CHAPTER 1
SMALL BUSINESS AND THE ENTREPRENEUR

1.1 What is Entrepreneurial Finance?

Finance, technically, refers to any transaction of money, or money-related medium of exchange and monetary measurement. More broadly, finance can be considered the art and science of money handling and capital management. Its significance lies in the understanding of how money works in a society, and how it is related to economic and legal systems, given the society's rules and regulations, and the structure of its financial institutions. The ultimate goal of finance is to achieve the highest efficiency in the way of using funds regardless of the nature and direction of the utilization of money. In this sense, and in the business domain, financial management would represent the firm's responsibility to plan, acquire, and manage capital to efficiently run the business as well as to grow it and further invest in its capital.

Entrepreneurial finance is the third major field of finance along with personal finance and corporate finance. It is all about applying the fundamental financial principles and basic theories in the domain of new and small-scale business firms. Furthermore, it is adapting those principles and theories for planning and developing, starting up, operating, growing and maturing, valuing, and harvesting entrepreneurial business projects. The nature, needs, and dynamics of a new venture and the entrepreneurial aspect are what primarily characterize and identify entrepreneurial finance and distinguish it from other finance fields. What remains common ground is the decision-making although it is different by nature and scope from finance field to another. In entrepreneurial finance, entrepreneurs and managers make decisions to finance, establish, and run a new business project, while in corporate finance, the chief financial officer and his team make decisions to generate, manage, and monitor the flow of public funds in a corporation. To a smaller and individual scale, a consumer would make all the financial decisions for himself and family, but the basic financial principles remain very close, and the field becomes personal finance.

The attention to the entrepreneurial aspects of a business project, especially during its planning phase, start-up, and early stages of production dictates the divergence in the application of the financial principles in a theoretical and practical mix with the concept of entrepreneurship. The following points highlight where entrepreneurial finance stands in comparison with other fields of finance:

• Entrepreneurial finance is directly related to a smaller scale and privately owned and managed business firms.
• Entrepreneurial finance focuses more on the establishment phase and continues to monitor the financial progress of the business project, build its value, and guide it through the end.
• In entrepreneurial finance, the investment value and gains are driven by the entrepreneur's own interests and incentives, while in corporate finance, investment value and returns are to reward the shareholders.
• Related to the previous point, entrepreneurial finance utilizes the managerial efforts of entrepreneurs, venture capitalists, angle investors, and other highly motivated investors who have high stake in building a new business and take it to its efficient performance. In corporate finance, investment and managerial decisions are made by professionals within the corporations, not by the shareholders.
• Another implication of the differences in investment nature and purpose is the weaker need for diversification for the entrepreneur in entrepreneurial finance tradition, and the reason is that the new venture takes a central importance for the entrepreneur, if not the only project that sucks in all investments. In corporate finance, diversification of investment is essential.
• Due to the differences in scale and nature of the operational business domains, some major financial theories in corporate finance may not fit well in entrepreneurial finance. Examples are Capital Asset Pricing Model (CAPM), efficient market hypothesis, and portfolio theory. Also, some concepts and operational terms may not be relevant in entrepreneurial finance such as those that are related to the stockholder's dividends like earnings per share, price-earnings ratio, some tax codes, and even some rules of the U.S. Securities and Exchange Commission.
• Other implied differences between entrepreneurial and corporate finance are manifested in the differences in the role and significance of cash, capital structure and ways of raising capital, capital market, project financing time frame, and on the impact of business downsizing on the owners and investors.
• Last but not least, entrepreneurial finance deals with a new venture that requires a different type of harvesting. Venture capitalists and entrepreneurs assess the potential value of investing in a project based on possible liquidity events that they expect to maximize their returns. Contrary to that, in corporate finance, investment projects are evaluated based on the calculated expected cash inflow throughout the life of the project, as well as the capital gains earned through the re-sold business shares.

In conclusion, entrepreneurial finance and corporate finance are generally different domains, based on the size and nature of financial resources as well as according to the ways to acquire, grow, manage, and evaluate these resources. They also have different audience, while corporate finance deals mostly with the big and most powerful corporations, entrepreneurial finance deals with entrepreneurs and individual private investors.

1.2 Significance of the Small Business

According to the Small Business Administration (SBA), the term "small business" refers to an American entity operating primarily within the United States and is

• organized to pursue profit;
• contributing to the US economy through its use of material, labor, products, and its payment of taxes;
• owned and operated privately and independently;
• not dominant in its field on a national basis.

As for the size of business, the SBA has established numerical standards to define how small is a small business, depending on the type of industry to which the business belongs. The size standard is based either on the number of employees or on the dollar amount of annual sales. Table 1.1 shows a summary of the size standards for a small business according to the type of industry. When the number of employees is the criteria, a wholesale business would be considered small if it employs up to 100 employees, while in 75% of manufacturing and mining industries, a business is small if it employs up to 500 employees. For the minority of 25% of manufacturing, a small business would be the firm that employs up to 1500 employees. The rest of the categories in the table go by the volume of annual sales as criteria for being small business, starting from an annual sale of $750,000 in agriculture to $35,500,000 in some services. The primary purpose of these standards is to determine eligibility for SBA's financial assistance as well as for the federal government procurement programs to provide help for small businesses.

Table 1.1 Size Standards for Small Business

• Agriculture
• Wholesales
• Retails
• Manufacturing and mining
  • 75% of industry
  • 25% of industry
• Construction
  • Land subdivision
  • Special trade contractors
  • Dredging
  • Heavy construction
• Services
  • Computer programming, data processing, and systems analysis
  • Other services

 100

500

               750-1500

750,000

7,000,000

7,000,000

14,000,000

20,000,000

33,500,000

7,000,000

25,500,000

35,500,000

Small business forms the backbone of the US economy and is credited for much of its strength and success. As shown in Figure 1.1, a little more than half of all small businesses in the United States are in the service sector while the other half is distributed on other sectors such as wholesales and retails 17%, construction 13%, real estate and insurance 9%, manufacturing 6%, and others 4%. They constitute more than 95% of the country's 25 million non-farm firms, employing about 53% of private non-farm workforce. They spend more than $100 million annually and are responsible for providing 52% of the private gross domestic product. As for new job creation, small businesses create 79% of the new jobs annually, as compared to large firms that provide only 21% of those new jobs in the economy. They also provide 67% of on-the-job training, and generate a significant number of patents per employee that is estimated as 17 times more than...