources, select and lead a staff, and monitor the outfit's
. . .

ment involves presenting

problems in such a way daily activities, so must you. These tasks are the subject of Chapter 7 and
that people seek to avoid following chapters. Exhibit 3.6, however, indicates some of the skills and
them." actions that contribute to the success or failure of a small business. And here
are some managerial tasks of special concern.

Planning the activities of the business

There's no room for vagueness when you are managing an enterprise, espe-
ciallv a new one. Thus, careful and detailed plans are essential. Before you
rush in to supply a product, you need to be sure that a market exists. No
amount of hard work can make a bad idea into a profitable one: The health-
food store in a meat-and-potatoes neighborhood and the child-care center in
a retirement community are probably doomed from the beginning.
You also need to develop plans for coping with problems as the\ arise.
What will vou do if one of your suppliers suddenly goes out of business'^ Can
vou locate another supplier quickly? What if the neighborhood suddenly
70 Part One: Focus on Business Today

starts to change —
even for the better? An influx of wealthier neighbors may
cause such a steep increase in rent that your business must move. Also, tough
competition may move into the neighborhood along with the fatter pocket-
books. Do you have an alternative location staked out? What if fashions sud-
denly change? Can you switch quickly from, say, hand-painted T-shirts to
some other kind of shirt?

Marketing for Che new business

Marketing is especially important in a new business, because the company's

ultimate success depends on building a customer base. Marketing encom-

passes a number of important activities such as product development, pric-
ing, distribution, and promotion.
In terms of product development, small companies often have an edge
over larger organizations because they can react more quickly. If a demand
for broccoli pizzas arises tomorrow, a small restaurant can make them up
almost as quickly as "Pop" can run out to the supermarket for the new in-
gredients and "Mom" can think of a way to incorporate them into the old
family recipe. A chain, on the other hand, would probably not get wind of the
new demand for months and would then need time to study the concept,
formulate a new recipe, order ingredients in quantity, ship them to each
outlet,and so on.
When it comes to prices, however, small companies may be at a disad-

vantage compared to larger firms. Because of their larger volume of business,

big firms may have lower costs per unit and thus be able to charge lower

You can learn from

ness ventures, providing you complement your creative or
others — if not always
technical skills with a strong grounding in business tech-
the secrets of success,
niques. You can get this experience in two ways: (a) Go to
then at least the most common causes of failure. Ex- work for someone else before going into business for your-
aminations of failed companies and studies of those self. Consider this first step an apprenticeship in the sort of
stalled in the early stages of growth reveal a pattern venture you want to start. Soak up all you can about the

of oft-repeated blunders and oversights that consis- problems, the opportunities, and the necessary technical
tently spoil the dream of entrepreneurial success. skills, (b) Go directly into business with a partner strong in

Consider the following mistakes, along with the management experience. A hobbyist chef and an experienced
guidelines for avoiding them, a survival guide for restaurant manager may have the right combination of skills

to get a venture off the ground.

entrepreneurs:
2. Trying to make the business appeal to everyone. Typically,
Mistaking a hobby for a business. Would-be entrepreneurs
1.
the small-business owner believes that appealing to the wid-
often go into business for the wrong reason — namely, the est possible range of consumers is a sure-fire prescription
dangerous and mistaken belief that a lifelong hobby can au- for success. Instead, this broad-brush approach creates a
tomatically be converted into a business. A hobbyist, no company that is likely to be weak in several areas rather
matter how skilled or creative, often lacks the critical busi- than strong in one. A wiser approach is to narrow the com-
ness experience essential to success. For example, the ability
pany's focus, identifying a specific market segment and mar-
to whip up a glorious souffle is not reason enough to open a shaling the necessary resources (merchandise, advertising,
restaurant. become
personnel, and so on) to a significant factor in it.

