Entrepreneurial Finance

Tutorial 1
Ahmed Khan
School of Accounting, Finance and Economics
The University of Waikato

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 Q1: Explain how you would choose between the following
situations. Develop your answers from the perspective of the
principles of entrepreneurial finance presented earlier in the
chapter. You may arrive at your answers with or without
making actual calculations.

A) You have $1,000 to invest for one year (this would be a luxury for
most entrepreneurs). You can earn a 4% interest rate for one year
at the Third First bank or a 5% interest rate at the First Fourth bank.
Which savings account investment would you choose and why?

• Third First bank: $1,000 x (1+ 0.04) = $1,040

• First Fourth bank: $1,000 x (1+0.05) = $1,050

• The First Fourth bank loan would be preferred because you would
receive $10 more ($1,050 versus $1,040) at the end of one year.
This example illustrates the principle: “real, human, and financial
capital must be rented from owners.” The time value of money is
an important component of the rent one pays for using someone
else’s financial capital.
 Q1: Explain how you would choose between the following
situations. Develop your answers from the perspective of the
principles of entrepreneurial finance presented earlier in the
chapter. You may arrive at your answers with or without
making actual calculations.

B. A “friend” of yours will lend you $10,000 for one year if you agree to repay him $1,000
interest plus returning the $10,000 investment. A second “friend,” has only $5,000 to
lend to you but wants total funds of $5,400 in repayment at the end of one year.
Which loan would you choose and why?

• First friend: $1,000/$10,000 = 10% interest rate

• Second friend: $400/$5,000 = 8% interest rate
• The second friend is offering you a lower interest rate (8% versus 10%) which would
be preferred, other things being equal. This example illustrates the principle: “real,
human, and financial capital must be rented from owners.” The time value of money
is an important component of the rent one pays for using someone else’s financial
capital.
• However, the dollar amount of financial that is needed also must be considered. For
example, if you “need” $10,000 then the lower interest rate $5,000 loan is not a viable
option. The only viable choice might be to borrow $10,000 at the 10 percent rate of
interest.
Q2: Phil Young, founder of Pedal Pushers, expects to spend the
next one-half year developing and testing prototypes for a pedal
replacement for children’s bicycles. Phil anticipates paying
monthly rent of $700 for space in a local warehouse where the
Pedal Pusher product will be designed, developed, and tested.
Utility expenses for power and heat are estimated at $150 per
month. Phil plans to “draw down” a salary of $1,000 per month.
Materials needed to build and test an initial prototype product are
expected to cost $9,500. In addition, each redesign and new
prototype will require an additional $4,500 investment. Phil
anticipates that before the final Pedal Pusher is ready for market
at the end of six months, the initial plus two more prototypes will
need to be built and tested. Costs associated with test marketing
the Pedal Pusher are estimated at $7,000.

A) Determine the amount of financial capital that Phil Young will need during the six-
months it will take to develop and test market the Pedal Pusher.
Q2: Phil Young, founder of Pedal Pushers, expects to spend the
next one-half year developing and testing prototypes for a pedal
replacement for children’s bicycles. Phil anticipates paying
monthly rent of $700 for space in a local warehouse where the
Pedal Pusher product will be designed, developed, and tested.
Utility expenses for power and heat are estimated at $150 per
month. Phil plans to “draw down” a salary of $1,000 per month.
Materials needed to build and test an initial prototype product are
expected to cost $9,500. In addition, each redesign and new
prototype will require an additional $4,500 investment. Phil
anticipates that before the final Pedal Pusher is ready for market
at the end of six months, the initial plus two more prototypes will
need to be built and tested. Costs associated with test marketing
the Pedal Pusher are estimated at $7,000.

B) What type of financial capital is needed and what are the likely sources
of that capital for Phil Young?

