How to Create an Effective Business Plan

by Wharton School of Business, September 16, 2010

When an entrepreneur has identified a potential business opportunity, the next step is developing a business plan for the new venture. What exactly should the new plan contain? How can the entrepreneur ensure it has the substance to find interest among would-be investors?

 

Business plans, explains Wharton management professor Ian MacMillan, must contain several crucial elements: They must articulate a market need; identify products or services to fill that need; assess the resources required to produce those products or services; address the risks involved in the venture; and estimate the potential revenues and profits.

Knowledge@Wharton: Professor MacMillan, thank you for speaking with us about the necessity of entrepreneurs writing business plans. To start with a basic question, what exactly is a business plan?

 

Knowledge@Wharton: Could you explain some of these elements in a little more detail and describe how entrepreneurs can develop an effective business plan?

MacMillan: Let me start by saying that you probably want to avoid developing a detailed business plan unless you have done some initial work. Basically what happens is that by doing a little bit of work, you earn the right to do more work. The first thing I would do before you start a business plan is think about a concept statement. A concept statement is about three to five pages that you put together and share with potential customers or investors just to see if they think it's worth the energy and effort of doing more detailed work.

 

The idea is to put together this concept document and begin to share it around with people who are going to have to support your venture if you take it forward. This allows you to rethink as a result of feedback that you get. You might get word back from the various stakeholders – like potential customers or distributors – that this really wasn't such a good idea after all. That saves you the energy and effort of putting together a big business plan.

Knowledge@Wharton: Assuming the concept statement works out and you want to move towards the business plan, what else would you need? And where can you find the information? Some information can be hard to locate, especially about your competitors.

MacMillan: It's really important to go out and speak to your potential customers. You need to find the people who you think will buy your product and talk to them about what dissatisfies them with their current offerings. You should get a sense from them about who is providing the alternative at the moment. Remember, the world has gone for maybe 100,000 years without your idea – and people are getting by; they're not dying. Something out there is servicing their need. So what is the closest competitive alternative to what you want to offer?

That is what you need to find out – and that involves talking and listening. And for all the enthusiasm you have for your venture or your idea, you really need to listen to people who are eventually going to write a check for it.

Before you go on to write a business plan, you have to do some more work. If the concept statement looks good, then the next step is to do a 15- to 20-page feasibility analysis. This means we are now going to take this idea to the next level. We've learned from potential customers and distributors. We've learned who the major competitors are. We've shaped the idea more clearly, and now we're digging deeper.

The next challenge you face is to say, well, if you start this business, what evidence do you have that the market actually wants it? Who do you think would write a check for your product? You need to articulate what makes your product or your service feasible. What has to be done in order to make this thing real?

 

Knowledge@Wharton: Once you have done your feasibility analysis and assuming you get the go ahead from your stakeholders, what is the next step?

MacMillan: The idea of the business plan is to convince the stakeholders. First, what we need to do in a business plan is show that we understand the needs – the unmet needs – of potential customers. Second, we need to understand the strengths and weaknesses of the current most competitive offering out there. Third, we need to understand the skills and capabilities that you and your team have as entrepreneurs. Next we need to understand what the investors need to get out of their investment, because they have to put their money in and they need to have some kind of sense of what they are going to get in terms of returns. In addition, the investment needs to be competitive with alternative investments that the investors might make.

The most important idea in the business plan is to articulate and satisfy the different perspectives of various stakeholders. This process sets in motion some basic requirements in the business plan – to tee up right from the start –evidence that the customer will accept it. Probably a third of the ventures out there that fail are because some person came up with the right product that they thought the world would love and then found out that the customers couldn't care less. What you want to try to do in a business plan is convince the reader that there are customers out there who will in fact buy the product – not because it's a great product, but because they want it and they are willing to pay for it.

Moreover, you need to convince the reader that you have some kind of proprietary position that you can defend. You also need to convince your readers that you have an experienced and motivated management team and that you have the experience and the management capabilities to pull it off. You need to convince potential investors that they are going to get a better return than they could get elsewhere, so you need to estimate the net present value of this venture. You need to show that the risk they are taking will be accompanied by appropriate returns for that risk. If we look at the contents of a typical business plan, you need to be able to articulate all these issues in some 25 to 30 pages. People get tired if they have to read too much.