Hobbies can serve as promising springboards for busi- For example, appeal to a single age category (senior citizens
Chapter 3: Small Businesses, New Ventures, and Franchises 71

Thanks to his raw material
cost advantage and auto-
mated production methods,
Ian Ward can sell his chop-
sticks for 25 percent less
than his foreign rivals can.
prices. To set prices at the optimum level, you have to analyze with a critical
eye your competition, your area, your costs, and your profit requirements.
And once you've set those prices, you have to remain tuned in to changing
conditions in the marketplace, so you don't get caught with too little demand
tor your supply or with too little reward lor your risks.
Choosing the ideal outlet for your product is another problem. To build a
distribution network, you must convince wholesalers or retailers to carry
your product. You also need to analyze how to use your promotion budget to
the fullest. Advertising is worthless if it doesn't reach potential customers
and bring them to you. Countless new businesses spend a fortune on advertis-
ing and have little to show for the expense —
because they've chosen the
wrong medium or the wrong message. What's worse is the opportunity cost
ot spending money ineffectively; a new business can always use more money
for something.
Monitoring and controlling operations
In addition to marketing your product, you need to develop an effective rec-
ordkeeping system that will handle customer files, billing, production and
inventory data, employee information, and basic accounting functions. New-
businesses must usually start from scratch in organizing the paperwork, and
the process can be time-consuming. The alternative, however, is chaos not —
only a drain on everyone's patience and good will but also a source of expen-
sive mistakes. Many a business has gone under because of a lax attitude
toward supplies, quality, money management, bill collection, and the like.

or teen-agers) or focus on one socioeconomic group, and 6. Bleeding the business Generous salaries, bonuses, and
stick to a single selling point (discount prices, high fashion. company cars are seen as the rewards of success. But they
or attentive customer service). may also sow the seeds of catastrophe. Disaster can be

3. Starting out with too little few companies

cash. Very averted by routinely saving some of the company's earnings.
move immediately most sustain losses for
into the black; The best approach is to establish a set amount — perhaps a
months, even years, before turning profitable. You should percentage of total earnings — and discipline yourself to
(a) create a worst-case scenario, projecting on a monthly leave that amount in the business.

basis minimum revenue and maximum expenses for the first
two years. Note the point at which income will cover ex-
penses, and calculate the amount of money necessary to
cover the shortfall until then. Add to this the amount of the
initial investment required to launch the business and to
cover ongoing expenses for inventory and equipment. This
total is the minimum amount required to launch the busi-
ness, (b) Try to arrange a line of credit at a bank so that you
can draw cash to cover expenses as required. A reserve like
this serves as a buffer between you and your creditors, al-
lowing you to keep the business going even when income
fails to cover expenses.
7. The Fortress complex. Unlike their counterparts in large
companies, small-business owners tend to run their ventures
single-handedly, making all key decisions without going
through an elaborate approval process. Although there is
strength in that approach — the company can respond faster
to emerging opportunities — the owner is insulated from
other points of view. The best way to overcome this prob-
lem is to bring in outside opinions by assembling an infor-
mal board of directors. Ask a banker, an accountant, and
another local business owner to sit on the board, joining you
once a month to discuss the company and to give their in-
sights into its needs and requirements.

4. Failing to detect bad credit risks early. Implement an

These seven mistakes are by no means the only
early-warning detection plan to short-circuit emerging credit
ones you can make. But anticipating and tackling such
problems before they jeopardize the company's finances.
common blunders may take you a long way toward
5. Setting the wrong price The right price tag can make the
building and maintaining a profitable company.
difference between a robust bottom line and one written in
red ink. Strike a delicate balance between the company's
need to make a profit and the consumer's search for value.
72 Part One: Focus on Business Today

Coping with red tape

No business operates in a vacuum or under a glass dome and like all other —
enterprises, new
businesses are subject to the pressures and requirements of
our society's legal system. If you need a trademark, a company brand, or a
patent, or if you are thinking of becoming incorporated, you will definitely
need legal help. Many other situations require the help of a lawyer, too.
Likewise, you'll be coping with government regulations, many of which
were written with larger businesses in mind but are applied to small busi-
nesses anyway. Disposing of hazardous wastes, for example, may be difficult
for small companies, which typically lack their own waste treatment facili-
ties.The number of waste disposal sites is decreasing throughout the coun-
try, and in some locations small companies are hard-pressed to find legal
ways of disposing of hazardous substances.