The venture is in the development stage since it is still developing the

product via prototypes. Therefore, it would be searching for seed financing
as its source of capital, which will most likely be obtained through the
entrepreneur’s assets, family, or friends.
Q2: Phil Young, founder of Pedal Pushers, expects to spend the
next one-half year developing and testing prototypes for a pedal
replacement for children’s bicycles. Phil anticipates paying
monthly rent of $700 for space in a local warehouse where the
Pedal Pusher product will be designed, developed, and tested.
Utility expenses for power and heat are estimated at $150 per
month. Phil plans to “draw down” a salary of $1,000 per month.
Materials needed to build and test an initial prototype product are
expected to cost $9,500. In addition, each redesign and new
prototype will require an additional $4,500 investment. Phil
anticipates that before the final Pedal Pusher is ready for market
at the end of six months, the initial plus two more prototypes will
need to be built and tested. Costs associated with test marketing
the Pedal Pusher are estimated at $7,000.

C) What would be your estimate of the amount of financial capital needed if the
product development period lasted nine months?
The total expenses would be the $36,600 as in (A) plus an additional three
months of expenses:

Total Nine-Month Expenses (Capital Needed): $36,600 + $5,550 = $42,150

Q2: Phil Young, founder of Pedal Pushers, expects to spend the
next one-half year developing and testing prototypes for a pedal
replacement for children’s bicycles. Phil anticipates paying
monthly rent of $700 for space in a local warehouse where the
Pedal Pusher product will be designed, developed, and tested.
Utility expenses for power and heat are estimated at $150 per
month. Phil plans to “draw down” a salary of $1,000 per month.
Materials needed to build and test an initial prototype product are
expected to cost $9,500. In addition, each redesign and new
prototype will require an additional $4,500 investment. Phil
anticipates that before the final Pedal Pusher is ready for market
at the end of six months, the initial plus two more prototypes will
need to be built and tested. Costs associated with test marketing
the Pedal Pusher are estimated at $7,000.

D) What compensation arrangements would you recommend as he hires

additional members of the management team?

Typically he would want to provide some base salary to provide normal

living expenses plus an incentive compensation package in options or stock
ownership that would be tied to the venture’s progress and profitability.
 Case Study
Interact Systems, Inc. has developed software tools that help hotel chains solve application integration
problems.Interact’s Application Integration Server (AIS) provides a two-way interface between central
reservations systems (CRS) and property management systems (PMS). At least two important trends in
the hotel industry are relevant. First, hotels are shifting away from the manual booking of room
reservations and electronic bookings will continue to increase as more bookings are made over the
Internet. Second, competitive pressures are forcing hotels to implement yield management programs and
to increase customer service. By integrating the CRS and PMS through Interact’s AIS, inventories can be
better managed, yields improved, and customer service enhanced.
All reservation traffic is routed from the CRS to individual hotel properties. This allows Interact Systems
to create a database that can be used to track customers and to facilitate marketing programs, such as
frequent stay or VIP programs, as a way of increasing customer satisfaction. Interact forecasts
application integration expenditures in the hospitality industry exceeding $1 billion by 2022.
Greg Thomas founded Interact Systems in 2016 and developed the firm’s middleware software and
hospitality applications. He has twelve years of systems applications experience and currently is
Interact’s Chief Technology Officer. Eric Westskow joined Interact in early 2019 as President and CEO.
Prior to that time, he worked in sales and marketing in the software industry for more than twenty years.
 
Interact Systems’ AIS software development which began in 2016 went through several design changes
in 2017. The first product was sold and installed in 2018. Sales were only $500,000 in 2018. However,
now that the firm has dependable market-tested AIS products ready to be shipped, revenues are
expected to reach $20.8 million in 2022.
Greg Thomas founded Interact Systems with $50,000 of his own savings plus $50,000 from friends. Two
private investors provided an additional $200,000 in 2017. In addition, $1 million was obtained from a
venture capital firm, Katile Capital Partners, in early 2019 in exchange for an equity position in Interact.
The firm currently is seeking an additional $5 million to finance sales growth.
 Case Study
A) Verify the two important trends that are developing in the hotel industry.
i. Hotels are shifting away from the manual booking of room reservations to electronic
bookings. This trend will continue to increase as more bookings are made over the
Internet.
ii. Competitive pressures are forcing hotels to implement yield management programs and
to increase customer service.