Now let's look at the various components of the business plan document:

First, you need an executive summary that grabs the attention of the potential investor. This should be done in no more than two pages. The executive summary is meant to convince the potential investor to read further and say, “Wow! This is why I should read more about this business plan.”

Next, you need a market analysis. What is the market? How fast is it growing? How big is it? Who are the major players? In addition, you need a strategy section. It should address questions such as, “How are you going to get into this market? And how are you going to win in that marketplace against current competition?”

After that, you need a marketing plan. How are we going to segment the market? Which parts of the market are we going to attack? How are we going to get the attention of that market and attract it to our product or service?

You also need an operations plan that answers the question, “How are we going to make it happen?” And you need an organization plan, which shows who the people are who will take part in the venture. You need to list the key events that will take place as the plan unfolds. What are the major things that are going to happen? If your plan happens to be about a physical product, are you going to have a prototype or a model? If it happens to be a software product, are you going to have a piece of software developed – a prototypical piece of software? What are the key milestones by which investors can judge what progress you are making in the investment? Remember that you will not get all your money up front. You will get your funds allocated contingent on your ability to achieve key milestones. So you may as well indicate what those milestones are.

You should also include a hard-nosed assessment of the key risks. For example, what are the market risks? What are the product risks? What are the financial risks? What are the competitive risks? To the extent that you are upfront and honest about it, you will convince your potential investors that you have done your homework. You need to also be able to indicate how you will mitigate these risks – because if you can't mitigate them, investors are not going to put money into your venture.

After that, what you get down to is a financial plan where you basically do a five-year forecast of what you think the finances are going to be – maybe with quarterly data or projections for the first two years and annual for the next three years.

You need a pro forma profit and loss statement. You need a pro forma balance sheet if you have assets in the balance sheet. You need to have a pro forma cash flow. Your cash flow is important, because it is the cash flow that kills. You may have great profits on your books but you may run out of money – so you need a pro forma cash flow statement. And you need a financing plan that explains, as the project unfolds, what tranches of financing you will need and how will you go about raising that money.

Finally you need a financial evaluation that tells investors, if you make this investment, what is its value going to be to you as an investor. That is basically the structure of the plan.

Knowledge@Wharton: Let's say you have written a business plan and presented it to your investors. How closely do you have to be tied to the plan? Does it mean that once you are executing against the plan, you should reject new opportunities you find because they are not part of your plan? Or should you build in some flexibility that allows you to explore emerging opportunities?

MacMillan: The thing about most entrepreneurial ventures is that your outcome is uncertain – because what you are doing is very new. It is very, very hard to predict what the actual outcome is going to be. One of the most fundamental flaws is that in the face of unfolding uncertainty, you single-mindedly and bloody-mindedly pursue the original objective.

The reality is that the true opportunity will emerge over time. What venture capitalists do is they will put a small amount of money into the project, allow the entrepreneur to enter that market space and then – contingent on performance and contingent on what apparent traction you can get in that market space – completely re-plan to find out what the true opportunity really is. It is insanity to insist that people actually meet their plan as it was originally written.

This doesn't mean you compromise your objectives. The idea is that I want to keep on trying to meet my objectives, but how I meet them must change as the plan unfolds. That's basically what led to all the work objectives, but how I meet them must change as the plan unfolds. That's basically what led to all the work that Wharton has done in the last few years on discovery driven planning. It's a way of thinking about planning that says, “I'm going to make small investments. If I'm wrong early, I can fail fast, fail cheap and move on. But as I find out what the true opportunity is, I can aggressively invest in what this opportunity is.”

Knowledge@Wharton: Could you give an example of a company that has used this discovery-driven planning process to take its business to the next level?

MacMillan: One company that has done the most in this area is Air Products. What they have been able to do is use discovery-driven planning to unfold completely different businesses from the ones that they were in. Air Products makes things like carbon dioxide and oxygen and nitrogen. It is a very old-line company. Using discovery-driven planning, they have been able to move aggressively into, for instance, the service sector. Once they recognized that they were able to deliver reliably and predictably in the face of uncertain demand, they developed a set of skills that allowed them to enter the service business where the return on investment and return on assets are far higher than putting a huge plant in place.

 
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