Adjusting to growth
One of the most difficult management problems you may face in a new busi-
ness is success. Trouble often occurs when the founder fundamentally an—
"idea person" —
assumes the role of manager. Many people who are good at
launching new companies lack the skills needed to manage them over the
long run. The person who excels during the start-up phase may not be able to
delegate work well or may have problems figuring out how to expand the
business.
And even if the person is flexible enough to adjust to changing conditions,
there is a lot to learn as a company grows. Arranging additional financing,
hiring new people, adding new products, computerizing the recordkeeping —
all these activities are demanding.

The Franchise Alternative

One way to avoid some of the management headaches associated with start-
franchise Business ar- ing a business is to invest in a franchise, an approach that enables you to use
rangement whereby an indi- a larger company's trade name and sell its products or services in a specific
vidual obtains rights from a exchange for this right, the franchisee (you, the small-business
territory. In
larger company to sell a
owner) pays an initial fee and often monthlv royalties as well to the
e
re rvice
n ° Wn
^^ ^ franchiser (the corporation).
There are three basic types of franchises. In a product franchise, the fran-
franchisee Person or chisee pays the franchising company for the right to sell trademarked goods,
group to whom a corpora- which are purchased from the franchiser and resold by the franchisee. Car
ve right dealers and gasoline stations fall into this category. In a manufacturing fran-
e of its name in a
chi Hke a so ft . drink bottling plant, the franchisee is licensed bv the parent
certain territory, usually in j-Im. * its u a
company to produce andj distribute •* j
. ,
i-
products, using supplies purchased.

plus monthlv rovaltv

from the franchiser. In a business-format franchise, the franchisee buys the
payments right to open a business using the franchiser's name and format for doing
30
business. The fast-food chains typify this form of franchising.
If vou are an average American, vou alreadv know somethine about fran-
that grants a franchise to an ,
° c uu-.
chises. TIn our economy, they are a rfactor
.
, ,
c • ->
-i
of rising importance, as Exhibit 3.7
individual or group
suggests. We buy our houses from franchised real-estate brokers, get our hair
cut in franchised beauty salons, and drive cars purchased from franchised
dealers. The soda pop we drink is bottled by franchisers, and the food we eat
is sold by such franchises as McDonald's, Wendy's, Pizza Hut, and Kentucky
Chapter 3: Small Businesses, New Ventures, and Franchises 73

Franchise Outlets (in thousands) Retail Franchise Sales (in $ millions) Franchise Market Shares
1987 (in $ billions; 1987 estimate)

Convenience
Retailing stores Auto products
(nonfood) $12.8 & services
$25.2 \ $12.9

Jl
u
,<^N , 1
~A
mJ.
\
|^ t^r~- /

V^ :

420
\
V\

EXHIBIT 3.7
The Growth of
Franchising
Both the number and rev-
Frie J Chicken. Franchises account for about one-third of all retail sales in the
enues of Franchises have
increased over the past United States and employ 7 million people. With sales growing at four times
decade. the rate of the GNP, franchises will be responsible for half of all retail sales
within 20 years. 31
Franchising is not a new phenomenon. It has been around since the nine-
teenth century, when such companies as Singer and International Harvester
established dealerships throughout the world. Early in this century, Coca-
Cola, General Motors, and Metropolitan Life Insurance Company, among
others, used franchises to distribute or sell their products. But the real boom
in franchising began in the late 1950s, with the proliferation of hotels and
motels like Holiday Inn and fast-food establishments like Baskin-Robbins
and Dunkin' Donuts.
The latest trend in franchising has been diversification in the variety of
products and services offered. Today, over 2,000 companies offer franchises,
ranging from day-care centers and health clubs to dental clinics, video-tape
rental outlets, and funeral parlors. By and large, most are service operations.