B) Describe how Interact Systems’ AIS software products are to benefit the hotel industry from
a profitability standpoint.
• Interact’s Application Integration Server (AIS) provides a two-way interface between
central reservations systems (CRS) and property management systems (PMS). By
integrating the CRS and PMS through Interact’s AIS, inventories can be better managed,
yields improved, and customer service enhanced.

C) Describe how Interact Systems’ AIS software is to help hotels improve customer satisfaction.
• All reservation traffic is routed from the CRS to individual hotel properties. This allows
Interact Systems to create a database that can be used to track customers and to
facilitate marketing programs, such as frequent stay or VIP programs, as a way of
increasing customer satisfaction.
.
 Case Study
D) Describe the life cycle stages that Interact Systems has progressed through to date.
• Interact Systems’ AIS software development which began in 2016, went through several design
changes in 2017 (development stage). The first product was sold and installed in 2018 and
sales were $500,000 in 2018 (startup stage). However, now that the firm has dependable
market tested AIS products ready to be shipped, revenues are expected to reach $20.8 million
in 2022 (survival stage and possibly rapid growth stage).

E) What types of venture financing have been obtained, or are being sought, by Interact?
• Seed Financing: Greg Thomas founded Interact Systems in 2016 with $50,000 of his own
savings plus $50,000 from friends. Two private investors provided $200,000 in 2017.
• Startup Financing: $1 million was obtained from a venture capital firm, Katile Capital Partners,
in early 2019 in exchange for an equity position in Interact.
• First-Round Financing: The firm currently is seeking an additional $5 million to finance sales
growth.

F) Relate major sources or players with the venture financing described in Part E.
• Major sources or players include:
• 2016: Entrepreneur’s assets ($50,000) and friends’ assets ($50,000).
• 2017: Two private investors (business angels) provided $200,000.
• 2019: Venture capital (Katile Capital Partners) provided $1 million.
.
 Case Study
G) What types of agency problems or conflicts should the founding entrepreneur have anticipated?
• Agency relationships arise when principals hire agents to perform specified activities or services.
Businesses are involved in two potentially conflicting relationships: (1) owner-manager conflicts and
(2) manager-debtholder conflicts. At this time, the founding entrepreneur, Greg Thomas, does not
have to worry about manager-debtholder conflicts. He, or the other equity investors, could have a
possible owner-manager conflict with Eric Westskow who joined Interact in 2019 as president and
CEO. Greg Thomas also could have possible conflicts with some or all three groups of investors
(friends, business angels, and venture capitalists) if they believe he is not managing the venture in
their best interests as investors.

H) What, if anything, should the founding entrepreneur have done in anticipation of agency conflicts?
• In order to minimize a possible owner-manager conflict, the president and CEO, Erick Westskow,
when hired in 2019 should have been given an equity stake in Interact so as to align his personal
goals with the financial goal of maximizing the value of the venture.

I) Assuming the venture succeeds, what are the potential advantages to other stakeholders (customers,
employees, and society more broadly)?
• The goal of maximizing the entrepreneurial venture’s value is not inconsistent with ethical behavior
in business practices. Actions by entrepreneurs to increase the value of their ventures also can be
consistent with the good of society. Customers benefit from the development of new ideas,
products, and services. Employees benefit through stable employment, salary increases, and
possibly from increased insurance, medical, and retirement benefits. Society benefits from higher
employment levels and higher gross national product, as well as possibly through charitable
contributions and other forms of venture philanthropy.
 Thank you
Ahmed Khan

WWW.WAIKATO.AC.NZ 0800 WAIKATO

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