Why franchising so popular? According to the president of the Interna-

is
Advantages of "The franchiser
tional Franchise Association, franchising has triple benefits:
franchising wins because he builds a strong foundation for his company. The franchisee
wins because he can take advantage of the franchiser's proven business sys-
tem. And the general public benefits from the consistency of the product or
32
service."
74 Part One: Focus on Business Today

For better or for worse, the

Great American franchise
machine rolls on.

The biggest winners are generally the franchisers, who are able to expand
their businesses through franchised outlets without depleting their own capi-
tal. For example, take the case of I It's Yogurt, Inc. The com-
Can't Believe
pany was founded by Julie and brother and sister team, who
Bill Brice, a
invested $10,000 of their own money in a frozen yogurt shop while they were
still students at Southern Methodist University. With the help of friendly

service, good promotion, and solid management methods, the Brices were
able to show a profit within four months. They opened seven more company-
owned stores within six years, but then they realized that further expansion
would require debt. At that point, they turned to franchising to finance their
33
business. The chain currently has 100 outlets.
Franchisers not only expand their business using other people's money,
they also receive regular income from franchisees, who pass on a percentage
of their gross revenues and help pay for advertising and promotional costs.
Investing in a franchise can also be good for the franchisee, because the
risk is reasonably low. Ninety-two percent of all franchise outlets make it
through their fifth year. 34 When you invest in a franchise, you know that you
are getting a viable business, one that has "worked" many times before. You
also have the advantage of instant name recognition and mass advertising. An
independent hamburger stand can't afford a national TV advertising cam-
paign, but McDonald's, Burger King, and Wendy's can.
In addition to giving you a proven formula, buying a franchise helps you
solve one of the biggest problems that small businesses face: lack of money.
Franchisers generally use a number of methods to make sure the franchisee is
on firm financial footing. First, before approving prospective franchisees, the
franchiser weeds out those whose own finances are in unacceptable shape; a
franchiser will not grant a franchise unless the applicant has enough money
for start-up costs. (The franchiser, unlike many independent proprietors, has
enough experience to estimate start-up costs realistically.) The total invest-
Chapter 3: Small Businesses, New Ventures, and Franchises 75

ment required varies widely, depending on the franchise (see Exhibit 3.8),
but covers the cost to build or lease the structure, decorate the building,
purchase supplies, and operate the business for 6 to 12 months. The one-time,
up-front franchise fee covers such franchiser services as site location studies,
market research, training, and technical assistance.
Few franchisees are able to write a check for the amount of the total
investment. Most obtain a loan to cover at least part of the cost. According to
the Department of Commerce, 16 percent of all franchisers provide some
form of financial assistance such as low-rate loans. Another 34 percent assist
the franchisees in preparing loan applications for banks, private investors, or
35
the Small Business Administration.
Besides financial aid and advice, the franchiser gives a new franchisee
training in how to run a business. For example, I Can't Believe It's Yogurt
operates a "Yogurt University" at company headquarters in Dallas, where
new franchisees go through a 10-day indoctrination program. Their training
includes role-playing exercises, where some franchisees play the parts of
salespeople while others act like temperamental customers. By offering this
course, I Can't Believe It's Yogurt is able to teach standard procedures to
each operator and thus maintain its distinctive image. 36 Many franchise or-
ganizations offer advice on advertising, taxes, and other business matters, as
well as instructions in the day-to-day operation of the franchise.

Although franchising offers many advantages, it is not the ideal vehicle for
Disadvantages of everyone. For one thing, owning a franchise is no guarantee of wealth. It may
franchising be the safest way to get into business, but it is not necessarily the cheapest.
According to some analysts, it costs 10 to 30 percent more to buy a franchise
than to open a business independently. 37 And not all franchises are extremely
profitable operations.

EXHIBIT 3.8 THE TEN MOST EXPENSIVE FRANCHISES

The Cost of Owning a COMPANY START-UP COST AND FRANCHISE FEE
Franchise
1 . Hampton
Inn $2,300,000
You pay more Tor well- 2. Quality Inns 1 ,900,000

established Franchises that 3. Econo Lodges 1 ,800,000

4. Hardee's Restaurants 433,000

require an investment in
5. Roy Rogers 396,000
real estate or expensive 6. McDonald's 363,000
equipment. 7. Ponderosa steakhouses 342,000
8. Jackin the Box 331,000
9. Round Table Pizza 322,000
10. Super 8 Motels 320,000

THE TEN LEAST EXPENSIVE FRANCHISES

COMPANY START-UP COST AND FRANCHISE FEE
1. Packy the Shipper $ 995
2. Novus Windshield Repair 2,000
3. Sunshine Polishing System 2,675
4. Coverall 4,200
5. Stork News 5,000
6. Chem-Dry 9,000
7. Coustic-Glo 11,250
8. Jani-King 13,500
9. Duraclean 16,800
10. Video Data Services 16,950
76 Part One: Focus on Business Today

One of the most significant financial variables is the monthly payment or

royalty that must be turned over to the franchiser. The fees vary widely, from
nothing at all to 20 percent of sales. High royalties are not necessarily bad —
if the franchisee gets ongoing assistance in return.
Another drawback of franchises is that they allow individual operators

very independence. Franchisers can prescribe virtually every aspect of

little

the business, down to the details of employees' uniforms and the color of the
walls. Franchisees may be required to buy the products they sell directly
from the franchiser at whatever price the franchiser feels like charging.
Franchisers may also make important decisions without consulting
franchisees.
Although most franchise opportunities are legitimate, it pays to be wary.
Franchises and "business opportunities" are occasionally fraudulent. Gail
Casano learned this painful lesson the hard way. In 1986, she invested
$125,000 in a Movieland video-rental franchise. But, as Casano says, "Buying
the franchise was the worst thing I ever did." After taking her money, the
franchiser never even bothered to visit the store. "We never received promo-
tional material. We never saw any advertising, though we, and other fran-
chisees, were responsible for paying 3 percent of our monthly gross to Movie-
land for this service." Nor is it likely that Casano will ever receive the
support she was promised. The owner of Movieland has disappeared amid
charges of fraud, deceit, incompetence, drug abuse, and intimidation. 38

The best way to protect yourself from a poor franchise investment is to study
Evaluating the the opportunity very carefully before you commit yourself. Since 1978, the
franchise Federal Trade Commission has required franchisers to disclose information
about their operations to prospective franchisees. By studying this informa-
tion, you can determine the financial condition of the franchiser and ascer-
tain whether it has been involved in lawsuits with franchisees.
Another good source of information about a franchise is other fran-
chisees. Find out what they think of the opportunity. If they had it to do over
again, would they still invest? That's the bottom line.

SUMMARY OF LEARNING OBJECTIVES

Differentiate between lifestyle <y List four factors that have 3 List four important functions
1 businesses and high-growth contributed to the revival of of small business in the
ventures. the small business sector. economy.
Most small businesses are lifestyle The revival of the small-business Small businesses provide jobs,
businesses, intended to provide the sector reflects a shift to services, a bring out new goods and services,
owner with a comfortable living. diminution in the advantages supply the needs of large corpora-
High-growth ventures, on the other afforded by large-scale manufactur- tions, and provide specialized
hand, are businesses with ambi- ing, the maturation of the baby- goods and services,
tious sales, profit, and growth boom generation, and an increase
objectives. in the number of women in the A Identify three ways of getting

work force mto business for yourself.

Chapter 3: Small Businesses, New Ventures, and Franchises 77

You can sunt a mow company from franchise (72) $300 for a jacket, $650 for a coat
scratch, buj a going concern, or franchisee (72) (setby Wolfson at about double the
invest in a franchise. franchiser (72) costs of production). No wonder
going public (68) the usual customer for Patricia
f Name five factors that are
Clyne & Associates is a woman
critical for the success of a
high-growth ventures (57)
making between $30,000 and
lifestyle businesses (56)
small business. $50,000 a year — in addition to her
small businesses (56)
Success requires a promising busi- husband's $60,000 or so.
ness opportunity, an appropriate
start-up company (60)
venture capitalists (67) Despite the big price tags, the com-
ownership structure, a good plan,
pany's first year was tough, as in
adequate financing, and effective
any new business. By the second
management.
year, Patricia Clyne & Associates
REVIEW QUESTIONS came out slightly ahead. In their
sources of financing
U List four
third year, Clyne and Wolfson
for lifestyle businesses.
1. What qualities usually charac- made $15,000 on sales of $370,000.
Lifestyle businesses ma> be terize the men and women who run They put the entire profit back into
financed through personal savings, successful small businesses, and the business.
loans from friends and relatives, why?
commercial-bank loans, loans 2. Why are small businesses being To date, Patricia Clyne & Associ-
from the Small Business started in record numbers in recent ates has been run on the slimmest
Administration, and credit from years? of shoestrings. The company's big-
suppliers. 3. What class of business organiza- gest expense is for materials:

•m List six sources of equity
capital available to
high-growth ventures.
High-growth ventures may raise
equity capital through private
investors, venture capitalists, cor-
porate sources, Small Business
Investment Companies and Minor-
ity Enterprise Small Business
Investment Companies, state and
local programs, and public stock
offerings.
r% List the pros and cons
owning a franchise.
A franchisee has the advantages of
low risk, wide name recognition
and mass advertising, financial
help, and training and support.
However, owning a franchise
involves considerable start-up
tions creates the most new jobs in $157,600 for fabrics for samples
the United States? last year alone. Although Clyne and
Wolfson recently gave themselves
4. In what ways do small busi-
raises, they each make only
nesses complement big businesses
in our economy? $20,000. Their only other employee,
5. Why do many new businesses seamstress Corina Jimenez, makes
fail, and how might such failures $800 more. Nobody has much of a
be avoided? financial cushion for times of
6. What are the principal sources emergency.
of financing for new businesses? Although Clyne's designs are catch-
7. What are the motives that en-
ing favor with such tastemakers as
courage big businesses to support Bloomingdale's and Vogue maga-
start-up companies? zine, the company cannot afford
8. How does a franchise operation
of the $20,000 a modest fashion show
work, and what are some of its would cost. Instead, during market
advantages and disadvantages for weeks when buyers flock to New
the franchisee? York to see the new fashions,
Clyne's designs are modeled infor-
mally in a small showroom she
shares with seven other designers.
The designers also share a sales
representative, w hose commissions
r

expense, monthly payments to the Stitching It Together

on Clyne's pricey threads came to
franchiser, constraints on the fran-
Fashion is a volatile industry, not nearly $24,000 last year.
chisee's independence, and possibly
for the fainthearted, as Patricia
questionable deals. Patricia Clyne & Associates has
Clyne and David Wolfson know all
been covering its expenses with
too well. They are the principals in
$285,000 provided by a wealthy
Patricia Clyne & Associates, a rela-
neighbor and supporter. The com-
tive newcomer to the fashion scene.
pany has repaid more than a third
KEY TERMS Using such lush fabrics as silks,
of the debt and is also paying its
and brocades, the com-
fine wools,
"angel" $200 a month to monitor
debt (65) pany produces elegant and classi-
cash flow.
economies of scale (58) cally designed clothes for women.
equity (65) The prices are special, too: around So far, the company has been mak-
 78
ing ends meet, but Clyne and Wolf-
son are hoping for an even brighter
performance in their fourth year:
$80,000 on sales of $600,000. Wolf-
son, who manages the company's
production and merchandising, is
the source of these forecasts. Indus-
try experts say he's too optimistic,
however, given the cost of making
samples to show buyers and the
need to absorb markdowns at the
end of the season. Other advisers
have suggested that the company's
prices are too high. Clyne and
Wolfson just wish they knew more
about running a business. 39
1. In setting up their business,
what do and David
Patricia Clyne
Wolfson appear to have done cor-
rectly? What may they have
overlooked?
2. Wolfson unsure about the pric
is
ing structure for Patricia Clyne &
Associates. How might he evaluate
it?
3. Despite the assistance of their
wealthy friend, Clyne and Wolfson
may need additional financing to
help their company grow and pros-
per. How would you recommend
that they finance their company's
growing pains?
Putting a Stamp
on the Market
Suppose that you had a bright idea
for a service business — a conve-
nient place where people could
rent a postal box, mail packages,
buy office supplies and stamps,
make copies, collect telephone mes-
sages, duplicate keys, and send
documents electronically by Telex
or FAX. Let's say you did some
market research and found that
people liked the idea. You thought
you could make a decent living by
opening such a center. Being ambi-
tious, you thought you might even
open a bunch of centers. After all,
if one is good, aren't two better?
And why stop at two? Why not
open centers in every town and
neighborhood throughout the coun-
try? You had a few reservations,
though. There was nothing patent-
able about your idea. Anybody
with a little capital could duplicate
your service. If you were successful,
people might imitate you and grab
the best locations before you could
afford to expand. So what should
you do?
Anthony DeSio, chief executive
cer of Mail Boxes Etc. (MBE),
solved the problem by franchising.
Since 1983, he has sold franchises
700 MBE centers scattered
for over
across the country from Alaska to
Florida; by 1990, he expects to sell
at least 300 more. DeSio estimates
that the U.S. market can accommo-
date up to 20,000 centers of the
MBE type, and he plans to lock up
a dominant position before rivals
such as Postal Annex can beat him
to the punch. He also plans to ex-
pand internationally before the
U.S. market becomes saturated.
During the expansion phase, MBE's
primary source of revenues is the
sale of both area and individual
franchises. The company also re-
ceives royalties from franchisees
and revenue from the sale of equip-
ment and supplies to franchisees.
As the MBE network matures and
growth slows, DeSio anticipates
that royalty income and equip-
ment/supply sales will replace fran-
chise fees as the main source of
company income.
DeSio believes that building a na-
tionwide network will eventually
provide MBE with a major advan-
tage over independent competitors.
Already, economies of scale have
helped bring down the cost of oper-
Part One: Focus on Business Today
ations. The centralized purchasing
and shipping department obtains
supplies and equipment in large
quantities at reduced prices and
passes the savings on to individual
franchisees.The headquarters de-
sign and construction staff helps
local owners plan their centers
more efficiently and get good deals
from national suppliers on cabi-
netry and fixtures. The MBE ad-
ministration and franchise support
departments provide customized
computer software to help fran-
chisees manage their accounting
and inventory control.
offi-
DeSio believes that in the long run,
MBE's success will depend on
strong, positive relationships
among the company's executive of-
fice, and the
the area franchisees,
individual franchise owners. He has
created seven regional franchise
advisory councils, composed of
area and individual franchisees, to
obtain feedback from the field.
DeSio also supports the franchisees
with training programs. He has
opened two company-owned stores
to experiment with new ideas and
test new products and services.
Ideas under investigation include
the sale of airline tickets and
money orders as well as the distri-
bution of assorted merchandise
that might appeal to MBE
customers. 40
1. Do you think DeSio was wise to
rely on franchising to expand his
business, or should he have at-
tempted to retain ownership of all
the stores? Explain you answer.
2. What are the pros and cons of
starting your own mail-and-busi-
ness-services center versus buying
an MBE franchise?
3. Ifyou were to invest in an MBE
franchise in your area, what unique
products or services would you
offer in order to attract business?
 New Ventures, and Franchises 79
Chapter 3: Small Businesses,

KEEPING CURRENT USING

JOURNAL
1. What problem or opportunity wards ol franchises from reading

duos each article present? Is ii an these articles?

The Wall Street Journal for arti-
problems or suc-
ssue that faces mam Franchises, or 3. Have you ever considered pur-
cles describing s it specific to oik- chain or chasing a franchise? What impact
s in franchise operations. ndustrj ? did these articles have on your in-
Clip or copv three or more arti- 2.What could a potential franchise terest — and why?
cles that interest you. owner learn about the risks and re-

~,